Download Validity of Twin Deficit Hypothesis: Evidence from Asian Developing

Validity of Twin Deficit Hypothesis: Evidence from Asian Developing
Countries using Panel Data
Md. Nurul Hoque1
K.M. Zahidul Islam2
Khandaker M. A. Munim3
Abstract
This paper aims to empirically test the validity of twin deficit hypothesis in 14 developing Asian countries.
Advanced panel data models were estimated to investigate the extent of influences of government budget deficits on
the countries' current account deficits covering 22 years from 1990 to 2012. After necessary diagnostic checks,
different estimation techniques such as random effects (e.g., FGLS), fixed effects, and OLS regression appeared to
be suitable for different sub-samples. Estimated results provide evidence to support the view that Asian budget
deficit causes current account deficit, directly controlling for other variables viz. broad money supply, per capita
income, and trade-GDP ratio. Estimated results suggest that a 1 unit change in the government budget deficit, on
average, translates into 0.31 units of current account deficit, thereby supporting the twin deficit hypothesis, but not
conforming to the theory of Ricardian Equivalence. This effect is substantially larger for South Asian countries than
that obtained from East Asian countries. The study also finds significant impacts of other explanatory variables
included in the model across different sub-samples. From policy perspectives, the statistical analysis suggests that
managing budget deficit offers ample scope for improvement in the current account deficit and thereby recommends
devising appropriate policy mix to handle the issue of external imbalance in the selected developing Asian countries.
Keywords Twin Deficit, Recardian Equivalence, Panel Data Models, FGLS, Developing Asia.
JEL Classification: F32, F41, E62, H62.
1. Introduction:
The studies focusing on the relationship between budget deficit and current account deficit relies
on two main theoretical ideologies-the Keynesian conventional approach, also called the twin
deficit hypothesis (TDH), and the Ricardian equivalence hypothesis (REH). In Keynesian view,
budget deficit affects current account deficit and, it is presumed that there is a causality running
from budget deficit towards current account deficit. The positive relationship between budget
1
Assistant Professor, Department of Economics, Jahangirnagar University, Savar, Dhaka-1342; Email:
[email protected]
2
Associate Professor, Institute of Business Administration, Jahangirnagar University, Savar, Dhaka-1342. E-mail:
[email protected]
3
Associate Professor, Department of Economics, Jahangirnagar University, Savar, Dhaka-1342; Email:
[email protected]
1
deficit and current account deficit is explained with TDH, which posits that an increase in budget
deficit will cause a similar increase in current account deficit. Unlike the Keynesian view, the
REH, however, supports the notion that there exists no such relationship between budget deficit
and current account deficit.
The twin deficit model is one of the most important macroeconomic identities, providing a clear
indication of macroeconomic management of a particular nation. Apart from this, it also tells us
that a country’s private, public and external sectors are immensely interdependent. It is
commonly assumed that a large budget deficit may pave the passage for economic instability and
in the same vein may lead a sharp increase in current account deficit and rate of interest and a
reduction in aggregate demand, leading to a reduction in investment. This may, in turn, increase
unemployment and impede the long-term economic growth. However, policy makers,
particularly of developing countries, are persistently failing to address this important aspect of
macro-relations and are putting all efforts to manage each sector independently. The aftermaths
of these types of insouciant and inappropriate policies include debt crisis, inflation,
unemployment and vulnerabilities in both external and public sectors.
Studies supporting the twin deficits hypothesis include, among others, Erceg, Guerrieri., andGust
(2005), Leachman and Francis (2002), Piersanti (2000), and Vamvoukas (1999). The findings of
these studies supported the conventional view that the twin deficits exhibit positive association
and that causality runs from budget deficit to current account deficit. On the other hand,
Kaufmann et al. (2002), Papaioannou and Ki (2001), and Kim (1995) supported the view of REH
as they failed to identify any stable long-run relationship between the two deficits. Interestingly,
some other studies supported the notion of reverse causality running from current account to
budget deficit (see for example Anoruo and Ramchander, 1998; Khalid and Teo, 1999).
Although the linkage between budget deficit and current account deficit had been identified
much earlier by Keynes and other economists, it became a peril to the policymakers in 1980s
when US economy incurred persistent trade deficit, coupled with fiscal imbalance, with the rest
of the world. By and large, many developing economies, including developing countries in Asia,
have also experienced the simultaneous upsurge of budget and current account deficits (Khalid
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and Teo, 1999; Anoruo and Ramchander, 1998; Laney, 1984) and are still struggling to survive
from the deadly consequences of twin deficits. It has also been confirmed that the unsustainable
budget deficit widens the external account deficits (i.e. trade account balances and current
account balances).
For example, Laney (1984) noted that the unsustainable budget deficit in the early 1980s had
widened the current account deficits. The author also highlighted the relationship between these
two variables to be much stronger in the developing countries. Currently, most of the Asian
nations are experiencing low saving ratios, where their growth process is largely contingent upon
foreign capital. Capital inadequacy and unsynchronized policy have been driving these nations to
go through the bitter taste of twin deficits. Thus, we can expect that a linkage between trade
deficit and budget deficit exists in the developing countries and the policymakers are expected to
come up with recommendations considering the possible linkage.
