OGBONNA CHUKWUMA BIG-BEN · 2016-02-09 · iii investigating the causal relationship between fiscal deficits and current account imbalance: evidence from nigeria and south africa,

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OGBONNA CHUKWUMA BIG-BEN

PG/Ph.D/11/60227

INVESTIGATING THE CAUSAL RELATIONSHIP BETWEEN FISCAL DEFICITS AND CURRENT ACCOUNT IMBALANCE: EVIDENCE FROM NIGERIA AND SOUTH

AFRICA ,

FACULTY OF BUSINESS ADMINISTRATION

DEPARTMENT OF BANKING AND FINANCE

Paul Okeke

Digitally Signed by: Content manager’s Name

DN : CN = Webmaster’s name

O= University of Nigeria, Nsukka

OU = Innovation Centre

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INVESTIGATING THE CAUSAL RELATIONSHIP BETWEEN FISCAL DEFICITS AND CURRENT ACCOUNT IMBALANCE:

EVIDENCE FROM NIGERIA AND SOUTH AFRICA,

1960 – 2011

BY


PG/Ph.D/11/60227

DEPARTMENT OF BANKING AND FINANCE,

FACULTY OF BUSINESS ADMINISTRATION,

UNIVERSITY OF NIGERIA, ENUGU CAMPUS

OCTOBER, 2014

iii

INVESTIGATING THE CAUSAL RELATIONSHIP BETWEEN FISCAL DEFICITS AND CURRENT ACCOUNT IMBALANCE:

EVIDENCE FROM NIGERIA AND SOUTH AFRICA,

1960 – 2011

BY


PG/Ph.D/11/60227

A Ph.D. THESIS SUBMITTED TO DEPARTMENT OF BANKING AND

FINANCE, FACULTY OF BUSINESS ADMINISTRATION, UNIVERSITY OF

NIGERIA, ENUGU CAMPUS.

SUPERVISOR: Prof. U. C. UCHE

OCTOBER, 2014

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DECLARATION

I, OGBONNA, CHUKWUMA BIG-BEN, a postgraduate student in the Department of

Banking and Finance with Number PG/Ph.D./11/60227 declare that the work

incorporated I this thesis is original and has not been submitted either in part or

in full for any other Degree or Diploma of this University or any or any other

Institution of higher learning.

………………………………………… …………………

OGBONNA, CHUKWUMA BIG-BEN DATE

PG/Ph.D./11/60227

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APPROVAL

This is to certify that this thesis by Ogbonna Chukwuma BigBen with registration

number PG/Ph.D/11/60227 presented to the department of Banking and Finance,

University of Nigeria, Enugu Campus was supervised and approved to have met

the conditions necessary for the award of a Doctorate Degree (Ph.D) in Banking

and Finance of the University.

…………………… ……………………

PROF. U. C UCHE DATE

(SUPERVISOR)

……………………… ……………………

Dr. CHUKE NWUDE DATE

HEAD OF DEPARTMENT

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DEDICATION

This study is dedicated to my ever loving wife and children.

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ACKNOWLEDGEMENT

I would like to thank a number of persons who have lent their kind support and

made useful suggestions throughout the research process. First and foremost, my

immense gratitude goes to my supervisors, Prof. C. U. Uche of the Department of

Banking and Finance, University of Nigeria, Enugu Campus, for his pro-active

supervision, brilliant observations and suggestions, professional advice, selfless

and persistent efforts in seeing to successful and timely conclusion of this study.

The contributions of all the academic staff of Banking and Finance Department,

University of Nigeria Enugu Campus (through their respective roles in the peer

review mechanism adopted for this study) are highly appreciated by the author. I

must have been leaving a wide lacuna, if I should fail to immensely thank Engr.

Gabriel Emerike, the Project Coordinator, Ebonyi State Community Based Urban

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Development Project (World Bank Assisted) for his tolerance, and patience with

me and allowing me access to the internet facilities throughout the period of this

study. In the same vein I say a big “thank you” to all the members of Project

Implementation Unit (PIU) for their co-operation. Above all, I graciously thank the

Almighty God for giving me the grace and fitness to conduct and conclude this

study.

OGBONNA, CHUKWUMA BIG-BEN

PG/Ph.D./11/60277

ABSTRACT

This study examines the empirical relationship between fiscal deficit and current

account imbalance employing data for Nigeria and South Africa for the period of

1960 to 2011. We employ co-integration analysis and, VEC and VAR granger non

causality process to investigate the existence of long-run and short term

causalities for the economies under consideration. The results indicate no

evidence of twin deficits hypothesis for both Nigeria and South Africa in the short-

run. For Nigeria, evidence of twin deficits hypothesis is identified in the long-run.

The absence of evidence of the twin deficits phenomenon for both Nigeria and

South Africa in the short-run time frame, suggests that the Ricardian equivalence

proposition (REP) holds for the economies under consideration within such time

horizon. This concept is of the view that since people are rational, they know that

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the reduction in taxes, resulting from the government expansionary fiscal policy

of tax cut or increase in public debt, is temporal and will save the extra disposable

income to pay for the future higher taxes. This suggests that the national savings

position will be sustained because the decrease in government savings

represented by increased fiscal deepening will be equitably compensated by the

additional precautionary private savings for expected future increase in taxes.

This designates fiscal balance variable as exogenous to current account balance

model and indicates lack of responsiveness of private consumption to fiscal

impulse. This casts doubts on the efficacy of the use of fiscal policy in the

management of external balance. This in effect suggests that fiscal policy should

not be intended for improvement in current account balance or in the least

should not be used in isolation to supervise developments in current account

stance in the short-run for both Nigeria and South Africa. The identification of

twin deficits hypothesis for Nigeria in the long-run suggests that use of fiscal

policy in the management of external balance may be advisable, which in effect

implies that fiscal policy may be intended for improvement in current account

balance in the long-run. The hallmark contribution to knowledge by this study is

the revelation from the results that intensity of Ricardian equivalence in any

economy may further be dependent on the poverty level of its citizens and the

level of per capita income in the economy.

TABLE OF CONTENTS

Pages

Cover Page i

Title Page ii

Declaration iii

Approval iv

Dedication v

Acknowledgement vi

Abstract vii

x

Table of Contents viii

List of Tables xi

List of Figures xii

CHAPTER ONE: INTRODUCTION

1.1 Background to the Study 1

1.2 Statement of the Problem

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1.3 Objective of the Study 12

1.4 The Research Questions 13

1.5 The Research Hypothesis 14

1.6 Scope of the Study 15

1.7 Significance of the Study 15

1.8 The Operational Definition of Terms 17

References 20

CHAPTER TWO: REVIEW OF RELATED LITERATURES

2.1 Theoretical Review 24

2.2 Empirical Review 34

2.3 Summary of Empirical Review 65

References 68

CHAPTER THREE: RESEARCH METHODOLOGY

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3.1 Research Design 75

3.2 Model Specification 77

3.3 Data Discussion 86

3.4 Data Source 88

3.5 Econometric Procedure 88

References 101

CHAPTER FOUR: PRESENTATION AND ANALYSIS OF DATA

4.1 Summary Statistic of Variables used: Nigeria & South Africa 103

4.2 Unit Root Test 106

4.3 Test of Research Hypothesis 110

4.3.1 Hypothesis One 110

4.3.1.1 Using Nigeria Data 111

4.3.1.2 Using South Africa Data 113

4.3.2 Hypothesis Two 114

4.3.2.1 Using Nigeria Data Set 115

4.3.2.2 Using South Africa Data Set 119

4.3.3 Hypothesis Three 121



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4.3.4 Hypothesis Four 128



4.3.5 Hypothesis Five 132

4.4 Complementary Results 133

4.4.1 Impulse Response Function for Nigeria and South Africa 133

4.4.2 Forecast Error Variation Decomposition Test 136

4.5 Stability Test 138

4.6 Discussion of Results 139

4.7 Comparative Analysis and Justification of Results 145

References 148

CHAPTER FIVE: SUMMARY OF FINDINGS, CONCLUSION

&RECOMMENDATIONS.

5.1 Summary of Findings 150

5.2 Major Contributions to Knowledge 154

5.3 Conclusions 155

5.4 Recommendations 156

5.5 Suggestions for Further Research 156

Bibliography 158

Appendix 169

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List of Tables

Table 1: Summary Statistic of Variables Used for Nigeria 104

Table 2: Summary Statistic of Variables Used for South Africa 104

Table 3: Unit Root Test of Data for Nigeria 108

Table 4: Unit Root Test of Data for South Africa 109

Table 5: Test for Co integration for Nigeria 112

Table 6: Estimates of Long-Run Co-integrating Vectors (Linearised) 113

Table 7: Co integration Test for South Africa 114

Table 8: Causality Test for Twin Deficits Hypothesis for South Africa 118

Table 9: Causality Test for Current Account Targeting for Nigeria 119

Table 10: Causality Test for Current Account Targeting for South Africa 121

Table 11: Granger Non Causality Test Results for Nigeria 124

Table 12: Granger Non Causality Test Results for South Africa 126

Table 13: Vector Autoregressive Estimates (Equation 12) 128

Table 14: Current Account Balance Variance Decomposition

for Nigeria 171

Table 15: Current Account Balance Variance Decomposition

for South Africa 171

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List of Figure Figure 1:

Impulse Response Functions Graphs for South Africa 169

Figure 2: Cusum Test for Equation Stability for South Africa 172

Figure 3: Impulse Response Functions Multiple Graphs for Nigeria 170

Figure 4: Cusum Test for Equation Stability for Nigeria 172

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CHAPTER ONE INTRODUCTION

1.1 Background to the Study

The association between fiscal policy dynamics and the current account

innovations started to draw the attention among academics, economists and policy

makers alike by the 80’s when record budget deficit (BDEF) and current account

deficit (CADEF) emerged in many countries, including the United States. For

example, the possible link between fiscal deficits and current account deficits has

spurred many studies analyzing the “twin deficit” hypothesis, particularly for the

case of the United States. For many countries where current account imbalances

are particularly huge, a relevant question has been to what extent fiscal adjustment

can contribute in resolving external imbalances.

Twin deficits hypothesis asserts that an increase in budget deficit will cause a

similar increase in current account deficit. But the results of testing this hypothesis

turned out different for different countries, and moreover, the results differ in the

case of using different econometric techniques and model specifications for the

same country data (Mukhtar, Zakaria and Ahmed, 2007). The close correlation

observed between these two deficits does not imply any causal relation between

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the two. This suggests that, identifying the causal relation between these deficits is

essential and would have different policy implications. Theoretically, there are five

possible scenarios about the causal relationship between budget and trade deficits:

The first one is called the Twin Deficit Hypothesis which posits positive and

significant causal relation between budget deficit and current account deficit with

budget causing current account. The second, which is referred to as current account

targeting, just like the Twin Deficit Hypothesis posits positive and significant

causal relation between budget deficit and current account imbalance, but this time,

with current account balance causing government budget deficit. The third, is the

twin divergence hypothesis which proposes negative causal relationship between

the twin anomalies; the fourth, is the scenario of bi-directional causal

correspondence between fiscal deficit and current account imbalance, and finally,

the Ricardian Equivalent proposition which predicts that the two deficits share no

significant causal relationship and therefore are independent.

Studies in favour of the twin deficits hypothesis include those undertaken by Abell

(1990); Islam (1998); Zietiz & Pemberton (1990); Bachman (1992); Kasak

(1994); Vamvoukas (1999); Aqeel & Nishat (2000); Piersanti (2000); Leachman

& Francis (2002); Cavallo (2005); and Erceg, Guerrieri., & Gust (2005). Results

of these studies supported the conventional view that the twin deficits share

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positive association and that causality runs from budget deficit to current account

deficit.

Furthermore, Laney (1984); Miller & Rusek (1989); Dewold & Ulan (1990);

Enders & Lee (1990); Boucher (1991); Evans (1993); Winner (1993); Kim

(1995); Bartlett (1999); Papaioannou, Kei – Mu Yi (2001); and Kaufmann et al.,

(2002) support the view of Ricardian Equivalent as they failed to identify any

stable Long-run relationship between the two deficits.

