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

deficit and current account deficit is explained with TDH, which posits that an increase in budget 1 Assistant Professor, Department of Economics, Jahangirnagar University, Savar, Dhaka-1342; Email: nurulhoque@juniv.edu 2 Associate Professor, Institute of Business Administration, Jahangirnagar University, Savar, Dhaka-1342. E-mail: jahid558@yahoo.com 3 Associate Professor, Department of Economics, Jahangirnagar University, Savar, Dhaka-1342; Email: earkmu@leeds.ac.uk

1

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

and Teo, 1999; Anoruo and Ramchander, 1998; Laney, 1984) and are still struggling to survive

2

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-to-

GDP 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

VAR techniques (Mansor and Puah, 2010; Khalid and Guan, 1999; Anoruo and Ramchander,

3

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.

2. Literature Review

4

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 non-

Asian 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

5

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 (1970-

2010). 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

6

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:

(1)

Another way to express national income identity is as follows:

(2)

Equating (1) and (2)

With mathematical manipulation and rearrangement we have:

or (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:

(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:

(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

capital inflow appreciated domestic currency and encouraged imports of foreign goods and

services, giving rise to current account deficit.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

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).

.44

2.4

7.7

1.9

3.6

4.6

-3.3

2

4.1

2.6

-.52

.71.3

7.5

4.6

7.7

10

7.9

.069

3.5

2.2

5.2

.21

1.7

-.52

.088

3.7

2.4

-50

510

BAN BHU CAM CHI Fij IDN IND LKA MDV NPL PAK PHIL THAI VNM

mean of cadgdp 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

capita incomes over the last 22 years. Bangladesh’s per capita income was the lowest ($1095.10)

9

,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

 Countries

Current

Account

Deficit

Budget

Deficit

GDP per capita

(Current PPP$)Broad Money Trade

GDP

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:

(6)

where Yit is the dependent variable and 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.

In the above equation (6) represents country-specific variables that do not vary over time, and

, when unobserved, is sometimes called unobserved heterogeneity in econometric literature.

10

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 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:

(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

β1 bdgdp Positive 

A rise in the budget deficit drives the governments to finance from

abroad, provided governments do not issue bonds to finance from

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  NegativeA rise in broad money depreciates domestic currency and hence trade

deficit is reduced through increase in exports.

Β3 tradegdp  Positive

Trade–GDP ratio rises as the country becomes increasingly involved

in trade. This normally rises as a result of reduction of import tariff.

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. 

Β4 gdppc  Positive

A rise in per capita income raises demand for foreign commodities.

Import rises and so does the current account deficit of a particular

country. 

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

11

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

not change when we will actually try to estimate parameters with advanced panel data models.

-20-

100

1020

30

-5 0 5 10 15 20bdgdp

cadgdp Fitted values-2

0-10

010

2030

0 2000 4000 6000 8000 10000gdppc

cadgdp Fitted values

-20-

100

1020

30

0 50 100 150 200m2gdp

cadgdp Fitted values

-20-

100

1020

30

0 50 100 150 200 250trdgdp

cadgdp 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:

(8)

12

where , is the composite error term. Ordinary least squares (OLS) can be applied if

is constant and not correlated with any other regressor. Complication, however, arises when

is unobserved and the OLS can no longer be BLUE. If 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:

(9)

Because 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 and rewrite the equation (9) as:

(10)

Equation (10) is the fixed effects regression model, in which , , ……… are treated as

unknown intercepts to be estimated, one for each country. But the slope coefficients are the

same for all countries, where i represents number of regressors. The fixed effect estimator

estimates the 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:

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

13

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:

(11)

Where , 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 between-

variations 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.

Table 3: Descriptive Statistics

  Variation Type Mean Std. Dev. Min. Max.

cadgdp Overall 2.413096 6.612533 -16.148 32.37

14

Between 3.553645 -3.31526 10.1427

Within   5.653556 -21.4428 24.6404

bdgdp

Overall 3.578407 3.728371 -4.506 21.137

Between 2.615528 0.088044 7.897956

Within   2.743833 -2.81746 16.81745

gdppc

Overall 2776.064 1945.139 505.457 10125.6

Between 1469.927 851.2434 6036.91

Within   1330.776 -350.615 8389.143

m2gdp

Overall 56.73175 33.01515 4.89446 187.5809

Between 29.2769 18.89307 135.3472

Within   17.07652 0.032809 123.9142

trdgdp

Overall 79.29373 42.91562 15.239 223.988

Between 39.60685 32.10457 162.7108

Within   19.50796 12.86027 140.5709

N = 322, 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, cross-

sectional correlation and group-wise heteroscedasticity. To confirm that these issues have been

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

15

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

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.

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).

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Table 4: Regression Results of Panel Data Models

Dependent Variable: Current Account Deficit in percent of GDP (cadgdp)

Variable

Full Sample (1990-2012, FGLS Random Effects estimators)

South Asian Sample (1990-2012, OLS with Driscoll- Kraay standard error)

East Asian Sample (1990-2012, OLS with Driscoll- Kraay standard error)

All Variables (1990-2000, Fixed Effects estimators with Driscoll- Kraay standard error)

All Variables (2000-2012, FGLS Random Effects estimators)

Constant 1.6118*** (0.3820) -0.1767(2.9943) -0.1016 (2.3976) 13.2232(2.3346)*** -2.2000*(1.3075)

bdgdp 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)

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

estimation technique with Driscoll-Kraay standard errors corrected for the underlying problems

in the dataset.6

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).

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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

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 two-

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variable 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

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

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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 GMM-

System 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

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.

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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.

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