Empirical studies concerning twin deficit model provide mixed results about the twin deficit
hypothesis. Several studies conducted, among others, by Rosensweig and Tallman (1993),
Piersanti (2000), Leachman and Francis (2002), Akbostanci and Tunç (2001) have supported the
existence of twin deficit hypothesis. Other studies, for example, Gagnon (2011); Abbas et al.
(2010); Bussière et al. (2010), Lee et al. (2008); Gruber and Kamin (2007); Chinn and Ito
(2005); Chinn and Prasad (2003) ; and Alesina et al. (1991); Bernheim (1988); Summers (1986)
have found that a 1 percent of GDP fiscal consolidation reduces the current account deficit-toGDP ratio by 0.1- 0.3 percentage points. In other words, achieving a 1 percent of GDP reduction
in the current account deficit requires a large fiscal adjustment of 3-10 percent of GDP.
However, results vary across samples of developed and developing countries. For example,
Abbas et al. (2010), Kouassi et al. (2002) have found that twin deficit model is more likely to be
dominant in developing countries. Some other studies seem to disagree with the linkage (Afonso
and Rault, 2008; Marinheir, 2007; Khalid and Guan, 1999). This indicates that the hypothesis
under the study is an empirical issue and is sensitive to changes in the samples.
In most of the studies, researchers dealt with time series data and tested Granger causality test,
and showed the presence of long-run equilibrium relationship by employing cointegration and
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VAR techniques (Mansor and Puah, 2010; Khalid and Guan, 1999; Anoruo and Ramchander,
1998). A few panel studies incorporating Asian developing nations, especially those are suffering
from severe trade and budget deficits, for example Bangladesh, India, Pakistan, Vietnam etc.,
have been undertaken. With a similar level of importance to the above studies, comprehensive
empirical studies testing the validity of twin hypothesis by applying panel data are very scarce.
Given this backdrop, the study attempts to test the validity of the twin deficit hypothesis for
selected Asian deficit-prone nations including Bangladesh. More specifically, the objective of
this paper is to examine the empirical linkage between current account deficits and a large set of
economic variables proposed by the theoretical and empirical literature.
In addition to testing the twin deficits hypothesis, we extend the results to a number of directions.
First, we have conducted a series of diagnostic tests while attempting to comprehensively
explore options to specify the appropriate model for estimation. Second, we have examined the
channels through which budget deficit as well as other explanatory variables affects the current
account. Again, to bring greater variation in the analysis, we carried out the estimation on
different dimensions such as considering the full sample, South Asian sample, and the East Asian
sample. Finally, we divided the sample further into two sub-periods, namely 1990-2000 and
2001-2012, to investigate whether the results varied between decades. Also, an effort was made
to explore the extent of influence of budget deficit on current account deficit by considering an
additional sample only for these two variables. In addition to determining the source of the
problem, this study is expected to provide the right policy mix while addressing the issue of
external imbalances in the developing countries in general and Asian countries in particular.
Moreover, understanding the factors behind the current account fluctuations is likely to have
important policy implications for the developing nations.
The rest of the paper is organized as follows: Section 2 reviews the literature; Section 3
highlights the theoretical background; Section 4 discusses the methodology and the data,
including some theoretical aspects of alternative panel-data models; Section 5 presents the
empirical results and discussion; and Section 6 draws conclusion rendering some policy
recommendations.
4
2. Literature Review
As this study investigates the validity of the twin deficit hypothesis for crisis-prone Asian
nations, it builds on two strands of literature: the literature on Asia and the studies that used nonAsian samples.
2.1 Evidence from Asia:
Anoruo and Ramchander (1998) tested twin deficit hypothesis for 5 South Asian nations, namely
India, Indonesia, Korea, Malaysia and Philippines. They employed Granger causality technique
and found unidirectional causality from fiscal deficit to current account deficit. Khalid and Guan
(1999) analyzed the causality and long-run relationship between budget and current account
deficit for five developing countries including India, Pakistan and Indonesia, and found that the
two deficits are cointegrated in the long run. In the same study, they observed no long-run
relationship when working with data set of five developed countries: USA, UK, France, Canada
and Mexico. They emphasized that the twin-deficit model was valid for developing nations as
their saving ratios are very low and was inadequate to meet the budget deficit and investment
demand.
Baharumshah et al.(2005) used cointegration and variance decomposition techniques to verify
the existence of twin deficit in four ASEAN countries: Indonesia, Malaysia, Philippines, and
Thailand. Using advanced econometric technique, they reached a conclusion that long-run
equilibrium relationship exists between fiscal and budget deficits in these nations. They also
detected bi-directional causality for Malaysia and Indonesia and unidirectional causality, running
from fiscal deficit to current account deficit, for other nations. Lau and Baharumshah (2006)
conducted a similar study on a sample of SEACEN and reached conclusions that were in
agreement with their previous study.