In the same vein, while Darret (1988); Kearney & Monadjemi (1990); and

Normandin (1999) have reported evidence in support of bi-directional causality

between the twin deficits (suggesting mutual dependence of the bi-variate model),

some other studies as Anoruo & Ramchander (1998); Khalid & Teo (1999); and

Alkswani (2000) support the reverse causuality running from current account to

budget deficit, which in Summers terminology is refered to as current account

targeting (Summers, 1988). There is also a fifth scenario that portrays the

possibility of a negative relationship between the deficits where, for example,

output shocks give rise to endogenous movements of the budget deficit and current

account deficit that are divergent (Holmes, 2004).

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Questions concerning the relations between fiscal policy, the current account, and

the exchange rate are of great analytical and empirical interest. From the

theoretical point of view, numerous models suggest that a fiscal expansion should

lead to a worsening of the current account and an appreciation of the real exchange

rate. The prime empirical example of such a relation is usually argued to be the

experience of the United States with “twin deficits” in the first half of the 1980s

(Soyoung & Nouriel, 2007). The standard Mundell-Fleming analysis argues that a

deficit financed expansionary fiscal policy will lead to an increased trade deficit

through either stimulated income growth in a fixed exchange rate scenario or

exchange rate appreciation in a flexible exchange rate regime. This gives rise to

twin deficits based on a positive co-movement and thus suggests the possibility of

using the budget deficit as a means of influencing the current account deficit.

But in contrast, a Ricardian equivalence scenario suggests that there is no positive

co-movement for the fact that domestic residents may anticipate that government

will raise taxes in the future to close the fiscal gap in order to pay back the

accumulated debt. This thinking was evidenced in the works of Evans, 1988,

Miller & Russek, (1989); Dewald & Ulan (1990); Enders & Lee (1990) and Kim

(1995). There is also a third scenario that portrays the possibility of a negative

relationship between the deficits where, for example, output shocks give rise to

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endogenous movements of the budget deficit and current account deficit that are

divergent (Holmes, 2004).

This suggests that problem of twin deficits has been one of the most disputed

issues in economics as different schools of thoughts have different ideas about the

relationship between budget deficits and current account deficits in both developed

and developing countries. Twin deficits are observed as a long-run (positive)

relationship between the current account and the budget deficit, including some

other factors (McCaskey & Kao, 1999). According by Stockman (2000), study of

twin deficit phenomena got serious attention from researchers due to the reason

that in most of the situation, twin deficits may leads to economic harms and hurt

economic growth. However, sometimes current account deficit is due to the

investment opportunities created by technical transformation, while in some other

times it results from reduction in saving rate, which may be due to the change in

consumer expenditures, changes in tax rate or changes in fiscal balance.

How does each policy lead from a budget deficit to deterioration in the current

account balance? First, consider the policy based on an increase in government

spending. When the budget deficit increases, domestic residents anticipate that the

government will raise taxes in the future to close the fiscal gap and pay back the

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accumulated debt. To pay for the expected future increases in taxes, people will

want to save and accumulate wealth. This they can do in two ways—by spending

less and by boosting their income by increasing the number of hours they work.

To the extent that people choose the second route and increase the hours they

work, they make the capital stock more productive, which fosters more private

investment. The increase in investment partially offsets the increase in private

saving, so that, overall, the current account balance deteriorates in response to the

deterioration of the government fiscal balance. Next, consider the policy based on

a persistent reduction in capital and labor tax rates. After the tax rate cuts, people

choose to work harder and increase the number of hours worked to take advantage

of the increase in their after-tax labor income. Given the higher supply of hours

worked, both output and the productivity of capital increase. The increase in output

mitigates the initial decline in tax receipts and in the government’s budget

situation. But this is more than offset by a strong expansion in domestic investment

that is driven by two things: first, as in the previous policy, the higher number of

hours worked increases the productivity (Michele, 2005).

Trade and fiscal deficits relationship have important policy implications for a

number of reasons; first, persistent large deficits cause indebtedness by borrowing

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internally and externally, second, it imposes burden on future generations. Thus,

rising trade deficits is indeed escalating government budget deficits. This suggests

that current account balance cannot be remedied unless policies that address

government deficits are put in place (Anoruo & Ramchander 1998). In the same

vein, if such a view concerning the causal role of the budget deficit is incorrect,

then reductions in the federal budget deficits may not resolve the trade deficit

dilemma and more over, scarce economic resources will be diverted from relevant

and urgently needed policy options (Belongia & Stone 1985).

The current account deficit in South Africa stems largely from strong domestic

demand. With terms of trade unchanged, the current account imbalance reflects the

volume of growth in imports outpacing exports and current accounts transfers such

as dividend payment to foreigners. The deficit on the trade balance averaged 2.2

per cent of GDP in the first half of 2007, while the net income receipts deficit

stood at 2.5 per cent of GDP in the same period. This strong increase in imports

has coincided with a strong domestic expenditure as lower interest rates in

previous years and broader participation in the economy boosted strong consumer

spending. Mineral products, in particular oil, put the most pressure on imports.

Crude and refined oil accounted for 16.1 per cent of total imports in 2006. Crude

oil grew by about 28.0 per cent between 2005 and 2006 and accelerated to 35 per

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cent in the first half of 2007 (Tonia, 2007). According to Edward, one of the

reasons for the high current account deficits in developed countries is that global

investors have confidence in countries such as the United States. They can safely

seek the highest possible return for their funds in these countries. This has led to a

substantial increase in the international demand for United States assets. Some of

the factors that lie behind such confidence are political stability; a legal system that

effectively protects property rights and enforces commercial contracts; economic

policies that promote and strengthen the role of markets; a financial system that

efficiently channels resources to their most productive uses; an educational system

that produces highly skilled workers; and supports rapid technological

development (Edwards, 2005a). He however stress that even though the United

States is able to attract large investments, at some point the current account deficit

will have to go through a significant adjustment or reversal. The recent dollar

depreciation of 20 per cent since 2002 could be part of the adjustment process.

1.2. Statement of the Problem

In recent years, the twin-deficit hypothesis, the argument that fiscal deficits fuel

current account deficits, has returned to the forefront of the policy debate (Bartolini

& Labiri, 2006). This follows the rising federal government budget deficit and

current account deficits in the United States and elsewhere which have sparked

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heightened interest in the impact of domestic and foreign deficits on the growth

potentials of the domestic economy (Nozar & Loretta, 2006). Recently, there has

been a growing concern of the ballooning current account deficit which warrants

some discussion on its causes and sustainability to avoid any current account

reversal. A sustainable current account is the one that generates no effect on

domestic variables (savings and investment) or does not lead to significant

international portfolio adjustments that make substantial changes in interest rates

(Mariam, Josep & Cecilio,2010). In distinguishing between solvency and

sustainability, an economy is said to be solvent if the present value of expected

future trade surpluses equals the current indebtedness, that is, if the economy

performs its external intertemporal budget constraint, while sustainability means

whether the economy is able to meet its budget constraint without a drastic change

in the private sector behavior or without the implementation of economic policy

measures (Milesi-Ferretti & Razin, 1996).

Currently, these twin anomalies have remained apparent in the economies of both

developed and developing countries, South Africa and Nigeria inclusive.

Investigating the trends of the twin deficits for Nigeria, revealed that the current

account deficits as a percentage of GDP increased from 2.4% in 1993 to 9.2% in

1995, 11.3% in 1998 and averaging 14% in surplus by 2008 (IMF-IFS on-line,

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2011). For South Africa, we observed that the current account deficit deteriorated

from 0.1 percent of GDP in 2000 to 6.4 percent in 2006 and averaging 6.7 percent

in the first of half of 2007. The current account situation in South Africa does not

seem to be a major concern because it is more than financed by capital inflows at

the back of strong macroeconomic fundamentals. However, there is the need to

underscore the fact that it is important to remain conscious of its magnitude and to

monitor the risks associated with running a current account deficit of this nature

(Tonia, 2007)

Nigeria, like most developing countries, adopted stabilization and adjustment

policies in the early 1980s. These programmes of reforms were attempts to move

the country away from regulated market to a more friendly market oriented

economy. This is because of the perception of policy-makers that the adoption of

the neo-classical economic doctrine is capable of propelling the economy to the

path of sustained growth and development, and therefore addresses the adverse

changes in current account balances. In line with this conceptualization of reform,

Nigeria has adopted various forms of policies and institutional reforms since

independence (Udah, 2011). These range from protectionism and excessive

government control of economic activity to movement towards free market

economy. All these were tended towards sustained economic growth and

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development and a healthy internal and external balance in the medium term.

Internal balance means the level of economic activity consistent with the

satisfactory control of inflation (Williamson, 1982), while external balance means

balance of payments equilibrium or sustainable current account deficit financed on

a lasting basis by expected capital inflow (Komolafe, 1996). Conventional wisdom

is that a large budget deficit is a source of economic instability and in the same

vein, a significant current account deficit increases the rate of interest, reduces

aggregate demand, leading to a reduction in investment and subsequent increase in

unemployment, which in all, will hurt the long-term economic growth. Other ills

associated with the twin anomalies in the event of persistent large deficits include,

increase in national indebtedness by borrowing internally and externally and

imposing burden on future generations.

On the above notes, this study intends to investigate the causal relationship

between budget deficit and current account imbalance for the period of 1960 -

2011. The model will be supported with other critical macroeconomic variables

that may influence the internal and external balances such as, real GDP

innovations, real exchange rate, real lending interest rate and trade openness.

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1.3. Objectives of the Study

This study intends to investigate the relationship between budget and current

account balances and most importantly to identify which one to target in order to

effect adjustment in the other. The inclusion of a trading partner is not just for the

purpose of comparison and references, but for the fact that the current account

balance of each country depends not only on its own budget deficit, but also on the

budget deficits of its trading partners (Douglas, 1988). The specific objectives of

the study include:

1. To determine the extent to which long-run steady state relationship exists

between budget and current account balances of the economies under

consideration.

2. To estimate the extent to which fiscal balance dynamics cause current

account imbalance in Nigeria and South Africa.

3. To explore the extent to which developments in current account deficits

cause variations in fiscal deficit of the countries under review.

4. To establish to what extent fiscal expansions influence developments in

private consumption in Nigeria and South Africa.

5. To investigate the degree of bi-directional causal relationship existing

between the twin anomalies.

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1.4. The Research Questions

Abstracting from the competing scenarios underlying twin deficits association, we

derive the following questions, whose answers would provide solutions to the

research problem, using data on the two largest open economies in African (by

GDP standard), South Africa and Nigeria.

1. To what extent does stable long-run relationship exist between current

account balance and budget balance?

2. To what extent do budget balance variations cause developments in current

account innovations in Nigeria and South Africa?

3. To what extent do current account deficit innovations cause developments in

fiscal balance of the economies under consideration?

4. To what extent do fiscal expansions influence developments in private

consumption in Nigeria and South Africa?

5. What degree of bi-directional causality exists between the twin anomalies in

Nigeria and South Africa?

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1.5. The Research Hypotheses

This section provides the tentative answer to the research questions subject to

proof or otherwise by the evidence from the study. Hence the working hypotheses

of the study are stated in null form as follows:

1. There is no stable long-run relationship existing between Fiscal balance

innovations and developments in current account balance of Nigeria and South

Africa.

2. Developments in budget deficit do not significantly cause developments in

current account imbalance in the economies under consideration.

3. Developments in current account imbalance do not significantly cause

innovations in fiscal deficit in Nigeria and South Africa.

4. Fiscal expansions do not exact significant influence on private consumption in

Nigeria and South Africa.

5. There exists no significant bi-directional causality between the twin anomalies

in Nigeria and South Africa

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1.6 Scope of the Study

The scope of the study defines the general outline of what the study did cover,

specifying the parameters to be employed with due regards to variables, geography

and timing. In the light of the above, this study surveyed the subsisting relationship

between government budget deficits and current account imbalance. The model

was supported with such other control variables as Gross Domestic Product

innovations, exchange rate dynamics, trade openness and market lending interest

rate for the period 1960-2011, using data on Nigeria and South Africa.

1.6. Significance of the Study

In recent years the twin deficits has been a subject of investigation. The decade of

1980s when deficits in budget and trade in case of the US economy behaved more

like twins rather than distant cousins, the interest in this topic increased further.

