The Journal of Developing Areas Volume 49
No. 4
Fall 2015
PAKISTAN’S POTENTIAL EXPORT FLOW: THE GRAVITY MODEL APPROACH Shujaat Abbas University of Karachi, Pakistan Abdul Waheed University of Bahrain, Bahrain
ABSTRACT Pakistan is facing a chronic trade deficit due to highly concentrated nature of its international trade. The exports are dependent on some lower value added agriculture and manufacturing industries, and are directed toward few trading partners. The high concentrated nature of exports result in higher vulnerability and dependence of the economy. Pakistan has signed regional and bilateral free trade agreements for diversification of its exports and markets. These free trade agreements significantly have distorted the trade balance due to relatively lower international specialization level. The trade theories and empirical studies urge achievement of competitive specialization in diversified exports and markets. This study attempts to investigate the macroeconomic behavior of export flow and export potential of Pakistan with its trading partners employing the augmented gravity model using panel data from its 40 trading partners for the period 1991-2011. The dependent variable is merchandise exports flow, which is explained by the domestic supply capacity, demand potential of trading partners, relative price level and binary variables for free trade agreements, common language and common border. The model is then used to investigate potential markets for exports by Pakistan and provides a framework for export and market diversification. The annual data for this study is available in the Statistical Year Book of Pakistan, World Development Indicators, and International Financial Statistics. The results show that Pakistan’s export is positively affected by its supply capacity and partner country’s demand potential as well as market size, whereas negatively affected by the geographical distance. The domestic supply capacity shows the highest possible effect. The relative price shows significant positive, but less elastic impact. The common language shows significant positive impact while common border shows negative impact. The free trade agreements of Pakistan show negative insignificant impact. The result of export potential shows that the Pakistan has higher export potential with India, Philippines, Japan, Singapore, Malaysia and Indonesia, in Asia. Morocco, Egypt and Tanzania, in Africa. New Zealand and Australia, in Oceana. Hungary, Austria, Switzerland, Finland, Norway, Denmark and Sweden, in Europe. Europe emerged as the most potential region for Pakistan’s exports. The policy implications of this study are that Pakistan needs to develop and diversify its industries targeting market fundamentals of potential economies, and revisit its regional and bilateral free trade agreements with a view to improving the trade balance and achieving sustainable economic development.
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JEL Classifications: C23. F12. F14. F15 Keywords: Gravity model, panel data, export potential, economic integration Corresponding Author’s Email Address:
[email protected]
INTRODUCTION International trade is an important factor for the achievement of sustainable economic development. The export growth acts as an engine for economic growth. The export-led growth hypothesis urges greater economic integration and expansion of exports for the achievement of sustainable economic growth in both short run and long run (Fedar 1983; Esfahani 1991; Barro 1991; Abbas 2012). The globalization and corresponding increase in international competition significantly distorted trade balance and economic growth in developing economies, and urged achievement of competitive specialization level (Greenaway et al. 2002; Abbas, 2014). Pakistan is home of 190 million people and is a small open economy due to the significantly lower contribution to the world trade. The total merchandise exports are only 0.138 percent of the world total exports. The major problem with exports by Pakistan lies in highly concentrated nature of its trade. The exports are dependent on the few lower value added agriculture and manufacturing industries. The agriculture and textile sector comprises more than 80 percent of total merchandise exports. The flow of exports is directed toward few trading partners. Five major trading partners account for 35.4 percent of total merchandise exports, among which the USA accounts for 15.9 percent. The highly concentrated nature of export of few commodities and markets results in high vulnerability and dependence of the economy. The trade theories and empirical studies urge achievement of competitive specialization in diversified exports and markets. Pakistan signed regional free trade agreement (FTA) with members of South Asian nations and several bilateral FTAs for diversification of its export markets. The list of selected trade agreements is presented in the table 1. TABLE 1 FREE TRADE AGREEMENTS Regional/ Bilateral Trade Agreements South Asian Free Trade Area (SAFTA)
Joining 2004
Pakistan – Sri Lanka Free Trade Agreement
2005
Pakistan – China Free Trade Agreement
2006
Pakistan – Malaysia Free Trade Agreement
2007
Pakistan – Mauritius Free Trade Agreement
2007
Source: Ministry of Trade and Commerce, Government of Pakistan
These FTAs distorted the trade balance of Pakistan by approximately 16.9 billion USD. The FTA with China alone costs 6.36 billion USD, which is followed by FTA with South Asia and Malaysia. The distorted trade balance indicates a significantly lower specialization level of Pakistan with respect to the countries involved. It is, therefore, essential to find out the determining factors of Pakistan’s exports flow to analyze its behavior for the enhancement of specialization level.