Lau et al. (2010) tested the twin deficit phenomenon in the case of the crisis-affected countries of
Asia. They found that causality runs from budget deficit to current account deficit for Malaysia,
Philippines (pre-crisis) and Thailand. For Indonesia and Korea, the causality runs in the opposite
direction, while a bi-directional causality exists for the Philippines in the post-crisis era. Puah et
al. (2006) conducted a similar study for Malaysia by employing Johansen cointegration test and
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rejected the twin deficit hypothesis. By applying Granger causality test, they identified
unidirectional causality from current account deficit to fiscal deficit.
2.2.Evidence from Other Regions:
Afonso and
Rault (2008) assessed cointegration relationship between current account and
budget balances, and effective real exchange rates, using recent bootstrap panel cointegration
techniques and SUR methods, for different groups of OECD and EU countries over the period
1970-2007 and found no conclusive evidence against or in favor of Twin Deficit Hypothesis.
Jayaraman et al. (2010) inquired the same relationships for six Pacific island countries: Fiji,
Papua New Guinea, Samoa, Solomon Island, Tonga and Vanuatu. Their study supported the
Twin Deficit Hypothesis for both long run and short run. Marinheir (2007) found no evidence of
twin deficits for long run for Egypt, but detected unidirectional causality running from trade
deficit to fiscal deficit.
Kouassi et al. (2002) conducted a study of time-series data of twenty developed and developing
economies to test the causality between trade and fiscal deficits. They found the evidence of
causality only for developing nations. Likewise in a recent study, Forte and Magazzino (2013)
tested the hypothesis using panel data from 33 European countries involving 40 years (19702010). Applying an advanced econometric technique – System GMM – the study came up with
the result that a 1% percent decrease in government budget decreases the current account by 0.37
percentage points. They further divided the sample into two parts (19970-1991 and 1992-2010)
and showed that the result varied significantly over time. The estimated coefficient was 0.48 for
the former period, while the coefficient for the later was 0.30.
Abbas et al.(2010) investigated the linkage between government budget deficit and current
account deficit using panel data of a large-country sample and showed that a cut in budget deficit
by 1 percentage point improves the current account balance by 0.2.-0.3 percentage point. They
also found that the linkage is relatively robust for samples of low income and developing
countries compared to developed countries. Gagnon (2011) came up with similar results and
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found that the coefficient of budget deficit was 0.2 for industrialized economies and 0.3 for a
broad sample of 112 countries.
3. Theoretical Framework
To elucidate the relationship between fiscal policy and current account, it is useful to start with
the national income account identity. This is the typical framework that may be used to trace the
linkage between current account and fiscal deficits under open economy. The twin deficit
hypothesis contends that there is a strong and positive association between a country’s current
account balance and its government budget balance. This association or linkage can be identified
from an economy’s national income account identity as follows:
Y  C  I  G  (X  M )
(1)
Another way to express national income identity is as follows:
Y  C  S T
(2)
Equating (1) and (2)
C  I  G  (X  M )  C  S  T
With mathematical manipulation and rearrangement we have:
X  M or NX  ( S  I )  (T  G )
(3)
If we assume that current account balance (CA) is simply the balance of goods and services,
omitting income and transfer balances, we can write:
CA  ( S  I )  (T  G )
(4)
Current Account Balance = Private Saving – Investment + Budget balance. Now, given the
saving investment gap, if budget deficit rises so does the current account deficit and hence we
have the appellation “Twin Deficit”. However, in reality both savings and investment change
from a fiscal expansion or contraction. Rearranging equation (4) we can also write:
CA  S  (T  G )  I
(5)
7
Current Account Balance = Private Savings + Savings in the public sector – Private Investment
or Current Account Balance = National Saving – Private Investment. From equation (5) it is
evident that current account balance is the difference between national savings and private
investment. It is also noticed that if the government runs budget deficit, it can finance in two
ways: (a) government can borrow from domestic sources, by issuing bonds to the public for
instance, and consume private saving, and/ or (b) the government can borrow from abroad. In the
latter case, there will be an equivalent inflow of capital in the home country to the amount of
current account deficit. In the former case, the policy would be successful as long as public buy
government bonds and there would be no pressure on the current account balance. So, the deficit
transmits into current account if the government fails to finance this from the domestic sources.
This idea, on the other hand, puts forward the theory of Ricardian Equivalence (RE).
Barro (1970s) argued that there is no reason for fiscal deficit to affect current account deficit.