Although a number of authors have acknowledged this observed sequence (e.g.,

Fajana, 1993; Egwaikhide, 1989), specific investigations into the effects of

government deficit on the current account balance in developing economies,

Nigeria and South Africa inclusive, are still sketchy and the few existing results

appear to be inconsistent. Trade and fiscal deficits relationship has important

policy implications for a number of reasons; first, persistent large deficits cause

16

indebtedness by borrowing internally and externally, second, it imposes burden on

future generations. Thus, rising trade deficits is indeed escalating government

budget deficits, and the current account balance cannot be remedied unless policies

that address government deficits are put into place. Further, if such a view

concerning the causal role of the budget deficit is incorrect, then reductions in the

federal budget deficits may not resolve the trade deficit dilemma and more over,

scarce economic resources will be diverted from relevant and urgently needed

policy options. Thus, the need for this study is for the purpose of establishing

concrete evidence on the causality of the two important macroeconomic variables

to ensure appropriate targeting and informed policy decisions for correction of

internal and external disequilibrium.

The fact that the magnitude of government has increased with amazing rapidity

since the early 1980s further serves as motivation for this study. The results of this

study, in specific terms, will be of benefits:

(a) To the policy makers, the study will provide guide to the most appropriate

informed policy decisions that will strike both internal and external balance and

hence propel the economies of interest on the path of growth.

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(b) To the consumers as economic agents, they will be exposed to the concept of

Ricardian Equivalence which will make them forward-looking and rational

individuals that can respond promptly and appropriately to developments in such

macroeconomic variables as public debt and government size.

(c) To the academic, the importance of the study is based on the fact that it

employed the econometric methods that have gained considerable currency in

recent times, using unit root tests, and co integration analysis, error correction

model (ECM), granger causality and variance decomposition methods. Finally, the

findings of this study would add to the econometric literature of the selected

countries

1.8 The Operational Definition of Terms

Twin Deficits: The traditional view of twin deficits, also refer to as the Keynesian

absorption theory, implies that when an economy is operating at or near full

employment capacity, all things being equal, an increase in domestic budget deficit

will cause a similar increase or reduction in the current account deficits (CAD) or

current account surplus (CAS) respectively. The causality transmission channel is

as follows: A tax cut, increases budget deficits. This drives government into

borrowing to meet its obligations and commitments, thus competing with the

18

private sector for the available credit in the financial market. This drives up the

demand in the FM, leading to increase in interest rate. Increase in interest rate

causes increase (appreciation) in exchange rate to make exports of domestic goods

and services dearer and less competitive in the global market while leaving imports

cheaper and more attractive. This tortuous process ends up with increase in imports

and decrease in export to impact current account balance negatively. In effect, twin

deficits identifies a scenario where internal balance (budget balance) and external

balance (current account balance) trend together in the same direction.

Ricardian Equivalence: The traditional view of Ricardian equivalence suggests

that there is no direct significant link between budget balance and current account

balance. The “equivalency concept” states that consumers expect that a tax cut

today which results in fiscal deficits will lead to future increases in taxes to pay up

the public debt. Therefore, the increase in the disposable income of individuals as a

result of the tax cut will be saved or capitalized to provide for the expected future

tax increase rather than expending such additional income on consumption of

goods and services. In effect, the decrease in public savings represented by the

increase in fiscal deficits resulting from tax cut, will be equitably compensated by

the increase in private savings occasioned by the provision of safety for expected

future tax increase, so that national saving, remain unchanged. This leaves interest

rate unchanged, exchange rate unaltered, leaves foreign trade (imports and exports)

19

unaffected and thus, current account balance stable. Thus, fiscal measures designed

to influence aggregate demand may prove futile as individuals reduce consumption

in anticipation of future tax liabilities.

Twin Divergence: Twin divergence identity is completely divorced from concepts

of twin deficits and Ricardian equivalence presented above. Twin divergence is

rather of the traditional view that fiscal consolidation (reduction in public budget

deficit) will deteriorate the current account balance and verse versa. This in effect

means that government budget deficits and current account deficits will trend apart

(move in opposite directions) in response to fiscal measures aimed at internal and

external balance adjustments. This concept literally proposes that there is a

negative correlation between the public budget surplus and the current account

imbalance.

Current Account Targeting: This refers to one of the possible twin deficits

scenarios, which suggests that innovations in the current account stance will

significantly cause developments in government budget balance. This concept is

the reverse of the twin deficits proposition.

Fiscal Deepening: This refers to the increase in the ratio of public expenditure to

the gross domestic product of an economy.

20

References Abell, J. D. (1990). Twin Deficits During 1980s: An Emperical Investigation. Journal of Macroeconomics, 12, 81 – 96. Alkswani, M.A. (2000, October). The Twin Deficits Phenomenon in Petroleum Economy:

Evidence from Saudi Arabia. Paper presented at the Seventh Annual Conference, Economic Research Forum (ERF), Amman, Jordan.

Anoruo, E., Ramchander, S. (1998). Current Account and Fiscal Deficits: Evidence from Five Developing Economics of Asia. Journal of Asian Economics, 9 (3), 487-501. Aqeel, A & Nishat, M. (2000). The Twin Deficits Phenomenon: Evidence from Pakistan.

The Pakistan Development Review, 39 (4), 535–550 Bachman, B. (1992). Current Account Deficit Unrelated to Budget Surplus. National Centre

for Policy Analysis, http://www.ncpa.org/barlett.html. Bartlett, B. (1999). Are Budget Surpluses Equivalent to Tax Cuts? Idea House. National Center

for Policy Analysis, 1-3. Bartolini, L., & Lahiri, A. (2006). Twin deficits, twenty years later. Current Issues in Economics and Finance 12, 1-7. Bellongia, M. T., & courtney C.S. (1985). Would lower federal deficits increase US farm exports? Federal Reserve Bank of St. louis, review No: 5-19. Boucher, J. L. (1991). The U.S. Current Account: A Long and Short Run Empirical Perspective. Cavallo, M. (2005). Understanding the Twin Deficits: New Approaches, New Results. FRBSF

Economic Letter, Number 2005-16. Darrat, A. F. (1988). Have Large Budget Deficits Caused Rising Trade Deficits? Southern Economic Journal, 879-87. Dewald, W. G., & Michael, U. (1990). The Twin-Deficit Illusion. Cato Journal, 9 (3), 689–707. Douglas, B. B. (1988). Budget Deficits and The Balance Of Trade. The National Bureau of Economic Research, 2, 1 - 33 Edwards, S. (2005a). The End of Large Current Account Deficits, 1970- 2002: are there Lessons for the United States? National Bureau of Economic Research Workin Paper Number 11669. Enders, W., & Lee, B. (1990). Current Account and Budget Deficits: Twin or Distant Cousins.

Review of Economics and Statistics, 72, 374-382.

21

Erceg, C. J., Guerrieri, L., & Gust, C. (2005), Expansionary Fiscal Shocks and the Trade

Deficit,” International Finance Discussion Paper No. 2005 (825), Federal Reserve Board.

Evans, P. (1988). Are Consumers Ricardian? Evidence for the United States. Journal of Political

Economy, 96, 983-1004. Evans, P. (1993). Consumers Are Not Ricardian: Evidence from Nineteen Countries. Economic

Inquiry, 31: 534-548. Fajana, F.O. (1993). Nigeria's Debt Crisis. UNECA Development Research Paper Series, No.5. Holmes, M. J. (2004). The budget and current account balance: a case of twin deficits, twin divergence or Ricardian equivalence? Applied Economics Research Bulletin 1- 14. Islam, M. F. (1998). Brazil's twin deficits: An empirical examination. Atlantic Economic Journal,

26 (2), 121 – 128. Kasa, K. (1994). Finite Horizons and the Twin Deficits. Economic Review, Federal Reserve

Bank of Boston, 3, 19-28. Kearney, C., & Monadjemi, M. (1990). Fiscal Policy and Current Account Performance:

International Evidence on the Twin Deficits. Journal of Macroeconomics, 197- 218.

Khalid, A. M., & Teo, W. G. (1999). Causality Test of Budget and Current Account Deficits:

Cross-Country Comparisons. Empirical Economics, 24, 389 – 402. Kim, K.H. (1995). On the Long-Run Determinants of the U.S. Trade Balance: A Comment.

Journal of Post Keynesian Economics, 17, 447-55. Laney, L.O. (1984). The Strong Dollar, the Current Account and Federal Deficits: Cause and

Effects. Federal Reserve Bank of Dallas Economic Review, 1-14. Leachman, L. L., & Francis, B. (2002). Twin Deficits: Apparition or Reality? Applied

Economics, 34, 1121 – 1132. Mariam, C., Josep, L. C., & Cecilio, T. (2010). External Imbalances in A Monetary Union: Does the Lawson Doctrine to Europe? Retrived from www.researchgate.net/...Lawson_doctrine.../9fcfd5099876220373.p McCoskey, S., & Chihwa, K.(1999). Comparing Panel Data Cointegration Tests with an Application to the Twin Deficits Problem. Syracuse University. Mimeo.

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Michele, C. (2005). Understanding the Twin Deficits: New Approaches, New Results. Frbsf Economic Letter Number 2005-16, Milessi-Ferreti, G. M. and A. Razin (1996). Sustainability of persistent current account deficits. NBER working paper 5467. Miller, S. M., & Russek, F. S. (1989). Are The Twin Deficits Really Related? Contemporary

Economic Policy, Western Economic Association International, 7(4), 91-115. Miller, S. M., & Russek, F. S. (1989). Are the Twin Deficits Really Related? Contemporary

Policy Issues, 7 Mukhtar T, M. Z., & Ahmed, M. (2007). An Empirical Investigation for Twin Deficits Hypothesis in Pakistan. Journal of Economic Corporation, 28 (4), 63 – 80. Normadin, M. (1994). Budget Deficit Persistence and the Twin Deficits Hypothesis. Center for

Research on Economic Fluctuations and Employment. Universite du Quebec, Montrel. Working Paper No. 31.

Nozar, H., & Loretta, W. (2006). The Dynamics of Current Account and Budget Deficits in

Selected Countries of the Middle East and North Africa. International Research Journal of Finance and Economics, 5, 111 – 129.

Papaioannou, S., & Yi, K. (2001). The Effects of a Booming Economy on the U.S. Trade Deficit.

Current Issues in Economics and Finance, Federal Reserve Bank of New York, 7, 2.

Piersanti, G. (2000). Current Account Dynamics and Expected Future Budget Deficits: Some

International Evidence. Journal of International Money, 19, 255 – 271. Southern Economic Journal, 58 (1), 93-111. Soyoung, K., & Nouriel, R. (2007). Twin Deficit or Twin Divergence? Fiscal Policy, Current Account, and Real Exchange Rate in the USA. www.crei.cat/people/canova/teaching%20pdf/Twin%20def.pdf Summers L. H. (1988). Tax Policy and the International Competitiveness. In J. Frankel (Ed), International Aspects of Fiscal Policy, 349 – 375. Tonia, K. (2007). Current Account Situation in South Africa: Issues to Consider. Economic Research Working Paper No 90. Udah, E. B. (2011). Adjustment Policies and Current Account Behaviour: Empirical Evidence

from Nigeria. European Journal of Humanities and Social Sciences, 6 (1), 217 – 231.

23

Vamvoukas, G. (1999). The Twin Deficits Phenomenon: Evidence from Greece. Applied Economics, 31, 1093-1100.

Williamson, J. (1982). The Exchange Rate System. Washington D. C. Institute for International Economics Winner, L. E. (1993). The Relationship of the Current Account Balance and the Budget Balance.

The American Economist, 37 (2) 78 – 84. Zietz, J., & Pemperton, D.K. (1990). The U.S. Budget and Trade Deficits: A Simultaneous

Equation Model. Southern Economic Journal, 23-35.

24

CHAPTER TWO

REVIEW OF RELATED LITERATURE

Every piece of ongoing research needs to be connected with the work already

done, to attain an overall relevance and purpose (Kumar, 2009). In effect, review

of literature provides a link between the study in session and the studies already

done in related field. Literature review is intended to expose the reader to the facets

of the current work that have already been established or accomplished by other

authors, bestows the reader a chance to value the evidence that has already been

collected by previous studies and consequently direct current research work in the

proper perspective. On the above note, this chapter will survey some of what has

already been written about our topic of study, to enable us determine the

contribution of each source to the topic, understand the relationship between the

various contributions, identify and resolve contradictions where feasible to provide

justification for the study. Literature review is structured into two subsections: the

theoretical review, to ex-ray the conceptual foundation of the study and empirical

review, to evaluate relevant empirical works of similar nature.