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This study attempts to investigate the macroeconomic behavior of Pakistan’s exports to its trading partners by augmenting standard gravity equation with relative prices and dummy variables for free trade agreements, common language and common border. It also investigates potential markets for exports by Pakistan and provides a framework for export and market diversification based on market fundamental of potential economies. This paper is comprised of five sections. Following introduction, the section two discusses theoretical foundation and reviews the empirical applications of the Gravity model. Section three presents research methodology and data sources. Section four discusses estimated results of the model and potential export markets for Pakistan. Section five concludes the study with policy implications. LITERATURE REVIEW History The gravity model describes the most stable relationship in economics, that is, the interaction between the large economies is stronger than that between the smaller ones, and nearer economies attract more than far off ones. The distance is a very broad concept as it reflects geographical distance, transportation cost, and other tariff and non-tariff trade barriers. The gravity model has a long history. Revenstein presented the early cogent narrative of the gravity model in 1885. Isard and Pack (1954) came closer to the standard gravity equation by empirically demonstrating negative impact of distance. They used the metaphor “electric potential” rather than gravity. The group of Dutch economists headed by Tinbergen presented the mathematical formulation and empirical application of gravity model in 1962 for the first time. He supervised Linnemann’s PhD thesis on gravity model in 1966, which became a standard reference to the early version of the model. These early contributions laid foundation of the gravity model to explain bilateral trade and capital flow, (see, Bergeijk & Brakman 2010). The standard version of gravity model is presented as follows 𝛽
𝑇𝑖𝑗 =
𝐺𝐷𝑃𝑖𝛼 . 𝐺𝐷𝑃𝑗 𝐷𝑖𝑗𝜗
(1)
Where: Tij indicates bilateral trade flow between country “i" and “j”, GDP i indicates supply capacity of exporter “i" measured in million of real GDP, whereas, GDPj indicates market demand potential and Dij presents bilateral distance. The parameters, 𝛼, 𝛽 and 𝜗 are often estimated in log-linear form. Theoretical Foundations The gravity model of trade flow introduced by Tinbergen in 1962 lacks theoretical foundations due to absence of price specification. Linnemann (1966) attempted to provide a theoretical argument by deriving gravity equation using the quasi-Walsarian model. Neither he nor Pöyhönen (1963) succeeded to provide any solid theoretical foundations. Anderson (1979) provided microeconomic foundations of gravity equation using constant elasticity of substitution (CES) utility function. He showed how the gravity model fit into
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an optimization framework. Bergstrand (1985, 1989 and 1990) extended microeconomic foundations by incorporating complex prices term in the model. He established relationship between the trade theory and bilateral trade flow by explicitly including both demand and supply side factors. The income of importing country acts as market demand and income of the exporting country reflects the supply capacity, whereas distance reflects transportation cost. Anderson and Wincoop (2003) extended theoretical foundation by introducing methods to deal with complicated price term in the model. Applications of the Gravity Model International Applications The model is widely used in empirical research due to its high explanatory power and strong theoretical foundations. Baier and Bergstrand (2001) investigated the macroeconomic impact of relative income growth, transportation cost reduction, tariff liberalization, and income convergence on trade flow among OEDC countries using the augmented gravity model. The result showed that 67 percent of trade among OEDC countries was explained by an increase in the rate of economic growth rate, 25 percent by a reduction in tariffs, and 8 percent by a reduction in transportation cost. The findings showed that income convergence had no effect on bilateral trade flow. Leitao (2010) attempted to investigate the macroeconomic determinants of trade flow from the USA to European Union, NAFTA, and ASEAN countries using the augmented gravity model. The finding showed that the bilateral trade flow was positively determined by GDP, population, FDI, per capita income differential, while negatively determined by the distance. The dummy variable for bordering countries also showed significant positive impact. The positive impact of per capita income differential indicates that the trade flow of the USA follows Linder hypothesis. Nsiah et al. (2012) investigated the manufacturing export performance of 50 U.S. states in 20 Asian markets employing the gravity model using panel data for the period from 1999 to 2005. They also investigated what determined whether a state under or over performed in manufacturing