This theory holds that consumers internalize the government budget constraint and, as a
consequence, the timing of tax changes does not affect their spending behavior. If government
issues bond today without raising tax, public debt will be accumulated and this must be paid by
the public in the form of taxes in future. Therefore, the choice is simply “tax now or tax later”. If
the government finances deficit by issuing bonds, people would buy bonds with the money they
save, leaving no impact of fiscal deficit on private investment and current account balance. Yet
the Ricardian Equivalence theorem suffers from many limitations and there is still some scope
for fiscal deficit to intrude into current account balance.4
If private saving happens to be insufficient to finance fiscal deficit and private investment
projects, current account deficit is inevitable and there will be net capital inflow equivalent to the
amount of current account deficit. Mundell and Fleming and other economists used this route to
show how budget deficit could possibly affect trade balance. In their analysis of open-economy
macro model, they showed that fiscal deficit raised interest rate and invoked capital inflow; this
4
In addition, since most of the developing countries of Asia rely on both domestic and foreign sources for deficit
financing, the likelihood of dominance of Recardian Equivalence is very slim. And by the same token, it can be
presumed that a one to one relationship between current account deficit and budget deficit has little practical
relevance. Rather we can, at best, expect a moderate response from one to the other.
8
capital inflow appreciated domestic currency and encouraged imports of foreign goods and
services, giving rise to current account deficit.
4. Data and Methodology:
The empirical investigation using the preceding model relies on a panel data set of selected
Asian nations from 1990 to 2012. More specifically, we have used a balanced panel of 322
annual observations from 14 Asian countries over the sample period. Annual data of current
account deficit, budget deficit, and per capita income are taken from IFS CDROM and the data
on broad money to GDP ratio and trade-GDP ratio are taken from World Development Indicator
dataset of the World Bank (WB).
10
10
7.7
7.5
7.7
7.9
5.2
5
4.6
2.4
4.6
4.1
3.6
3.7
3.5
2.6
2
1.9
1.7
1.3
.7
.44
2.4
2.2
.21
.088
0
.069
-.52
-.52
-5
-3.3
BAN BHU CAM CHI
Fij
IDN
IND
mean of cadgdp
LKA MDV NPL PAK PHIL THAI VNM
mean of bdgdp
Figure 1: Figure 1: Deficit situation in developing Asia (average of sample years)
Countries are selected on the basis of average per capita income and the deficit situations they
face over time. The countries under consideration for the present study are, in fact, not extremely
heterogeneous; rather they share and face common challenges in managing deficits. As can be
seen from Figure 1, average budget deficit and current account deficit do not vary much across
nations over the sample period except for Maldives and Sri Lanka because of their low GDP
figures. Similarly, most of the countries in the sample maintained modest GDP growth rates (see
Table 1) except China, which has been greatly robust over the last two decades (around 10%).
Again, these countries manifested a steady financial integration and a promising degree of trade
openness, over the sample period, as reflected by broad money to GDP ratio and trade-GDP ratio
respectively. Additionally, these nations do not differ much on the basis of their average per
9
capita incomes over the last 22 years. Bangladesh’s per capita income was the lowest ($1095.10)
,while Thailand’s standing was at the top ($6036.91) among this pool of countries under the
study.
Table 1 :Period Average (1990-2012) of Selected Variables in the Sample Countries
Current
Countries
Account
Deficit
Budget
GDP per capita
Deficit
(Current PPP$)
GDP
Broad Money
Trade
Growth
(Percent)
BGD
0.44
2.35
1095.10
42.65
34.24
5.44
BTN
7.71
1.89
3125.06
44.97
85.81
7.23
KHM
3.63
3.64
1199.31
19.18
105.10
7.74
CHN
-3.32
1.98
3548.89
132.97
48.27
10.01
FJI
4.11
2.69
3591.31
54.72
119.34
2.05
IND
1.28
7.54
1915.46
57.10
31.05
6.38
IDN
-0.52
0.81
2906.72
46.05
57.62
5.15
MDV
10.14
7.90
4894.31
40.99
160.44
7.30
NPL
0.07
1.03
851.24
50.77
48.05
4.44
PHL
0.21
1.54
2770.31
53.95
85.17
3.92
LKA
4.57
7.74
3183.17
36.76
72.89
5.45
THA
-0.52
1.14
6036.91
103.55
113.41
4.68
VNM
3.75
2.32
1784.33
61.62
116.44
6.89
PAK
2.22
4.84
1962.80
44.19
34.63
4.05
Source: World Economic Outlook Database, IMF & World Development Indicators, WB. Figures are in
percent of GDP unless otherwise stated
4.1 Methodology:
The empirical model that captures the essential features of the extent of relationship between two
broad categories of deficit is given by the following equation:
Yit   0  i X it  i  vt  it
(6)
where Yit is the dependent variable and X it represents a set of explanatory variables that have
been observed and hence included in the study, and are supposed to have some influence over
the variation in the dependent variable.
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In the above equation (6) i represents country-specific variables that do not vary over time,
and i , when unobserved, is sometimes called unobserved heterogeneity in econometric
literature. On the other hand, one may notice that some variables are time-dependent, but do not
vary across entities (variable having time trend). To include this time trending factor, the model
explicitly incorporated another term, vt . The last term of the equation it denotes idiosyncratic
error term, which captures the effects of other factors on the dependent variable that vary both
across entity and over time, and hence is purely random.