2.1 Theoretical Review

The question of the relationship between budget deficit and current account

imbalance has three basic theoretical possibilities: the first is the twin deficits

25

hypothesis proposed by Keynes, second is the Ricardian equivalent proposition

(REP) and the third is the twin divergence theory.

Twin Deficits Hypothesis

The Feldstein chain’s argument, that an increase in the government deficit pushes

the interest rates up, which in turn attracts foreign capital and strengthens the

domestic currency driving the current account balance into deficits, appears to

have been the most important explanation for the controversial twin deficits

phenomenon (Feldstein, 1986). There are two approaches to the transmission

mechanism behind the twin deficits hypothesis as could simply be explained

through the Keynesian income-expenditure approach and the Mundell- Fleming

(FM) model founded on open economy and high capital mobility. From the

perspective of the income-expenditure approach, an increase in budget deficits will

increase domestic absorption (C + I + G) and, therefore the domestic income. The

increase in income will induce imports and eventually will reduce the surplus or

increase the deficit in the trade balance which is a component of current account

and thus makes the public sector and external sector deficits act as twins rather

than distant cousins. In Keynesian open economy models with high capital

mobility, an additional linkage can explain the deterioration in the trade balance

due to higher budget deficits. An increase in the budget deficit will cause an

26

increase in the aggregate demand and domestic real interest rates. The high interest

rates will cause net capital inflow from abroad and result in appreciation of the

domestic currency. The strong currency will make imports cheap and domestic

exportable less competitive in the global market and adversely affect net exports to

deteriorate the current account. Though these mechanisms may differ slightly, this

conclusion is valid both under fixed and flexible exchange rate regimes (Elif and

Gul, 2002). While admitting the harmful economic and social consequences of

huge budget deficits, critics of the FM approach are strongly doubtful of the

illustrated sequence of causation implied by these models. This has led some

researchers to cite the Ricardian equivalence hypothesis to argue that whether

fiscal deficit is financed through public debt or with increase in tax , the impact on

real interest rates, aggregate demand, private spending, the exchange rate or the

external accounts will remain neutral. Proponents of this view point out that while

tax cuts have the effect of reducing public saving and enlarging the budget deficit,

they increase private saving by an amount equal to the expected increase in the tax

burden in the future years (Nozar and Loretta, 2006).

Giancarlo and Müller (2006) in presenting the traditional debate on fiscal

transmission and twin deficits, stress two distinct transmission mechanisms: One

stresses relative price movements, the other intertemporal (borrowing and lending)

27

decisions. The first transmission mechanism is central to the Mundell- Fleming

model. Here, an expansionary fiscal shock raises disposable income and internal

demand. Part of the higher consumption demand ‘leaks abroad’ in the form of

higher import demand, deteriorating the trade balance. Moreover, with flexible

exchange rates a stronger domestic demand also appreciates the exchange rate,

crowding out foreign demand. Because of differences in the multiplier, the impact

is stronger for spending hikes than for tax cuts. The increase in the external deficit

is somewhat mitigated to the extent that the upsurge in domestic demand raises the

domestic interest rate, and thus crowds out domestic investment. Overall, however,

the emphasis is on the static transmission mechanism, linking fiscal deficits to

excess demand and relative price movements.

Some other studies support the twin anomalies hypothesis, that higher budget

deficit lead to higher current account deficits. For instance, based on his

assessment of the data from the United States, Normandin (1994) deduced that a

tax increase would directly decrease the budget deficit and would indirectly

decrease the external deficit, due to reduced imports induced by the decline of

private after-tax incomes. Kasa (1994) reports a significant connection between

trade deficits and budget deficits for the post war era for the United States, Japan

and Germany after controlling for the effects of fiscal expenditures on Gross

28

National Product (GNP).Similar results reported by Zietiz and Pemberton (1990),

Vamvoukas (1999), Miller and Russek (1989) and Islam (1990) are all in favour of

twin deficit hypothesis.

Despite the plethora of studies in favour of the conventional twin deficits

hypothesis, results of some other studies revealed reversed causation running from

current account balance to budget balance, what Poterba & Summers (1988) would

refer to as current account targeting. These include studies by Anorua and

Ramchander (1998), Ahmed & Teo (1999) and Alkswani (2000). Policy

implications of research findings dealing with the subject remain basically

ambiguous, time and space dependent and hence appear to be impracticable.

This inconclusiveness could come as a surprise when one considers the twin-deficit

hypothesis which suggests that when a government increases its fiscal deficit, for

instance by cutting taxes or increasing expenditure, domestic residents use some of

the additional income to boost consumption, causing national savings to decline.

The decline in national saving requires the country to either borrow from abroad or

reduce its foreign lending, unless domestic investment decreases enough to offset

the saving shortfall. Thus, a wider fiscal deficit typically should be accompanied

by a wider current account deficit. However; the twin-deficit hypothesis rests on

the assumption that the relationship between fiscal deficits and private

29

consumption is a positive one as suggested by the Keynesian model. This is not

necessarily true. In theoretical models the relationship between fiscal policy and

private consumption depends largely on whether Ricardian equivalence is

assumed. This equivalence theorem states that for a given path of government

expenditures, the timing of taxes should not affect the consumption decision made

by individuals paying the taxes (Christiane and Isabel, 2008). In concurrence,

Barro (1974) asserts that the simple idea behind the theorem is that rational

economic agents realize that substituting taxes today for taxes plus interest

tomorrow via government debt financing is the same. Therefore, the financing of

government spending via debt or taxes should not affect the current account either.

However, Keynesian economic models assume that a shift from tax to debt

financing increases private consumption. In many Keynesian models private

consumption depends on disposable income (income minus taxes). Therefore,

fiscal deficits (and lower taxes) increase private consumption and the current

account deficit.

The Ricardian Equivalence Hypothesis

On the other hand, proponents of the Ricardian Equivalence Hypothesis (REH)

deny any correspondence between the budget deficit and the current account

imbalance. This concept is of the view that since people are rational, they know

30

that the reduction in taxes, resulting from the government expansionary fiscal

policy of tax cut, is temporal and so they will save the extra disposable income to

pay for the future higher taxes. This suggests that the national savings will not be

affected because the decrease in government savings represented by increased

fiscal deepening will be equitably compensated by the additional precautionary

private savings for expected future increase in taxes.

According to Elif and Gul (2001) this hypothesis suggests that the equilibrium

levels of current account, interest rates, investment and consumption will not be

affected by the changes in the level of budget deficit. This assertion can be

regarded as an extension of the Permanent Income Life-Cycle Hypothesis

including government expenditure, taxes and debt, which indicates that a change in

the level of budget deficit will not change the lifetime budget constraint and real

wealth of the consumer. As a consequence of intertemporal consumption behavior,

according to the Ricardian equivalence proposition, temporary changes in the level

of government expenditures and marginal tax rates are much more important than

the ways of financing it. REH proposes that to explain the balance of payments

deficit, interest rate, productivity differentials, and temporary increases in the

public sector spending could be considered as alternative explanatory variables

besides budget deficits. Furthermore, the “equivalence theory” as articulated by the

31

classical economist, David Ricardo in 1817, suggests that government budget

deficits should not alter capital formation and economic growth or the level of

aggregate demand including demand for imports due to the fact that far-sighted

individuals fully capitalize the implied future taxes associated with budget deficits.

Otherwise s tated, the theory implies that there is no apparent correlation between

the two deficits. Though controversial, Ricardo’s neutrality hypothesis suggests

that the private sector views budget deficits as public investment and treats public

and private investment as perfect substitutes. Thus, fiscal measures designed to

influence aggregate demand will prove fruitless as individuals reduce consumption

in anticipation of future tax liabilities.

The REP further concludes that a tax cut has no effect on consumption since

rational individual, being aware of the intertemporal government budget constraint,

base their consumption decision on permanent income and will hence anticipate

increase in future tax liability by saving amount equivalent to the tax cut. The

theory is based on relatively strongly assumptions such as rational and forward-

looking individuals, Lump-Sum taxes, perfect capital market and infinite lives of

consumers all of which may render the REP’s practical relevance, at least in its

perfect form, questionable (Gerhard and Jesus, 2004).

32

In the same vein, the Ricardian equivalent hypothesis further states that if

government expenditure remains constant and there is a tax cut, individuals will

anticipate a tax increase some times in the future. Therefore, for this reason,

individuals will allocate the increase in disposable income dollar for dollar to

savings. The interest earned on this money will cover the interest element of

government debt liability, so that there will be no change in the present value of

real tax liability. To this effect, national savings will remain constant, because

dollar for dollar, the increase in private savings equals the decrease in government

savings. Therefore there will be no change in wealth unless government spending

changes and, the interest rate and current account balance should remain

unperturbed so long as change in private savings equal to the change in

government saving (Winner, 1993).

Others results that are in favour of Ricardian equivalence proposition include that

evidenced in Laney (1984) which found no “statistically significant linkages for

the postwar period between the actual U. S. and most of the larger industrial

countries’ budget balance and the current account balance. Other studies on the

relationship between twin deficits comprise those carried out by Kearney and

Monadjemi (1990), Godley and Cripps (1983), Enders and Lee (1990) and Evans

(1993). These authors do not detect a stable long-run association between the two

33

deficits using variety of samples. Other proponents of Ricardian equivalent include

Evans (1988), Miller and Russek (1989), Dewald and Ulan (1990), Kasa (1994),

Kim (1995) and Barlett (1999), Bhattacharya (1977), Boucher (1991) and

Papaioannou and Kei-Mu Yi (2001) who are unable to detect a plausible causal

relationship between the two deficits in their investigations and thus subscribed to

the Ricardian equivalence.

The Twin Divergence Theory

Although theory indicates that the budget deficit and the current account deficit

should move together, there is evidence equally that they could follow quite a

divergent path. One possible explanation for this divergence is related to the

impact of output fluctuations on budget and current account deficits. Let us

presume, for instance, that the economy enjoys a pour in productivity that results in

a growth in economic activity. To reap the opportunities of the high productivity,

private investment increases. As investment expenditure in general reacts more

strongly to the business cycle than private saving does, the current account balance

deteriorates. At the same time, the output expansion generates both an increase in

tax receipts and a decline in government expenditure, due, for example, to a

decline in unemployment benefits. Therefore, the budget balance improves

(Economic Letter 2005 – 16). This twin divergence hypothesis suggests that there

34

is negative correlation between the government budget balance and the current

account balance (Cardosoa and Doménech, 2008). This empirical evidence is very

interesting, since it seems to contradict well-known economic theory of twin

deficits. In fact, the recent experience of the Spanish economy seems to

corroborate the empirical findings by Kim and Roubini (2008) about what they call

ˇtwin divergence, that is, the usual empirical fact in the United States such that

when the public budget worsens the current account improves and vice versa.

Corsetti and Müller (2007) and Cavallo (2005 & 2007) obtained similar evidence

in support of the twin divergence theory.

2.2. Empirical Review

The empirical test for the role of the budget deficits in causing the trade deficits

has been a subject of controversy. Do the budget deficits affect the trade deficits?

If so, to what extent and through which channels do budget deficits affect the trade

deficits? The issues involved have important policy implications. Suppose that the

basic reason for rising trade deficits is indeed the escalating budget deficits. In this

case, policy makers may focus on curtailing the budget deficits in order to resolve

the trade deficit problem. This policy adversely affects several sectors such as

manufacturing industries and agriculture. However, if such a view concerning the

“causal” role of the budget deficits is incorrect, then reductions in the budget

35

deficits may not resolve the trade deficits dilemma and, moreover, attention will be

diverted from more relevant and urgently needed policy options.

There is surfeit of literature on the factors that may determine current account

behavior. For instance, Baharumshah et al., (2000) examine the twin deficit

hypothesis in Indonesia, Malaysia, the Philippines and Thailand and found a long

run relationship between budget deficit and current account. Their results also

showed a unidirectional causality without feedback effect, which runs from budget

deficit to current account deficit for Thailand. In Indonesia, current account

targeting was detected, whereas in Malaysia and Philippines, the causality was

bidirectional. Just as Udah in (2011) employs three methodologies of Granger

Causality test, the Co-integration test, the Variance decomposition and impulse

response function with the variance decomposition and impulse response function

following the Cholesky ordering. Evidence from the results suggests that causality

is bidirectional between current account balance and budget deficit. The Granger

Causality test also revealed the existence of a unidirectional causality of current

account balance with exchange rate and that exchange rate, monetary policy

credibility and budget deficit are important macroeconomic variables that influence

current account movement. However, the study found no causal link between

measures of financial indicator variables and current account balance. The study in

36

conclusion argues that to address the adverse changes in current account

movement, policy should tackle the problem from the demand and supply sides.