exports to the Asian market. The estimated results revealed that a state’s manufacturing union density, infrastructure, legal system, tax rate, employment density, pollution abatement cost, and regional location significantly impacted on whether the state would under or over perform vis-à-vis its export potential. Hatab et al. (2010) attempted to investigate macroeconomic determinants of the Egyptian agricultural export to its major trading partners using gravity model. The findings revealed that the Egyptian agricultural export flow was positively determined by real exchange rate and per capita GDP of trading partner, whereas distance had ssignificant negative impact on export flow. He justified negative impact of Egypt’s per capita GDP on export flow by urging the increase in per capita demand for all normal good. Nguyen (2010) investigated Vietnam’s export flow to its fifteen major trading partners using the static and dynamic panel augmented gravity approach for the period from 1986 to 2006. The estimated result revealed that the export flow of Vietnam was positively determined by its own lag value, domestic income level, income of partner economy, and real exchange rate. The distance variable showed significant negative impact on its export flow. The dummy variable ASEAN depicted the negative insignificant impact showing independence of Vietnam’s export flow. It urged currency devaluation and export to close economies.
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Batra (2004) attempted to investigate the behavior of Indian trade with 146 trading partners employing the augmented gravity model using cross sectional data for the period of 2000. The ordinary least squares estimation technique was used to explain the macroeconomic behavior of trade flow. The finding revealed that the trade flow of India was determined by income, geographical distance, cultural and historical characteristics. He found highest trade potential of India with China, UK, Italy, and France. Among the countries with trade agreements, India had high trade potential with Pakistan in SAARC, and Cambodia and Philippines in ASEAN. Rahman (2010) investigated the macroeconomic determinants of Bangladesh’s exports employing the generalized gravity model using panel data. He performed sensitivity analysis to check robustness and fragility of the estimated coefficients. The estimated results showed that the main contributors to Bangladesh’s export flow were the exchange rate, import demand by the partner countries, and openness of the Bangladesh’s economy, whereas the transportation cost had insignificant negative impact. He, therefore, urged reduction in trade barriers, competitive devaluation of currency, and improvement in product quality and variety. National Applications In Pakistan there are few notable studies which attempted to address the behavior of its export flow using the gravity model. Khan and Mahmood (2000) investigated the relationship between the trade flow (export and import of 10 commodities) of Pakistan and economic, geographic, border, cultural factors, and common language employing the augmented gravity model using cross sectional data for the period of 1985, 1990 and 1994. The result revealed that the domestic GDP and GDP of trading partner positively affected bilateral trade flow, whereas distance affected negatively. The real exchange rate and the common language (English as the official language) showed significant positive impact, whereas tariffs and border dummy showed significant negative impact. Achakzai (2006) attempted to investigate trade flow of Pakistan with nine ECO countries employing the augmented gravity model using panel data. The result revealed significant positive impact of ECO on intra-regional trade flow. The predicted value of inter-ECO trade was significantly higher than the actual value of trade flow, suggesting greater scope for regional integration. Butt (2008) investigated export potential of Pakistan with its trading partners employing the gravity model using cross-sectional data from 132 exporting and 154 importing countries. The finding revealed that domestic GDP, GDP of importing countries, and real exchange rate positively affected export flow, whereas distance and tariffs affected negatively. The analysis of export potential showed the highest export potential with India, Japan, Hong Kong, and China, whereas exhausted potential was observed with USA, UK, Bangladesh and Turkey. Gul and Yasin (2011) attempted to investigate trade flow of Pakistan with its 42 trading partners employing the augmented gravity model using panel data for the period from 1981 to 2011. The result revealed expected impact of selected macroeconomic variables, except negative border dummy indicating political tension with bordering economies. The trade potential of Pakistan showed the highest potential with selected ASEAN, EU, Middle East, Latin America, and North American economies, whereas lower trade potential was observed with SAARC and ECO nations. They urged settlement of political tension for expansion of trade with SAARC, ECO, NAFTA, and EU.