The general model specified in equation (6) can be rewritten as follows:
cadgdpit  0  1bdgdpit  2m2 gdpit  3tra deg dpit  4 gdppcit  i  vt  it
(7)
where cabgdp = current account deficits in percent of GDP; bdgdp = budget deficit in percent of
GDP; m2gdp = broad money supply (M2) in percent of GDP, tradegdp = trade openness index
and gdpcpi = per capita GDP adjusted for purchasing power parity (PPP). Table 2 presents the
expected signs of the variables used in various models.
Table 2: Expected Signs of the Variables used in the Model:
Parameters
Variables
Expected Sign
Theoretical Underpinning
A rise in the budget deficit drives the governments to finance from
abroad, provided governments do not issue bonds to finance from
β1
bdgdp
Positive
domestic sources. As capital inflow rises because of external
financing, there would be an equivalent amount of deficit in the
current account balance.
Β2
m2gdp
Negative
A rise in broad money depreciates domestic currency and hence trade
deficit is reduced through increase in exports.
Trade–GDP ratio rises as the country becomes increasingly involved
in trade. This normally rises as a result of reduction of import tariff.
Β3
tradegdp
Positive
The sign of the coefficient of trade-GDP ratio is, therefore, expected
to be negative. As tariff reduces, price of commodities to be
imported falls and hence current account deficit rises.
A rise in per capita income raises demand for foreign commodities.
Β4
gdppc
Positive
Import rises and so does the current account deficit of a particular
country.
11
Given the sample, this paper checks the potential signs of the parameters to be estimated, and
identifies if there is any coherence between the data and theoritical discussion herein. In
particular, the study plots each explanatory variable agaist the dependent variable. The scatter
plots, unsurprisingly, exhibit exactly the same pattern for the given data set as predicted earlier
in the text. Budget deficit, trade openness, and GDP per capita exhibit some positive relation,
while m2gdp shows negative relation (see linear fit lines in figure 2) when plotted agaist the
dependent variable. We can, therefore, expect that the sign of the parameters in the model would
10 20 30
0
-20 -10
-20 -10
0
10 20 30
not change when we will actually try to estimate parameters with advanced panel data models.
-5
0
5
10
bdgdp
20
0
2000
cadgdp
4000
6000
gdppc
8000
10000
Fitted values
0
-20 -10
-20 -10
0
10 20 30
Fitted values
10 20 30
cadgdp
15
0
50
cadgdp
100
m2gdp
150
200
0
Fitted values
50
cadgdp
100
150
trdgdp
200
250
Fitted values
Figure 2: Scatter plots of the variables
4.2 Model Estimation: Theoretical Aspect
The static panel regression analysis has been used to estimate the existence of twin deficit among
14 developing countries in Asia by applying three most common panel data models such as
pooled OLS, the fixed effects model and the random effects model.
Pooled OLS estimators:
The Pooled OLS model, relevant to the current situation, to estimate equation (7) can be
specified as:
12
cadgdpit  0  1bdgdpit  2m2 gdpit  3tra deg dpit  4 gdppcit  it
(8)
where it  i  vt  it , is the composite error term. Ordinary least squares (OLS) can be applied
if i is constant and not correlated with any other regressor. Complication, however, arises when
i is unobserved and the OLS can no longer be BLUE. If it contains only a constant term, OLS
provides consistent and efficient estimates of the common α and the slope vector β (Greene,
2010). In most of the panel dataset, however, unobserved heterogeneity is present and simple
OLS fails to provide efficient and consistent estimators. We then resort to some other estimators
in this situation, and fixed and random effects estimators often give better result, if carefully
applied.
Fixed Effects (FE) estimators:
To understand the fixed effect regression model for our current problem, we can start with the
following panel regression model:
cadgdpit  0  1bdgdpit  2m2 gdpit  3tra deg dpit   4 gdppcit  i  it
(9)
Because i varies from one country to the next in our current problem but do not vary over time,
the regression model can be interpreted as having n intercepts, one for each individual country.
More precisely, we can assume i  i   0 and rewrite the equation (9) as:
cadgdp it   i   1bdgdpit   2 m 2 gdpit   3 tra deg dpit   4 gdppcit   it
(10)
Equation (10) is the fixed effects regression model, in which 1 , 2 , 3 ……… n are treated as
unknown intercepts to be estimated, one for each country. But the slope coefficients i are the
same for all countries, where i represents number of regressors. The fixed effect estimator
estimates the i in two steps: firstly, the entity specific average is subtracted from each variable;
secondly, the regression is estimated using “time-demeaned” variables (Stock and Watson,
2003). By doing so, the fixed effect estimators remove the unobserved heterogeneity problem
from the dataset, but often open doors for omitted variable bias.
Random Effects (RE) estimators:
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Unlike fixed effects model, the random effects model assumes that entity specific effects are
independently distributed of the other variables included in the model. Again, the crucial
distinction between fixed and random effects is whether the unobserved individual effect
embodies elements that are correlated with the regressors in the model, not whether these effects
are stochastic or not (Greene, 2010). And by assuming so, the unobserved heterogeneity term is
merged with the idiosyncratic error term, and we have a composite error term instead.