Thirlwall's Law believes that growth can be constrained by the balance-of-

payments when the current account is in permanent deficit. This Law centers on

external imbalances as impediments to growth without considering the case where

internal imbalances (budget deficits or public debt) can also constrain growth. The

recent European public debt crisis shows that when internal imbalances are out of

control, they can constrain growth and domestic demand in a severe way. It is in an

attempt to fill this gap that Elias et al., (2012) developed a growth model in line

with Thirlwall's Law that takes into account both internal and external imbalances.

The model is tested for Portugal which recently fell into a public debt crisis with

serious negative consequences on growth. The empirical results show that the

growth rate in Portugal is in fact balance-of-payments constrained and the main

drawback is the high import elasticity of the components of demand and in

particular that of exports.

Furthermore, Ozman (2004) empirically investigated the effects of institutional and

macroeconomic policy stance variables on current account deficits. The results

strongly suggest that better governance increases the ability of a country to control

37

adverse changes in current account behavior. In addition, the findings of the paper

indicated that a flexible exchange rate and openness imposes a discipline on

current account behavior. The net impacts of the financial deepening and monetary

credibility on current account balance were found to be insignificant.

Christiane and Isabel (2008) use a dynamic panel threshold model to shed light on

the relationship between the fiscal balance and the current account of the balance

of payments and to investigate the role of Ricardian equivalence for 22 industrial

countries during the period 1981-2005. In this model, the relationship between the

government balance and the current account is allowed to alter according to the

government debt level. At the same time we control for other factors influencing

the current account. Our calculations find three thresholds for the government debt

to GDP ratio: In low debt and medium debt countries (up to a debt level of 44% of

GDP) the relationship is positive, i.e. an increase in the fiscal deficit leads to a

higher current account deficit. In medium-to-high debt countries with debt ratios

between 44% and 90% of GDP the relationship is still positive but much less so. In

the very high debt countries with debt ratios of above 90% of GDP the relationship

is negative and insignificant, suggesting that a rise in the fiscal deficit does not

result in a rise in the current account deficit. Implicitly this result suggests that

private consumers have become Ricardian (i.e. they have offset the increase in the

38

fiscal deficit by a fall in private consumption). The results are similar when

estimating the same model for the 11 euro area countries included in the larger

panel. Here, two thresholds for the government debt to GDP ratio are found: at

56% and 80%. In this case, the relationship between current account and the

government budget balance is positive when the government debt to GDP ratio

remains below 80%. Thereafter the relationship is negative and insignificant.

Darrat (1988) has reported evidence supportive of bi-directional causality between

the twin deficits. Using quarterly data for the period 1960: I – 1984: IV, he

concludes that in the case of the United States, there is evidence of “budget-to-

trade deficit causality, but also stronger evidence of trade-to budget deficit

causality.” Darrat argues that studies that have assumed the budget deficit to be the

exogenous variable “could be biased and inconsistent. Moreover, as Cuddington

and Vinals (1986) have demonstrated the linkages between the two deficits is

influenced by the extent of unemployment and the stage of the business cycles.

These authors have shown that when the economy faces classical unemployment in

the short run, “an expected future increase in government spending will improve

the current account today.”

39

In response to the question of whether one can find any statistical evidence in

support of the hypothesis that fiscal innovations systematically move the budget

deficit and the trade deficit in the same direction, Giancarlo and Müller (2006)

reconsider the international transmission mechanism in a standard two-country

two-good business cycle model, and find that fiscal expansions have no effect on

the trade balance and thus on the current account (i) if the economy is not very

open to trade and (ii) if fiscal shocks are not too persistent. Under these conditions,

the crowding out effect of fiscal shocks on private investment is stronger than

conventionally believed. They take this insight to the data and investigate the

transmission of fiscal shocks in a VAR model estimated for Australia, Canada, the

UK and the US. For the US and Australia, which are less open to trade than

Canada and the UK, they find that the external impact of shocks to either

government spending or budget deficits is limited, while private investment

responds significantly – in line with our theoretical prediction. The reverse is true

for Canada and the UK. These results suggest that a fiscal retrenchment in the US

may have a limited impact on its current external deficit. However, the results do

not negate the case for fiscal consolidation: by crowding in investment, a fiscal

correction will strengthen the ability of the US to generate resources required to

service future external liabilities.

40

Within this literature, a few studies have focused on the effects of fiscal policy on

foreign trade, including Clarida and Prendergast (1999) who analyze the effects of

budget deficits on the real exchange rate, and Giuliodori and Beetsma (2004) who

use European data to investigate the effects of government spending on imports,

and especially Kim and Roubini (2003) who is the first to address the twin deficit

issue explicitly within a VAR framework using US data and find that a negative

innovation to the budget balance increases the current account. This suggests that

they find ‘twin divergence’ instead of twin deficits. The same finding was recorded

by Müller et al., (2004).

For the purpose of contributing further on the twin deficits debate in a developing

economy, Ahmad and Evan (2007) employed data for Thailand over three decades

and used as a case study. The major findings are: first, a stable, long-run

equilibrium relationship between fiscal deficit, interest rate, exchange rate, and

current account was found. Second, the causal relationship between the two

deficits runs from fiscal deficit to current account deficit. This evidence is

supportive of the twin deficits hypothesis. Further econometric analysis reveals

that the two financial variables (interest rate and exchange rate) act as

intermediating variables – that is, an increase in fiscal deficit causes interest rate to

rise, and this in turn puts pressure on the exchange rate. The appreciation of the

41

domestic currency causes a current account deficit. The paper is of value by

showing both direct and indirect channels to uncover the twin deficits phenomena.

Based on a persistent profile response, it was found that the adjustment process

may take as long as a year to complete.

Evan and Ahmad (2006) using a Panel Data Analysis investigate Twin Deficits

Hypothesis in SEACEN Countries. The twin deficits hypothesis was examined

using the panel data of nine SEACEN countries. Empirical results provide

evidence to support the view that Asian budget deficit causes current account

deficit directly as well as indirectly. From policy perspectives, the statistical

analysis suggests that managing budget deficit offers scope for improvement in the

current account deficit. However, this finding does not support the policy of

manipulating the intermediate variables to reduce the twin deficits to a sustainable

level since these variables appear to be endogenous in the system.

In what appears to be in response to the recent global financial crisis which has led

to graver imbalances in both the external and the internal deficits of several

countries including India, Suchismita and Sudipta (2011) commissioned this

empirical inquiry with a view to examining the causal linkages between the

government budget deficit and the current account deficit for India, within a multi-

dimensional system with the exchange and interest rates acting as the interlinking

42

variables. According to them, the causal chain of such linkages is important as

different results lead to very different policy recommendations regarding the target

variable for controlling the twin deficits. The conventional hypothesis of causation

running from the fiscal deficit to interest rates to exchange rates and then to the

external deficit is only partially borne out by the results, while evidence in favour

of reverse causation is very strong. Bringing in oil prices helps complete the chain

of reverse causation in the twin deficit hypothesis for India, as the direction of

causation is unambiguously seen to run from oil prices to the external deficit to the

fiscal deficit.

Since the mid 1980s, an extensive empirical literature has examined the

relationship between U.S. Fiscal deficits, exchange rates, and trade balances.

Jeffrey and Ellis (1993) investigate two questions that continue to spark debate: do

increased government deficits cause dollar appreciation, and do fiscal deficits lead

to higher trade deficits (the popular ‘twin deficit’ notion)? These issues are

investigated fusing a five-variable VAR system, generating posterior probability

bounds to assess significance. Results provide some evidence that growing

government deficits appreciate the dollar, and support the “twin deficit” notion that

government deficits contribute to trade deficits.

43

Recent developments in the Bulgarian economy bring into question the validity of

the twin deficit hypothesis. To this effect, Ganchev (2010) analyses the theoretical

foundations of an alternative explanations for this hypothesis and uses different

econometric approaches to test its validity on a sample of the Bulgarian data. A

Granger causality test suggests the existence of dual causality between the fiscal

and current account deficits. A vector autoregressive and a vector error correction

model both reject the twin deficit hypothesis in the short run, but indicate that it

might be valid in the long run.

In the same vein, Onafowora and Owoye (2006) used cointegration and vector

error-correction techniques, Granger-causality tests and, generalized impulse

response analysis to examine the "twin deficits" phenomenon in Nigeria - a small

open but oil dependent economy in Africa. Evidence of positive relationship

between trade and budget deficits in both the short- and long-run was found. This

finding supports the conventional Keynesian twin deficits proposition and refutes

the Ricardian Equivalence Hypothesis. Contrary to the conventional proposition

that budget deficits cause trade deficits, results indicate unidirectional causality

from trade deficits to budget deficits for Nigeria. An implicit policy implication of

our findings is that attempts to reduce budget deficits in Nigeria must begin with

44

reductions in trade deficits which could be achieved through indirect monetary

channels.

Halil and Sami (2011) investigate the twin deficit problem for the Turkish

economy using bounds testing approach known as ARDL (autoregressive

distributed lag) to cointegration analysis and Toda and Yamamoto Granger

causality test. The study covers the annual data from 1974 to 2010. The

cointegration test results suggest that the variables are moving together in the long

run. The positive value on the budget deficit coefficient implies that Turkey has a

twin deficit problem. The presence of twin deficit has also been supported by the

Toda-Yamamoto causality test results. As expected, the negative and less than 1

investment coefficient indicates Feldstein-Horioka hypothesis holds. Further, it

indicates that Turkey could not well-integrated into the international capital

markets with the model revealing that one fifth of the investments are financed

through foreign savings.

Sofia and Suzanna-Maria (2011) re-examine the issue of the twin deficits

hypothesis since recent theoretical and empirical analysis suggests that this

hypothesis is subject to structural shifts, the identification of which is very

important for policymakers in order to take the correct decisions to overcome

45

situations of economic turmoil. They used a different empirical approach and

extending the data sets. Furthermore, the employed a multivariate Vector Error

Correction framework including the endogenous determination of structural

breaks, to determine the causal relation between the budget deficit and the current

account deficit for Greece. The two deficits are found to be positively linked

through the Current Account Targeting Hypothesis.

Walter & Bong-Soo (1990) developed a two-country micro-theoretic model

consistent with the Ricardian equivalence hypothesis (REP). Specifically, tax

increases used to retire government debt will not affect private spending or the

current account balance. However, increases in government spending, regardless of

the means of finance, can be expected to induce a current account deficit. An

unconstrained vector autoregression shows some patterns in the recent U.S. data

which appear to be inconsistent with the REP. However, Rigorous testing of the

model, the results failed to reject the independence of the record federal

government budget and current account deficits.

Using panel structural VAR analysis and quarterly data from four industrialized

countries, Morten et al., (2007), investigate the proposition that an increase in

government purchases leads to an expansion in output and private consumption, a

46

deterioration in the trade balance, and a depreciation of the real exchange rate (i.e.,

a decrease in the domestic CPI relative to the exchange-rate adjusted foreign CPI).

They proposed an explanation for these observed effects based on the deep habit

mechanism and estimated the key parameters of the deep-habit model employing a

limited information approach. The predictions of the estimated deep-habit model

fit well the observed responses of output, consumption, the trade balance, and the

real exchange rate to an unanticipated government spending shock. In addition, the

deep-habit model predicts that in response to an anticipated increase in government

spending consumption and wages fail to increase on impact, which is consistent

with the empirical evidence stemming from the narrative identification approach.

In this way, the deep-habit model reconciles the findings of the SVAR and

narrative literatures on the effects of government spending shocks.

Philip & Roberto (1998) investigate the short-run impact of movements in different

components of fiscal policy on the trade balance, exports and imports, for a panel

of OECD countries over 1960–1995. The results indicate that the composition of a

shift in fiscal policy and the exchange rate regime is material for its transmission to

the external account. The strongest result indicates that an expansion in wage

government consumption causes a contraction in exports and a deterioration of the

trade balance, especially under flexible exchange rates.