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This study investigates macroeconomic determinants and export potential of Pakistan with its 40 bilateral trading partners employing the augmented version of gravity model using panel data. It thus provides a framework for exports and market diversification based on market fundamentals of potential economies. EMPIRICAL METHODOLOGY Modeling Export Flow This section discusses the macroeconomic behavior of Pakistan’s export flow to its trading partners employing the augmented gravity model using panel data of 40 cross sections for the period from 1991 to 2011. The panel random effect estimation technique is used to investigate the macroeconomic impact of selected explanatory variables on bilateral export flow. The standard gravity equation argues that the bilateral export flow is positively determined by size of the economy and negatively by bilateral distance. The standard gravity model is presented as follows 𝐿𝑛𝐸𝑥𝑖𝑗𝑡 = 𝛽0 + 𝛽1 𝐿𝑛(𝐺𝐷𝑃𝑖. 𝐺𝐷𝑃𝑗)𝑡 + 𝛽2 𝐿𝑛𝐷𝑖𝑗 + 𝜇𝑡
(2)
Where, 𝐸𝑥𝑖𝑗𝑡 is export flow from the country i to partner country j. (𝐺𝐷𝑃𝑖. 𝐺𝐷𝑃𝑗)𝑡 is the product of size of the economy, and 𝐷𝑖𝑗 is the bilateral distance in Km. We augmented the standard gravity equation by addition of relative prices, and dummy variables for FTAs, common language, and bordering countries. The augmented version of the gravity model is presented as follows 𝐿𝑛𝐸𝑥𝑖𝑗𝑡 = 𝛽0 + 𝛽1 LnGDPit + 𝛽2 𝐿𝑛𝐺𝐷𝑃𝑗𝑡 + 𝛽3 𝐿𝑛𝑃𝑜𝑃𝑗𝑡 + 𝛽4 𝐿𝑛𝐷𝑖𝑗 + 𝛽5 𝐿𝑛𝑅𝑃𝑖𝑗𝑡 + 𝛽6 𝐵𝐷𝑅𝑖𝑗 + 𝛽7 𝐶𝐿𝐴𝑁𝐺𝑖𝑗 + 𝛽8 𝑃𝑇𝐴𝑖𝑗 + 𝜔𝑖𝑡 (3) Where, GDPi is domestic income level; GDPj and PoPj are the income level and population of trading partners respectively; RPij is relative price level; BDRij and CLANGij are dummy for countries with common border and language respectively. The PTAij is a binary variable for countries with preferential trade agreements, whereas 𝜔𝑖𝑡 is composite error term. As per standard gravity model parameters 𝛽1 and 𝛽2 are expected to be positive, and 𝛽4 is expected to be negative. The relative price level is calculated using the bilateral nominal exchange rate and price ratios. 𝑅𝑃𝑖𝑗 = 𝐸𝑅𝑖𝑗 ×
𝐶𝑃𝐼𝑗 𝐶𝑃𝐼𝑖
(4)
Where, ERij is the bilateral nominal exchange rate; CPIi is domestic price level, and CPIj is the price level of trading partners. The parameter 𝛽5 is, therefore, expected to be positively associated. The distance negatively affects trade flow, and therefore, the parameter 𝛽6 is expected to be positively associated. The common language parameter 𝛽7 , according to Egger and Lassmann (2012), is expected to be positive. The parameter of FTAs 𝛽8 is also expected to be positively associated with Pakistan’s exports.