Specifically, the random effect model can be specified for the underlying problem as follows:
cadgdpit   0  1bdgdpit   2 m2 gdpit   3tra deg dpit   4 gdppcit   it
(11)
Where  it  i  it , is the composite error term under the assumption of strict exogeneity. Now,
if we want to estimate equation (11) by Pooled OLS, we can have unbiased and consistent
estimates under strict exogeneity assumption, but the composite error term becomes serially
correlated. In this situation, given that the pooled OLS is unlikely to produce efficient estimates,
the Feasible Generalized Least Squares (FGLS) estimator takes this serial correlation into
account and provides us with efficient estimators.
5. Empirical results and discussion
Table 3 summaries the descriptive statistics (mean and standard deviation) of the variables used
in different models by decomposing them into two parts: between and within group variations.
The overall and within-variations are calculated on 322 observations, while the betweenvariations are calculated over 14 countries, and the average number of years each country was
observed is 22. The Table 3 also shows minimum and maximum values for each variable. The
average current account deficit was 2.413096, with a standard deviation of 6.612533 when
observing 14 nations over 22 years and the current account deficit varied between -16.148 and
32.37 over the sample period.
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Table 3: Descriptive Statistics
cadgdp
Variation Type
Mean
Std. Dev.
Min.
Max.
Overall
2.413096
6.612533
-16.148
32.37
Between
3.553645
-3.31526
10.1427
Within
5.653556
-21.4428
24.6404
3.728371
-4.506
21.137
Between
2.615528
0.088044
7.897956
Within
2.743833
-2.81746
16.81745
1945.139
505.457
10125.6
Between
1469.927
851.2434
6036.91
Within
1330.776
-350.615
8389.143
33.01515
4.89446
187.5809
Between
29.2769
18.89307
135.3472
Within
17.07652
0.032809
123.9142
42.91562
15.239
223.988
Between
39.60685
32.10457
162.7108
Within
19.50796
12.86027
140.5709
Overall
bdgdp
Overall
gdppc
Overall
m2gdp
Overall
trdgdp
N = 322,
3.578407
2776.064
56.73175
79.29373
T = 22
n = 14
Source: Authors’ Own Computations
The average current account deficit varied across countries by 3.553645, with a minimum of 3.31526 and a maximum of 10.1427. The other part of the overall variation lies in the within
individual nation observed over 22 years that refers to deviation from each country’s own
average. The data reveals that the average within deviation is 5.653556, which varies between 21.4428 and 24.6404. The same interpretation applies to other variables presented in the same
table. It is worth mentioning that all variables exhibited strong within variation as well as
between variations.
5.1 Conducting necessary diagnostic checks for the econometric model:
Conducting a series of diagnostic checks, the study comprehensively tried to specify the
appropriate model for estimation. The necessary diagnostic checks followed from the caution
underscored by Greene (1997) that panel data would typically exhibit serial correlation, crosssectional correlation and group-wise heteroscedasticity. To confirm that these issues have been
15
addressed we first applied a modified Wald test for group-wise heteroscedasticity to check for
common variance in the panels. Based on the test results, we rejected the null hypothesis of
homoscedasticity across the panels due to the different characteristics of the countries under
consideration. The study has applied a Lagrange-multiplier test, also known as Woolridge test,
for detecting autocorrelation in panel data. It has been found that all null hypotheses can be
rejected at 1% level of significance for all samples; and can be concluded that first-order
autocorrelation is present in the dataset under different samples considered in the study. Finally,
cross-sectional dependence is tested with a Breusch-Pagan LM test and, except for the years
1990-2000 (all country), we have rejected the null hypothesis of no cross-sectional dependence5.
5.2 Selection of Estimators:
As the panel dataset have exhibited serial correlation, cross-sectional correlation and group-wise
heteroscedasticity therefore we comprehensively tried to find the most relevant estimator for
different samples derived from the full sample. To choose between fixed and random effects
models, the study applied Hausman test and robust Hausman test, which corrects
heteroscedasticity, for full samples and sub-samples under the study. It is found that except for
the sub-sample drawn from 1990-2000 time periods, the random effects estimators are suitable
for estimation. The study additionally investigated the relative suitability of the random effects
estimator over the pooled OLS by applying the Breusch-Pagan langrage multiplier (LM) test.
Results reveal that the random effects estimators are apposite for the full sample, sub-sample
considering only two variables, and for the sub-sample drawn from 2001-2012. In each case,
however, the model has been estimated correcting for all the panel data problems discussed
earlier.
5.3 Interpreting the panel data regression:
Table 4 summarizes the estimation results of the regression model (equation 7), using different
panel data techniques, for different samples that appeared to be appropriate after various
diagnostic tests. The results from the feasible generalized least squares (FGLS) regression, when
applied for the full sample (1990-2012), suggest that a 1 unit increase in the government budget
5
All the diagnostic checks mentioned above have been conducted for different samples (results not shown here to
conserve space but would be available upon request).