47

Neda and Mohammad (2011) using panel data, theoretically studied the two

visions (Keynesian theory and Ricardian equivalence) of twin deficits using macro

economic variables for 70 countries for the period of 1985 – 2006. This review

first classifies the mentioned countries based on World Development Indicators

into different income groups of high, middle and low income countries. Then the

review of required variables based on the evaluation of budget deficit effect on

private consumption, economic growth and current account deficit on all income

groups are assessed and estimated by comparative method. A summary of the

acquired results would not affirm the relationship between the budget deficit and

current account deficit, consumption and economic growth in the period of study in

high-income countries. This relationship remains in force in middle and low

income countries, in other words Ricardian equivalence is rejected in these

countries

Ali Abbas et al., (2010) examine the relationship between fiscal policy and the

current account, drawing on a larger country sample than in previous studies and

using panel regressions, vector auto regressions, and an analysis of large fiscal and

external adjustments. On average, the results suggest that a strengthening in the

fiscal balance by 1 percentage point of GDP is associated with a current account

improvement of 0.2–0.3 percentage point of GDP. This association is as strong in

48

emerging and low-income countries as it is in advanced economies; and

significantly higher when output is above potential.

Romer and Romer (2007) investigate the impact of exogenous changes in the level

of taxation on gross domestic product (GDP) in the U.S. They use the narrative

record, presidential speeches, executive branch documents, and Congressional

reports to identify the size, timing, and principal motivation for all major postwar

tax policy actions. This narrative analysis allows them to distinguish tax policy

changes resulting from exogenous legislative initiative (aimed, for example, at

reducing an inherited budget deficit, or promoting long-run growth) from changes

driven by prospective economic conditions, countercyclical actions, and

government spending. Their estimates indicate that exogenous tax increases are

highly contractionary, mainly through a powerful negative effect on investment.

Insofar as investment spending is an important current account determinant, the

results point to a strong association between fiscal contraction and current account

improvements. Further, using Romer-Romer data, Feyrer and Shambaugh (2009)

estimate that one dollar of unexpected tax cuts in the U.S. worsens the U.S. current

account deficit by 47 cents.

Eugene et al., (2004) re-examined the causality between the twin deficits by testing

for Granger non-causality between Budget Deficits and Current Account Deficits.

49

Using international data from a sample of twenty developed and developing

countries, results provide evidence of causality (unidirectional or bi-directional)

between the twin deficits for some developing countries. However, the results for

developed countries are less persuasive. The empirical findings of this study are

robust to alternative and independent causality testing procedures.

In spite of the apparent importance of the effect of budget deficit on

macroeconomic variables, not much empirical work has been carried on the

ASEAN economies. Hence, Evan and Chan (2003) in this study intend to establish

the causal relationship between the twin deficits. An insight on the particular story

of twin deficits nexus in Malaysia and Thailand is presented in this paper. The role

of exchange rate and interest rate which acts as a source transmission mechanism

are proven to be important in the innovation of twin deficits debate and a version

of a ‘vicious circle’ is detected in Malaysia. First, we found causality run from

budget deficit to current account deficit (Keynesian paradigm) for Thailand and bi-

directional causality for Malaysia. Second, on the whole, budget deficit is the

driving force for interest rate, exchange rate and current account where the

transmission mechanism channel operates through exchange rate and interest rate

between the two deficits, supporting a version of Abell’s causal chain (or

Keynesian view). Third the exchange rate was found to “Granger” cause current

account deficit and not vice versa.

50

Ahmed and Teo (1999) in this study attempt to determine the causal relationship

between budget and current account deficits as well as the direction of such

causality. A selected sample of some developed and developing countries with

annual time series data is used and co integration techniques are applied to bring

evidence regarding this important issue. Results do not support any long-run

relationship between the two deficits for developed countries while the data for

developing countries do not reject such a relationship. However, results suggest a

causal relationship between the two deficits for most of the sample countries.

Bemheim (1988) employs econometric methodology to identify historical

relationships between fiscal policy and the current account for the United States

and five of its major trading partners. He attempts to provide some measures of the

extent to which variations in budget deficits explain variations in current account

balances, both across time and across countries. The evidence from the estimations

corroborates the view that fiscal deficits significantly contribute to a deterioration

of the current account. Indeed, the results subscribe to the fact that U.S. budget

deficits may have been responsible for roughly one-third of the U.S. trade deficit in

recent years.

51

Islam (1998), in his paper: “Brazil's twin deficits” examines empirically the causal

relationship between budget deficits and trade deficits for Brazil from 1973:1Q

through 1991:4Q. This relationship is investigated in the context of Granger's test

of causality. The final prediction error criterion, is applied in determining the

appropriate lag length of the two variables. Empirical results suggest the presence

of bilateral causality between trade deficits and budget deficits.

For the United States, Alberto (2005) assesses the effectiveness of some policy

measures aimed at reducing the size of the US “twin deficits”. The effects of these

policy changes are evaluated on a medium-run simulation horizon ranging from

2005 to 2015 using a world macro econometric model. Two scenarios are

evaluated: a fiscal consolidation carried out through an increase in direct tax rates,

and a devaluation of the USD. The results point out that a politically viable fiscal

consolidation or a plausible amount of exchange rate devaluation cannot prevent

the US external debt/GDP ratio to grow further in the next years. The stabilization

of the US net external liabilities requires a structural change in either the trade

flows or the saving and investment ratios in the US. US fiscal and external

imbalance sustainability has recently attracted a growing attention in the applied

macroeconomics literatures that focus explicitly on the “transpacific” dimension of

the US external imbalances and analyze scenarios where the adjustment comes

52

mainly from the Asian economies via private investment, fiscal deficit, or

exchange rate, among others. Their study is in a sense complementary to that of

Alberto (2005) which instead focuses mainly on the actions that could be taken by

the US. However, their model does not consider the EMU as a separate entity and

embodies it in the “Rest of the OECD” sector. Therefore, the impacts on the

EUR/USD exchange rate, or the EMU interest and growth rates, are not easy to

extricate from the results. Moreover, their claim that an interest rate increase could

help the US external deficit to shrink via reduction in US imports is acceptable

only in a model in which the net investment incomes from abroad are exogenous.

Results further suggest that a more realistic assessment of external imbalances

sustainability should take into account the debt/interest spiral.

John and Daniel (2011) investigate the effect of fiscal consolidation on the current

account. They examined contemporaneous policy documents, including Budget

Speeches, Budgets, and IMF and OECD reports, to identify changes in fiscal

policy motivated primarily by the desire to reduce the budget deficit, and not by a

response to the short-term economic outlook or the current account. Estimation

results based on this measure of fiscal policy changes suggest that a 1 percent of

GDP fiscal consolidation raises the current account balance-to-GDP ratio by about

0.6 percentage point, supporting the twin deficits hypothesis. This effect is

53

substantially larger than that obtained using standard measures of the fiscal policy

stance, such as the change in the cyclically adjusted primary balance.

In Nigeria, Egwaikhide (1997) considering the fact that the magnitude of

government has increased with amazing rapidity since the early 1980s, examines

the effect of budget deficit on the current account balance in Nigeria, covering the

period from 1973 to 1993. A macro econometric model that captures the salient

interrelationships between government budgetary developments, credit creation

and the current account balance is constructed. Evidence from the results suggests

that budget policy affects the current account balance in Nigeria. In particular,

simulation experiments show that budget deficit, engendered by increased

expenditure, leads to a deterioration of the current account, whether it is financed

through bank credit or external borrowing. This suggests that budget discipline is

necessary for the achievement of external balance in Nigeria.

Furthermore, Ali (2002) revisits the relationship between government budget

deficits and interest rates in Greece. Contrary to the results of Vamvoukas (1997)

the evidence deduce from system estimations of error-correction models

consistently denies any causal impact of the deficits on interest rates. Indeed, the

high correlation observed between the two variables appears to the outcome of

54

interest rates causing purposeful changes in the stance of fiscal policy. These

findings stand up to numerous sensitivity tests and provide further support to the

overwhelming evidence against the crowding-out hypothesis.

Also for Nigeria, Olopoenia (1986) adopted Morgan's analytical framework to

evaluate the implications of fiscal operations in Nigeria's balance of payments

developments. On the basis of the theoretical relationships established, the

argument was advanced that because the source of financing the domestic budget

balance comes mainly from the foreign budget balance, increased aggregate

demand enhanced through the monetization of foreign exchange earnings would

propagate inflation and create a balance of payments problem. In effect, this

evidence suggests that adequate care must be taken in financing budget deficit

through credit creation in order to achieve the macroeconomic objective of price

stability with external balance.

Oladipo and Akinbobola (2011) investigate the nature and direction of causality

between budget deficit and inflation with a view to providing empirical evidence

on budget deficit operation in stimulating economic growth through inflation in

Nigeria. Secondary data were used in this study. Data on inflation rate, exchange

rate, Gross Domestic Product (GDP) and budget deficit were collected from

55

statistical Bulletin and Annual Report and Statement of Account published by the

Central Bank of Nigeria (CBN) and the International Financial Statistics (IFS)

published by International Monetary Fund (IMF). Granger Causality pairwise test

was conducted to determine the causal relationship among the variables. The

results indicate that there was no causal relationship from inflation to budget

deficit (F = 0.9, P > 0.05), while the causal relationship from budget deficit to

inflation was significant (F = 3.6, P < 0.05). This implies that a uni-directional

causality from budget deficit to inflation exist in Nigeria. Furthermore, the result

showed that budget deficit affects inflation directly and indirectly through

fluctuations in exchange rate in the Nigerian economy.

Javid et al., (2011) empirically investigates the effects of fiscal policy or

government budget deficit shocks on the current account and the other

macroeconomic variable: real output, real interest rate and exchange rate for

Pakistan over the period 1960-2009. The structural Vector Autoregressive model is

employed; the exogenous fiscal policy shocks are identified after controlling the

business cycle effects on fiscal balances. The results suggest that an expansionary

fiscal policy shock improves the current account and depreciates the exchange rate.

The rise in private saving and the fall in investment contribute to the current

account improvement while the exchange rate depreciates. The twin divergence of

fiscal deficit and current account deficit is also explained by the output shock

56

which seems to drive the current account movements and its co-movements with

the fiscal balance.

In the same manner, Christiane and Isabel (2008) analyze the empirical

relationship between fiscal policy and the current account of the balance of

payments and consider how Ricardian equivalence changes this relationship. To do

so, they estimate a dynamic panel threshold model for 22 industrialized countries

in which the relationship between the current account and the government balance

is allowed to alter according to the government debt to GDP ratio. The results

show that for countries with debt to GDP ratios up to 90% the relationship between

the government budget balance and the current account is positive, i.e. an increase

in the fiscal deficit leads to a higher current account deficit. For very high debt

countries this relationship however turns negative but insignificant, suggesting that

a rise in the fiscal deficit does not result in a rise in the current account deficit.

Implicitly this result suggests that households in very high debt countries tend to

become Ricardian. Estimating the same model for the 11 largest euro area

countries shows that the relationship between the government balance and the

current account turns statistically insignificant when the debt to GDP ratio exceeds

80%.

57

Since, the early days of independence Nigeria’s fiscal operation and current

account position has been characterised by deficits and imbalances. It is on this

note, that Olanikpekun (2012) investigates the relationship between budget deficit

and current account balance in Nigeria from 1960-2008. Ordinary least square was

first explored to determine the effect of budget deficit on current account balance

in Nigeria. Various diagnostic tests preceded cointegration analysis. In order to

capture the short-run disequilibrium situation among the variables, namely current

account balance, budget balance, investment and private savings, an error

correction model was estimated as a follow up to cointegration analysis.

Estimation of long-run elasticities was done from the computed autoregressive

distributed lag. Thereafter Granger causality test was conducted to determine the

causal relationship among the variables. Ordinary least square result show that a

unit increases in budget deficit will cause 0.71 unit increase in current account

balance. Bound cointegration test established a long run relationship among the

variables. Evidence from the error correction model shows that 1% change in

budget deficit will cause 0.67% change in current account balance. The empirical

findings further indicate that there is a bi-directional relationship between budget

deficit and current account balance as revealed by the Granger causality test. The

findings support the twin deficits hypothesis for Nigeria.