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Estimation of Export Potential The result obtained from the augmented gravity equation 3 is subject to evaluation of the forecasting efficiency. The estimated efficient coefficients are then used to evaluate the export potential of Pakistan with its 40 bilateral trading partners based on actual and forecasted values of export flow. The export potential is estimated as follows 𝐸𝑥𝑃𝑖𝑗𝑡 =
̅̅̅̅𝑖𝑗𝑡 ∑ 𝐸𝑥 ∑ 𝐸𝑥𝑖𝑗𝑡
(5)
̅̅̅̅𝑖𝑗𝑡 is predicted or forecasted value; and ∑ 𝐸𝑥𝑖𝑗𝑡 Where, 𝐸𝑥𝑃𝑖𝑗𝑡 is export potential; ∑ 𝐸𝑥 represents the actual value of export flow. The value 𝐸𝑥𝑃𝑖𝑗𝑡 > 1 indicates that the actual export performance is less than predicted, showing untapped potential, whereas the value 𝐸𝑥𝑃𝑖𝑗𝑡 < 1 indicates that the actual export flow is greater than predicted, and showing exhausted potential. The value 𝐸𝑥𝑃𝑖𝑗𝑡 = 1 indicates that both the actual and the predicted values are equal. Data Sources The data for this study are collected from various national and international sources. The annual data of Pakistan’s exports to its 40 trading partners, reported in the appendix, are collected from various issues of the Statistical Year Book, published by the government of Pakistan. The data on GDP, population, and nominal exchange rate are collected from the World Development Indicators, published by the World Bank. The data of CPI are taken from the International Financial Statistics, published by the World Bank. The data of bilateral distance in Km from the capital cities of the trading partner countries are taken from www.indo.com/distance. The data on dummy variable for FTAij countries are generated valuing 1 when Pakistan signed free trade agreement with its trading partners and 0 otherwise. Similarly, the data on CLANGij and BDRij are generated valuing 1 if trading partners have the same language or share a common border and 0 otherwise. RESULTS This section discusses the methodology used to estimate the macroeconomic determinants of export flow and export potential of Pakistan with its bilateral trading partners. Determinants of export flow The macroeconomic behavior of Pakistan’s exports to its bilateral trading partners estimated using the augmented gravity model employing panel random effect estimation technique, eq. 3, is reported in the table 2.
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TABLE 2 THE RESULTS OF GRAVITY MODEL Explanatory Variable
Dependent Variable: Ln Xij Coeff. t-stat. -13.040* -6.293 2.422* 12.545 0.436* 3.899 0.139** 1.953 -1.057** -2.432 0.036*** 1.886 -0.178 -0.445 0.599** 2.141 -1.693** -2.310
p-value 0.000 Constant Ln GDPi 0.000 Ln GDPj 0.000 Ln PoPj 0.051 Ln Dij 0.015 Ln RPij 0.059 FTA 0.656 CLANG 0.032 BDRij 0.021 Diagnostic Tests Adjusted R2 0.713 134.171 F-stat. U-Coeff. 0.057 MAPE 19.285 Variance proportion 0.031 Bias Proportion 0.000 Source: Authors’ estimation. Note: *, **, and *** indicate significant at 1, 5 and 10 percent respectively
The result shows that Pakistan’s export flow is positively determined by its supply capacity and partner country’s demand potential as well as market size, whereas negatively determined by the geographical distance. The domestic supply capacity shows the highest possible effect. The one percent increase in GDPi results in increase in exports by 2.42 percent, whereas an increase in GDPj and PoPj results in increase in exports by 0.44 and 0.14 percent respectively. The relative price shows significant positive but less elastic impact. One percent increase in the relative price is associated with an increase in exports by only 0.04 percent. The result of CLANG shows significant positive impact while common border shows negative impact. It implies that Pakistan tends to export more to the countries that have a common language (English official or native language), and its exports to the bordering economies are significantly lower than predicted value. The result of free trade agreements shows negative insignificant impact, indicating the destructive impact of these free trade agreements on Pakistan’s exports. The log linear model is used to the address the problem of heteroskedasticity and serial correlation in the panel regression models. The value of adjusted R 2 shows that 71 percent variation in export flow is explained by these eight explanatory variables. The value of the F-statistic shows the goodness of fit of the regression model. The forecasting efficiency of the model is evaluated using Mean Abs. Percent Error, MAPE, Thiel Inequality Coefficient, U-Coff., and corresponding Bias and variance proportion. The result of diagnostic tests suggests using the model for evaluation of export potential. Export Potential The export potential of Pakistan with its bilateral trading partners determined using the predicted and the actual value of export flow, eq. 5, is reported in the table 3.