16
deficit as percent of GDP, over time and across countries, leads to a 0.31 unit increase in the
current account deficit. And this remains valid or statistically significant irrespective of the
choice of other variables in the model.
Table 4: Regression Results of Panel Data Models
Dependent Variable: Current Account Deficit in percent of GDP (cadgdp)
East Asian Sample (19902012, OLS with DriscollKraay standard error)
All Variables
(1990-2000, Fixed
Effects estimators
with DriscollKraay standard
error)
All Variables (2000-2012,
FGLS Random Effects
estimators)
-0.1767(2.9943)
-0.1016 (2.3976)
13.2232(2.3346)***
-2.2000*(1.3075)
0.3072***(0.0343)
0.18541(0.18541)**
0.1769 (0.2219)
-0.0668 (0.2065)
0.3659***(0.0972)
gdppc
0.0010***(0.0001)
0.0009(.0005)*
0.0006(0.0003)*
0.0009 (0.0013)
0.0005*(0.0002)
m2gdp
0.0821***(0.0086)
-0.0902(0.0489)*
-0.0685(0.0116)***
-0.2120(0.0599)***
-0.0472***(0.0149)
trdgdp
0.0204***(0.0069)
0.0603(0.0455)
0.0404(0.0220)*
-0.0382 (0.0473)
0.0412***(0.0135)
Variable
Full Sample (19902012, FGLS
Random Effects
estimators)
South Asian Sample
(1990-2012, OLS
with Driscoll- Kraay
standard error)
Constant
1.6118*** (0.3820)
bdgdp
Notes: Asymptotic standard errors are in parentheses. *** indicates ‘significant at the 1% level’, ** ‘significant at the 5% level’ and * ‘significant at the 10% level’.
The findings of this study are in line with the conventional view and are similar to the previous
findings such as Saleh et al. (2005), Mohammadi (2004), and Vamvoukas (1997). On average,
the estimated results of their studies suggest that the increase of budget surplus/GDP ratio by one
percentage point improves the current account/GDP ratio by 0.31 to 0.49 percent in developing
countries and 0.21 to 0.24 percent in industrialized countries. Our results, however, vary across
samples when considering South and East Asia. In both these sub-samples, we applied OLS
17
estimation technique with Driscoll-Kraay standard errors corrected for the underlying problems
in the dataset.6
The coefficients of budget deficit in South and East Asian samples are 0.19 and 0.18,
respectively. Although they have correct signs as expected, the coefficient of budget deficit has
appeared to be statistically significant only for the South Asian sample. And weak evidence has
been found for the existence of the twin deficit hypothesis for the East Asian nations. This result
is in agreement with the findings of some previous studies (e.g., Magazzino, 2013; Abbas et al.
2010; Kouassi et al. 2002) which concluded that the model seemed to work only for samples of
the developing nations. In the last two sub-samples, samples from 1990-2000 and 2001-2012, the
coefficient of budget deficit has turned out to be statistically significant at 1% level for the
sample 2001-2012, but insignificant for the other sample.
Regarding other variables, per capita GDP has positive and significant influence on current
account deficit except for the sub-sample drawn from 1990-2000. We can, therefore, conclude
that as per capita GDP rises by one unit current account deficit as percent of GDP deteriorates,
other things being equal, by 0.001 unit for a given country for the full sample, where the results
do not vary substantially across samples. Similarly, trade to GDP ratio has appeared to have
positive and statistically significant impact on the dependent variable under study, but not for all
the sub-samples. For the South Asian sample and the sample covering 1990s, the estimated
coefficients are insignificant. For the full sample, the estimated coefficient reveals that when a
country increases its trade openness by one unit the current account deficit increases by 0.02
units, other things being constant.
Broad money to GDP ratio also has statistically significant effects on current account deficit in
all the samples. The estimated coefficients on the m2gdp vary between -0.04 to -0.09 across
samples. The results obtained from the full sample suggest that a one unit increase in m2gdp
ratio, on average, improves the current account deficit to GDP ratio by 0.08 units for a given
country. This suggests that an economy’s monetary policy and level of financial development, in
6
Since dataset suffers from cross sectional dependence, in addition to heteroscedasticity and autocorrelation, the
traditional fixed, random and other estimation techniques can provide consistent, although not efficient, estimates,
but the estimated standard errors can be biased. In this situation, one way out could be applying standard panel data
models as suggested by Driscoll and Kraay (1998).
18
addition to government’s budgetary management, are directly associated with the external
balance and both monetary and fiscal policies can be useful in current account crisis
management. Although regression results presented in Table 4 clearly reveal the existence of
twin deficit problem in the different samples and subsamples, the study further made an effort to
reconcile this empirical problem by considering a 2-variable econometric model. The twovariable regressions for all countries, South Asian countries and East Asian countries, have been
estimated using different panel data models to see how the result varies across model
specifications.