58

Furthermore, Somia et al., (2011) examine the empirical relationship between

budget deficit and current account deficit in case of Pakistan over the period of

1971 to 2008, using autoregressive distributed lag (ARDL) approach in order to

test the validity of the Keynesian stance, which, states that there is positive and

significant relationship between the said variables. The results show that in case of

Pakistan, the long run Coefficients of control variables (GDP, ER and INT)

appeared to be significant and the most significant variable is budget deficit.

Hence, the Keynesian stance is valid in case of Pakistan. The feedback coefficient

is negative and significant suggesting that about 35% disequilibrium in the

previous period is corrected in current year. They find a stable long run

relationship between budget deficit and trade deficit as indicated by the CUSUM

and CUSUMq stability test.

Kumhof et al., (2012) investigate the empirical and theoretical link between

increases in income inequality and increases in current account deficits. Cross-

sectional econometric evidence shows that higher top income shares, and also

financial liberalization, which is a common policy response to increases in income

inequality, are associated with substantially larger external deficits. To study this

mechanism they developed a DSGE model that features workers whose income

share declines at the expense of investors. Loans to workers from domestic and

59

foreign investors support aggregate demand and result in current account deficits.

Financial liberalization helps workers smooth consumption, but at the cost of

higher household debt and larger current account deficits. In emerging markets,

workers cannot borrow from investors, who instead deploy their surplus funds

abroad, leading to current account surpluses instead of deficits.

Eberechukwu & Maxwell (2012) examine the determinants of current accounts

balance in Nigeria with emphasis on oil-related variables, using the Johansen-

Julius VAR co-integration estimation, the impulse response function and the

variance decomposition analysis. The results show that oil price, oil balance and

oil revenue are positively related with the current account, with only oil wealth

having a significant negative impact in the long-run. They find that the impact of

oil price on the current account balance is only significant in the short-run. The

variance decomposition analysis indicates that the variance in the current account

is better explained by own shocks followed by shocks to oil price, oil wealth

balance and fiscal balance

Recent theoretical and empirical analyses of the relation between the current

account and the government budget balance suggest that the “twin deficits”

relation is subject to structural changes. Most previous empirical analyses impose

the change point without resorting to econometric testing.

60

To this effect, Alberto (2006) uses time series data to evaluate the impact of

structural breaks on the long- and short-run relation between current account,

government balance and investment in 22 OECD countries. Results show that

when allowing for the possible existence of structural breaks of unknown date, the

data reveal more clearly the long-run relation between the current account and its

determinants. Moreover, the empirical results show that the degree of financial

integration is generally increasing in most OECD countries, including the leading

non-EU economies. This contrasts some recent evidence on the persistence of the

so-called Feldstein–Horioka puzzle.

Over the last three decades, many developing countries have experienced severe

currency crises. Levan and Akinori (2011) commissioned a study of how the

importance of twin deficits (budget and current account deficits) has changed in

predicting sudden stops from the 1970s to the mid-2000s using data from 42

developing countries. Results show that the explanatory power of twin deficits has

declined over the decades but that deficits of these kinds remain important factors

for predicting sudden stops. Our results imply that a large current account deficit is

an issue even when it is not accompanied by a budget deficit. This finding

contradicts Lawson’s Doctrine.

61

Oladipo et al., (2012) examine the effects of twins’ deficits in Nigeria for the

period 1970-2008 using Secondary time-series data and econometric techniques.

The results show a bidirectional causal relationship between budget deficits and

trade deficits in Nigeria. The study concludes that an appropriate policy measures

to reduce budget deficits could play an important role in reducing trade deficit and

complement this with budget-cut policies via a coherent package that focus on

policies for export promotion, productivity improvement and exchange rate,

amongst others.

Sophocles et al., (2012) commissioned this study with the aim of studying the main

macroeconomic, financial and structural factors that shaped current account

developments in Greece over the period from 1960 to 2007 and discuss these

developments in relation to the issue of external sustainability. Concerns over

Greece’s external sustainability have emerged since 1999 when the current account

deficit widened substantially and exhibited high persistence. The empirical model

used, which theoretically rests on the intertemporal approach, treats the current

account as the gap between domestic saving and investment. They examined the

behaviour of the current account in the long run and the short run using co-

integration analysis and a variety of econometric tests to account for the effect of

62

significant structural changes in the period under review. Results suggest that a

stable equilibrium current account model can be derived if the ratio of private

sector financing to GDP, as a proxy for financial liberalisation, is included in the

specification. Policy options to restore the country’s external sustainability are

explored based on the estimated equilibrium model.

Riccardo (2011) investigates the links between international global imbalances and

the recent international financial crisis. It also focuses on the asymmetries of the

dollar standard exchange rate regime. Global imbalances preceded the crisis but

were one of the ingredients that led to the financial crash of 2007-2008. The paper

rejects the ‘saving glut' explanation of the US trade deficit and shows that the key

role of the dollar in the international monetary system allows the USA to exert

seignorage in the international economy and created a circuit where Asian and oil-

producing countries financed the US deficit. The inflow of foreign capitals

increased the US domestic credit supply contributing to the development of the

sub-prime bubble. The paper concludes that only the creation of a supranational

monetary authority can eliminate the dangers of the asymmetric dollar standard

regime.

63

Joseph (2011) finds statistically robust and economically important effects of fiscal

policy, external financial policy, net foreign assets, and oil prices on current

account balances. The statistical model builds upon and improves previous

explanations of current account balances in the academic literature. A key advance

is that the model captures the effect of external financial policies, including

exchange rate policies, through data on net official financial flows. Based on

current and expected future policies, current account imbalances in major G-20

economies are likely to widen much more in the next five years than projected by

the International Monetary Fund (IMF). This paper concludes with a discussion of

appropriate policies to prevent widening imbalances.

Nozar and Ernie (n.d), employed structural vector auto regression (VAR) to test

the hypothesis that innovations in government budget deficit are positively

transmitted to trade deficit for middle Eastern and Northern African Economies of

Bahrain, Egypt, Iran, Jordan, Kuwait, Morocco, Oman, Nigeria, Syria, Tunisia,

Turkey and Yemen in the Middle East subcontinent. The empirical findings

suggest that the incidence of twin deficits appears to be country specific.

The observed cross-country variations with regard to the effects of fiscal deficits

on current account deficits tend to confirm that the dynamic relationship between

64

the two deficits is subject to change depending on the underlying tax system, trade

patterns and barriers, monetary regimes, the exchange rate and a complex host of

internal and international forces that shape a country’s economic status in the

global economy. Their findings further indicate no significant relationship between

changes in budget deficits and changes in the current account for Egypt, Iran,

Morocco, Syria, Nigeria, Tunisia, and Bahrain. By contrast, a reversed causality is

observed running from ∆CABt to ∆GBBt for Egypt, Jordan, Oman, Syria and

Yemen. In the case of Yemen, changes in budget deficits in response to changes in

the current account are delayed for at least one period since ∆GBBt-2 is statistically

significant while ∆GBBt-1 is not. In Egypt and Syria, changes in budget deficits in

response to changes in trade deficits are delayed for at least one period because

∆CABt-2 is statistically significant while CABt-1 is not.

Most applications of structural VARs and cointegration to the study of the short-

and long-run relationships among macroeconomic variables, in an open economy

context, do not include budget deficits as one of the key variables. Salifu and

Francis (1996), in an attempt to rectify this omission, incorporated budget deficits

into the analysis of the co movements in macroeconomic variables (budget deficits,

money interest rates, exchange rates and the current account balance) in the short

and long runs using a VAR approach. Empirical results suggest that a larger

65

proportion of variations in the interest rate differential between financial centres as

well as of variations in current account balances of countries is accounted for by

monetary innovations rather than by fiscal innovations. However, fluctuations in

real exchange rates are better explained by fiscal innovations.

2.3 Summary of Empirical Review

The entire gamut of empirical tests reviewed for the role of the budget deficits in

causing the trade deficits has been a subject of controversy as to: do the budget

deficits affect the trade deficits? If so, to what extent and through which channels

do budget deficits affect the trade deficits? Two competing views of Mundell-

Fleming [(Mundell (1968), and Fleming (1967)] and Ricardian equivalence (Barro,

(1974, 1989) explaining such variations in the deficits were identified.

According to Mundell-Fleming model, budget deficits cause current account

deficits. Studies in favour of the twin deficits hypothesis include those undertaken

by Abell (1990); Islam (1998); Zietiz & Pemberton (1990); Bachman (1992);

Kasak (1994); Vamvoukas (1999); Aqeel & Nishat (2000); Piersanti (2000);

Leachman & Francis (2002); Cavallo (2005); and Erceg, Guerrieri., & Gust

(2005) etc. Results of these studies supported the conventional view that the twin

66

deficits share positive association and that causality runs from budget deficit to

current account deficit.

Furthermore, Laney (1984); Miller & Rusek (1989); Dewold & Ulan (1990);

Enders & Lee (1990); Boucher (1991); Evans (1993); Winner (1993); Kim

(1995); Bartlett (1999); Papaioannou, Kei – Mu Yi (2001); and Kaufmann et al.,

(2002) amongst others support the view of Ricardian Equivalent as they failed to

identify any stable Long-run relationship between the two deficits.

The plethora of empirical literature reviewed above, each has investigated the

possible causal correspondence between budget deficit and current account deficit

using the five possible scenarios as theoretical foundation. All have employed co

integration analysis and granger causality tests for the parameter estimation. Most

of the studies specified bi-variate VAR model, while some others augmented the

two variable VAR model with some other critical variables as control to avoid the

problem of misspecification. Such variables include: real interest rate, real

exchange rate, real output and real money supply.

In all of the survey, the author is yet unaware of any of the studies that have

included trade openness in the model for investigating the causal relationship

67

between government budget balance and the current account imbalance. Bearing in

mind the likely influence of this variable on the stance of both budget and current

balances, which may be of great consequence, this study, in a bid to remedy this

lacuna, incorporated trade openness into the analysis of the co movements in

macroeconomic variables of budget deficits, money market interest rates, exchange

rates and the current account balance in the short and long runs using co

integration approach. Furthermore, this model used real GDP annual innovations

(growths) rather than the absolute/aggregate value as identified in most of the

reviewed empirical literature and, finally, we employed real market lending

interest rate which drives developments in private investment, in place of using

prime lending rate/bank discount rate as observed in most of the reviewed studies

that employed this variable. These have provided enough justification for the

study.

68

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CHAPTER THREE RESEARCH METHODOLOGY

3.1 Research Design

Research design refers to the overall strategy that a researcher chooses to integrate

the different components of a study in a coherent and logical way, thereby,

ensuring the researcher effectively addresses the research problem. In effect, it

constitutes the blueprint for the collection, measurement, and analysis of data and

it is the research question that determines the type of design to adopt and not the

other way around. This is quite different from research Methodology which refers

to the methods, techniques, and procedures that are employed in implementing a

research plan (design). For this study, Causal Comparative or Ex Post Facto

Research Design is adopted. This is because the study attempts to explore cause

and affect relationships where causes already exist and cannot be manipulated.

Ex-post facto research is systematic empirical inquiry in which the scientist does

not have direct control of independent variables because their manifestations have

already occurred or because they are inherently not manipulated. Inferences about

relations among variables are made, without direct intervention, from co

commitment variation of independent and dependent variables. This kind of

research is based on a scientific and analytical examination of dependent and

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independent variables. Independent variables are studied in retrospect for seeking

possible and plausible relations and the likely effects that the changes in

independent variables produce on a single or a set of dependent variables.

The study used what already exist and look backwards to explain why. In this

study, we seek to establish the association between current account balance and

fiscal deficit for Nigeria and South Africa. The study goes further to establish the

direction of the flows. To achieve these fits, we opted to deploy the relevant

variables as follows: current account deficit (CAB) as the explained variable, and

budget deficit (GBB), real exchange rate (RER), real gross domestic product

(RGDP), real interest rate (RIR) and real trade openness (OPNESS)) as

explanatory variables. Real GDP means the gross domestic product as adjusted for

inflation and is included in the model to control for business cycle.