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TABLE 3 THE EXPORT POTENTIAL OF PAKISTAN Bilateral Trading Partners
Export Potential 1991-00
2001-11
Asian Partners
Export Potential
Bilateral Trading Partners
1991-00
2001-11
Panama
0.90**
0.91**
Bangladesh
0.97**
0.974**
Guatemala
1.12*
1.06*
Sri Lanka
0.76**
0.79**
Argentina
1.13*
1.17*
China
0.83**
0.79**
Chile
0.87**
0.73**
India
1.50*
1.34*
Africa
Malaysia
1.06*
1.05*
Mauritius
0.53**
0.64**
Hong Kong
0.64**
0.74**
Tanzania
0.94**
1.07*
Japan
0.92**
1.19*
Egypt
1.79*
1.22*
Philippines
1.26*
1.22*
Kenya
0.86**
0.58**
Singapore
0.89**
1.05*
Morocco
2.23*
1.45*
Indonesia
0.91**
1.04*
Europe Belgium
0.78**
0.81**
Middle East Saudi Arabia
0.90**
0.92**
Denmark
1.07*
1.14*
UAE
0.75**
0.76**
France
0.91**
0.96**
Bahrain
0.99**
0.97**
Norway
1.16*
1.19*
Iran
0.79**
0.81**
Netherlands
0.86**
0.84**
United Kingdom
0.92**
0.91**
Oceana Australia
1.02*
1.015*
Germany
0.86**
0.92**
New Zealand
0.98**
1.02*
Austria
1.38*
1.43*
Fin Land
1.62*
1.37*
America United States
0.86**
0.83**
Sweden
0.98**
1.09*
Canada
0.95**
0.98**
Switzerland
1.25*
1.40*
Mexico
2.32*
1.12*
Hungry
1.97*
1.43*
Source: Authors’ estimation. Note: * Indicates high export potential, whereas, ** Indicates exhausted export potential.
The result shows that in Asia, Pakistan has high export potential with India, Philippines, Japan, Singapore, Malaysia, and Indonesia. Among these potential economies, an increasing trend is observed in Singapore and Indonesia, whereas, India, Malaysia, and Philippines show deteriorating behavior. Pakistan has exhausted its export potential with Sri Lanka, Hong Kong, Bangladesh, and China. In Africa, it has high export potential with Morocco, Egypt, and Tanzania, whereas exhausted potential is observed in Kenya and Mauritius. In Oceana, it has high trade potential with both New Zealand and Australia. New Zealand depicts increase in trade potential, whereas Australia shows decrease. The Europe emerged as the most potential region. Pakistan has high trade potential with
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Hungary, Austria, Switzerland, Finland, Norway, Denmark, and Sweden in Europe. The finding urges Pakistan to develop domestic supply potential and diversify its exports to potential economies. CONCLUSIONS This study investigates macroeconomic behavior of export flow and export potential of Pakistan with its bilateral trading partners employing the augmented gravity model using panel data from 40 trading partners for the period 1991-2011. The standard gravity model is augmented by addition of relative prices and dummy variable for free trade agreements along with border and common language dummies. The results show that the domestic supply capacity (GDPi) and the partner countries’ demand potential (GDPj) and market size (PoPj) have significant positive impact on Pakistan’s export flow, whereas bilateral distance shows significant negative impact. The relative price shows positive but less elastic impact with the elasticity of only 0.04 percent. The dummy variable of common language shows significant positive impact on export flow, whereas the border dummy has significant negative impact. The result of free trade agreements of Pakistan shows negative but insignificant impact. The estimated result of export potential shows potential export markets. The Europe and Asia emerged as the highest potential regions for Pakistan’s exports. The policy implications of this study are that Pakistan needs to develop and diversify its industries targeting market fundamentals of potential economies, and revisit its regional and bilateral free trade agreements with a view to improving the trade balance and achieving sustainable economic development. The study urges the necessity of carrying out another study that would determine inter- and intra-industry trade of Pakistan with its trading partners and provide a complete pattern of bilateral trade flow.
APPENDIX BILATERAL TRADING PARTNERS OF PAKISTAN Region
Countries
Asia
Bangladesh, India, Sri Lanka, Indonesia, Malaysia, Singapore, Philippines
Middle East America Europe Africa Oceana
Bahrain, Iran, Saudi Arabia, UAE USA, Canada, Mexico, Panama, Guatemala, Argentina, Chile Belgium, Denmark, France, Netherlands, United Kingdom, Germany, Austria, Finland, Sweden, Switzerland and Hungry Mauritius, Egypt, Tanzania, Kenya, Morocco New Zealand, Australia
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