Table 5 shows the estimated results obtained under four different estimators, namely FGLS, OLS
with Driscoll-Kerry standard errors, FE with Driscoll-Kraay standard errors, and RE with panel
corrected standard error, PCSE. The estimated coefficient of budget deficit for the full sample
appears to be significant in all different specifications, but it varies from 0.30 to 0.47 meaning
that a rise in budget deficit by one unit increases current account deficit, in percent of GDP,
between 0.30 and 0.47 units for a given country depending on the model specification.
Table V:Panel Regression Results for Two Variable Model with Different Estimators
Dependent variable: cadgdpand Independent variable: bdgdp
Full Sample
South Asia
East Asia
FGLS
0.29597***(0.03548)
0.3718***(0.0909)
0.1563*(0.0888)
OLS
0.4766**(0.1702)
0.4517**(0.1963)
0.5175*(0.3039)
FE
0.2964*(0.1523)
0.9409***(0.2363)
-0.0759(0.1599)
PCSE
0.3416**(0.1567)
0.6416**(0.2946)
0.1376(0.1726)
Notes: *** represents ‘significant at the 1% level’, ** ‘significant at the 5% level’ and * ‘significant at the 10%
level’.
It is also shown in Table V that the result differs significantly between South and East Asian
samples. In the South Asian case, the twin deficit problem is still dominant; the estimated
coefficients of budget deficit in the two-variable model are significant and vary from 0.37 to 0.94
in different model specifications as opposed to the East Asian case, where it significantly varies
from 0.16 to 0.52. This further supports our previous findings that the better the macroeconomic
performance of an economy the less dominant the twin deficit problem is. In other words, as an
economy becomes richer and richer government consolidation encourages domestic savings and
19
hence influence of budgetary expansion over the external account becomes weaker, and the
Ricardian Equivalence theorem turns stronger.
To sum up, the estimated results show that the twin deficit problem is evident in the sample
countries, controlling for other variables. Although the government budget deficit significantly
influences the current account deficit, the relationship is far below unity; a one unit increase in
the budget deficit does not translate fully into current account deficit. This indicates that the
relationship of the twin deficit is much weaker than what economic theories predict (the
Keynesian view). However, another explanation might help rationalize this weaker result: as
economies are growing and integrating by trade with each other and the world, additional factors
also exert influence on the current account deficit along with the government budget deficit. On
the other hand, no country included in the sample has been entirely relying on external financing.
Countries, in fact, utilize both sources and hence the association between trade and government
deficit naturally becomes weaker.
The previous literature documented as well as the empirical evidence presented in this study,
however, suggest that the relationship between budget and current account deficits is complex
and necessitates further research. For further studies, applying panel cointegration and GMMSystem estimates (see for example, Forte and Magazzino, 2013), use of vector autoregressive
models and impulse response functions (see for example, Anoruo and Ramchandar, 1998),
incorporating structural breaks (see for example: Hatemi-J and Shukur, 2002), general
equilibrium model, and estimating Granger non-causality tests (see for example: Pahlavani and
Saleh, 2009), may help deepen our understanding of twin deficits and hence help formulate
appropriate macroeconomic policies in Asian countries.
6. Conclusion
The study has made an empirical contribution to the existing literature on the validity of twin
deficit hypothesis, using panel dataset of 14 developing countries of Asia covering 22 years from
1990 to 2012. The study applied a number of advanced econometric techniques, e.g. error
component model estimation, fixed effect model, etc., to investigate influences of government
budget deficits on the countries' current account deficits. Among different variants of error
20
component models, random effects, fixed effects and pooled OLS estimation techniques were
applied, when seemed appropriate, upon necessary diagnostic tests. The study finds positive
association between government budget deficit and current account deficit for the sample
countries, controlling other variables viz. broad money supply, per capita income and trade-GDP
ratio.
Specifically, the study finds that a 1 unit change in the government budget deficit translates into
0.31 units, on an average, of the current account deficit. The results from the empirical models
also show that gdppc, m2gdp and trdgdp appear to play an important role in explaining the
current account balance. It has also been found that among the pool of 14 developing countries
of Asia, the twin deficit problem is dominant in the South Asian countries than those in the East
Asian countries under the study. Despite the fact that the coefficient of budget deficit is
significant in all samples and different model specifications, budget deficit actually exert much
lower influences on current account deficit than what economic theories predict (the Keynesian
view). In addition, this study finds other variables, especially broad money to GDP ratio,
playing significant role in determining the countries’ current account deficit along with budget
deficit.
Based on the findings of the study, it can be concluded that government’s expansion, greater
integration among economies through trade and investment, and higher per capita income tend to
deteriorate current account deficit, while greater financial integration and development is likely
to improve it. This inference becomes more relevant if the country is less developing in nature.
On the contrary, the Ricardian Equivalence theorem appears to have insignificant impacts across
samples, as long as the twin deficit hypothesis holds. Therefore, it could be better for the
policymakers, especially of less developed countries, not to prescribe policy that focuses on
these two broad categories of deficits separately. They may rather comprehensively
accommodate the empirical findings in their policy design to manage government and external
accounts.
21
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