Annual data were sourced from the IMF-International financial statistic (IFS),

direction of trade (DOT) on-line and Central Bank of Nigeria (CBN) statistical

bulletin for the periods 1960 to 2011. Different variables and latest analytical

econometric application package software such as E-View 7.0 was used frequently

during the study. For the purpose of diagnosing the employed variables for fitness

and suitability for purposes intended, E-view 7.0 econometric application package

(software) was used to check whether the data are stationary or otherwise,

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employing the Augmented Dickey-Fuller and Phillip Peron (PP) tests procedures.

Whether long run and short run relationship exist or otherwise, among the choice

variables was gauged through co-integration and ECM estimations. Furthermore,

the study ran granger causality and variance decomposition tests, with impulse

response function to establish the direction of flows and the degree of influence of

each explanatory variable on the explained variable respectively.

3.2 Model Specification

Twin deficit hypothesis mainly states that government budget deficits will cause

trade deficits. However, this is not the only theoretically possible relationship

between the budget and the trade deficits. The other extreme of Ricardian

equivalence hypothesis, holds that it is also possible that the two deficits are not

related at all. In the light of the above, this study investigated these hypotheses of

twin deficits and twin divergence or Ricardian equivalent for South Africa and

Nigeria for the periods 1960 – 2011 using bi-variate and multi-variate (VAR)

models based on co–integration analysis and the error correction model (ECM)

strategy. This enabled us examine the relationship between internal and external

deficits in both long and short-run frameworks.

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Higgins & Klitgaard (1998), Nozar & Loretta (2006) amongst others, define gross

national product (GNP) as the sum of income derived from producing goods and

services for private consumption (C), private investment (I), government purchases

of goods and services (G), and exports (X). Consistent with the standard GNP

identity, we treat imports (M) as a negative item to avoid double counting of

consumption or investment goods purchased at home but produced abroad. To this

effect, GNP is represented by:

GNP = C + I + G + X – M, (1)

Where X - M signifies net exports plus net factor income. A second basic equation

in the national income accounts is established on the theory that income received

by individuals has four possible uses of being consumed “C”, saved “S” (private

saving), paid in taxes “T”, or transferred abroad “Trf”. Because GNP is simply the

sum of the income received by all individuals in the economy, we have:

GNP = C + S + T + Trf, (2)

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By equating the two expressions for GNP developed above, canceling out

consumption (C) common to both expressions, and rearranging terms, we derive

the external and internal balance equation as:

X - M - Trf = (S - I) + (T - G), (3)

Where, (X - M – Trf) = current account balance (CAB) and [(S - I) + (T - G)] =

government budget balance (GBB). In other words, the current account balance is

equal to the difference between private saving and investment, and the gap

between government tax receipts and government expenditures on goods and

services.

At this point, we considered it plausible to follow the framework adopted by Aqeel

and Nishat (2000) to define the relationship between budget deficit and current

account deficit as:

CAB = [(S - I) + (T - G)] (4)

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Where CAB is the current account balance, (S - I) represents private savings less

private investments and (T – G) indicates total government tax receipts minus total

government expenditures on goods and services.

In other words, the current account balance is equal to the difference between

private saving and investment, and the gap between government tax receipts and

government expenditures on goods and services (government budget balance,

GBB). Thus, equation 4 expressed in a more clear term would appear as:

CAB = GBB (5)

We suppose that current account balance (CAB) and government budget balance

(GBB) are jointly determined by a two variable VAR with constant as the only

exogenous variable. With two lagged values of the endogenous variables, the VAR

(2) is expressed as:

CABt = a11CABt-1 + a12CABt-2 + β 11GBBt-1 + β 12GBBt-2 + c1 + e1t (6) GBBt = a21CABt-1 + a 22CABt-2 + β 21GBBt-1 + β 22GBBt-2 + c2 + e2t (7) Then for the purpose of investigating the extent to which long-run causal linkage

exist from budget deficits to current account deficits and vice versa, equations 6

and 7 are augmented with their respective error correction terms lagged one period

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denoted by δ. This transform the above VAR (2) models to vector error correction

models (VECM).

Where a, β, c are parameter to be estimated and e, stochastic error term. While equation (5) shows that current account balance is associated with the gap

between domestic saving and investment, it does not provide a theory of how the

current account balance is determined. In effect, this phase of the investigation is

bereaved of any attempt to incorporate the complex theoretical linkages between

exchanges rates, domestic interest rates and other contributing factors that could

influence the magnitude of savings, investment, export and import flows. Though,

since both current account and government budget data are reported in the same

frequency, equation (5) may still offer a satisfactory basis for empirical research

and trade policy debate, the absence of the critical macroeconomic fundamentals

constitutes a significant gap that may impair the results of this study and thus needs

to be filled. This suggests the need for multivariate formulation by augmenting

equation 5 with real GDP, bank lending rate, exchange rate and trade openness as

follows:

CAB = f (GBB, RER, LENDRATE, RGDP, OPNESS) (8)

The role of exchange rate and interest rate which acts as a source transmission

mechanism, are proven to be important in the innovation of twin deficits debate

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(Evan & Chan, 2003). For the purpose of estimation, the above functional notation

is expressed in multivariate linear model with intercept as follows:

CAB = a0 + a1GBB + a2RER + a3LENDRATE + a4RGDP + a5OPNESS + µ (9) For more accurate prediction of the relationship between the explained and the

explanatory variables and other usual statistical reasons, equation (9) is further

transformed to log-linear model excepting for the real GDP innovations with

mixtures of positive and negative values in the time series variables.

LCAB = a0 + a1LGBB + a2LRER + a3LLENDRATE + a4RGDP + a5LOPNESS + µ (10) Where CAB is the current accounts balance, GBB = government budget balance,

RER = real exchange rate of the naira to a USD, LENDRATE proxied real

domestic lending interest rate, RGDP means real GDP innovations and OPNESS

represents ratio of total trade to GDP, a0 is a constant, a1;…;a5 indicate the

explanatory power of the variable or correlation coefficients, and µ is the stochastic

error term, while L is the logarithm. One motivation for using the log-linear model

for estimations is the ease of output interpretation, because under a log-linear

model the rates change at a constant percent per year, when comparing trends

across divergent group variables or data where the rates are very different, the

advantage of a log-linear model is that the annual percentage change (APC) is a

metric which makes sense to compare across widely different scales and again is

that log-linear models are flexible. (www.google.com.ng/#q). The above equations

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(8-10) were intended just to predict the linear function of the employed variables,

but for the purpose of investigating the short and long run causal links between

fiscal deficits and current account imbalance, VAR (6, 2) models are specified and

evaluated as indicated from equations (11-16).

CABt = a1 + a11CABt-1 + a12CABt-2 + b11GBBt-1 + b12GBBt-2 + C11RERt-1 + c11RERt-z + d11Lendratet-1 + e11RGDPt-1 + e12RGDPt-2 + f11Opnesst-1 + f12Opnesst-2 + ε1t (11) GBBt = a2 + a21CABt-1 + a22CABt-2 + b21GBBt-1 + b22GBBt-2 + C21RERt-1 + C22RERt2 + d21Lendratet-1 + d22Lendratet-2 +e21RGDPt-1 + e22RGDPt-2 + f21Opnesst-1 + f22Opnesst-2 + ε2t (12) RERt = a3 + a31CABt-1 + a32CABt-2 + b31GBBt1 + b32GBBt2 + c31RERt-1 + c32RERt-2 + d31Lendratet-1 + d32Lendratet-2 + e31RGDt-1 + e32RGDPt-2 + f31Opnesst-1 + f32Opnesst-2 + ε3t (13) Lendratet = a4 + a41CABt-1 + a42CABt-2 + b41GBBt-1 + b41GBBt-1 + b42GBBt-2 + c41RERt-1 + c42RERt-2 + f41Opnesst-1 + f42Opnesst-2 + ε4t (14) RGDPt = a5 + a51CABt-1 + a52CABt-2 + b51GBBt-1 + b52GBBt-2 + c51RERt-1 + c52RERt-2 + d51Lendratet-1 + d52Lendratet-2 + e51RGDPt-1 + e52RGDPt-2 + f51Opnesst-1 + f52Opnesst-2 + ε5t (15) Opnesst = a6 + a61CABt-1 + a62CABt-2 + b61GBBt-1 + b62GBBt-2 + c61RERt-1 + c6RERt-2 + d61Lendratet-1 + d62Lendratet-2 + e61RGDPt-1 + e62RGDPt-2 + f61Opnesst-1 + f62Opnesst-2 + ε6t (16)

The motivation for using multi-variate VAR models stem from the fact that

Vamvoukas (1997), in his investigation of twin deficits for Greece, estimated bi-

variate model and found no existence of co-integration between the two deficits,

but when he augmented the model with GDP as the third variable, he found strong

and stable co-integration between the two deficits. Furthermore, in testing for

causality between budget and trade deficits, it is most appropriate to employ a

multivariate rather than a bivariate framework in order to avoid distorting the

causality inferences due to the omission of relevant variables, and research into

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the twin deficits story requires explicit examination of the entire gamut of variables

that may relate meaningfully to trade and government deficits behavior (Tallman

and Rosensweig, 1991). Akaike’s information criterion (AIC) was employed in the

selection of the VAR lag length being guided by the lag length which yields the

smallest value for our information criterion.

Decision Rules: Abstracting from Koop (2005), the following conditions govern the findings of this

study:

(1) If equation 11 is evaluated and b11 = b12 = 0, it suggests that budget balance

position does not significantly cause current account balance, which

suggests that twin deficit hypothesis is violated.

(2) For equation 12, if a21 = a22 = 0, it indicates that current account deficits do

not significantly cause Budget deficits, which will mean that current account

targeting scenario is equally violated.

(3) And if b11 = b12 = 0 and a21 = a22 = 0, provides evidence of no bi-directional

relationship between current account balance and government budget

balance in Nigeria.

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(4) If any cointegrating equation is identified among the variables, which

suggests evidence of long-run steady state equilibrium relationship among

the variables, then the models are best specified in VECM (Engle-Granger,

1987). In this instance, equations 11 – 15 are retained but each is augmented

with an additional regressor of its error term lagged one period designate by

e1t-1,…,e6t-1, with their coefficients of λ1,…,λ6, for equations 11 – 15

respectively. This transforms the VAR (2) models to VEC (2) models to

enable us test for the existence of long run causal link between fiscal deficit

and current account imbalance.

(5) Equations 11 and 12 as adjusted with inclusion of λ1e1t-1 and λ2e2t-1

respectively are evaluated for flow of long run causality from budget deficits to

current account deficits and vice – versa. If equation 11 as adjusted is evaluated

and b11 = b12 = λ1 = 0 indicates no long-run causal link from budget deficits to

current account deficits and if for equation 15 as adjusted a21 = a22 = λ2 = 0

suggests no significant long run causal association from current account balance to

budget deficit.

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3. 3 Data Discussion

The six variables employed in this study are discussed below.

The Current Account Balance (CAB): By current account balance we mean net

trade in goods and services, plus net earnings from rents, interests, profits,

dividends and net transfer payments (such as pension funds and salaries). Trade

balance, analogous to current account balance (CAB), in most instances is stated as

the value of net exports (X – M). In this study we measure current account balance

as the ratio of the values of total credits in current accounts to the total debits in the

current accounts. The x/m ratio has been employed in many empirical analyses to

determine trade balance exchange rate relationship (Rincon, 1998; Bahmani-

Oskooee and Brooks, 1999 and, Gupta-Kapoor and Ramakrishnan, 1999). One

reason adduced for its use according to Bahmani-Oskooee, (1991) is that this ratio

is not sensitive to the unit of measurement and can be interpreted as nominal or

real trade balance. Furthermore, this ratio in a logarithmic model yields the exact

point elasticity rather than approximation (Boyd et al, 2001).

Government Budget Balance (GBB): In the same vein, government budget balance,

for the same reasons adduced above, is proxied as the ratio of total revenue

accruing to federal government to total expenditure of the federal government on

goods and services. Further motivation for preferring this unit of measurement is

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that it saves us the quagmire of taking negative values to logarithm in the process

of generating log-linear model. Such transformation is required for more robust

estimation results.

Real exchange rate (RER): A real exchange rate between two currencies is

calculated as the product of the nominal exchange rate and relative price levels in

each country. To this effect, the real exchange rate variable will be derived by

multiplying the world price (Pw) by the nominal exchange rate and dividing the

product by the domestic price index (NER*Pw/DCPI) to transform the data into

index form.

Real Bank Lending Rate (LENDRATE): This refers to nominal interest rate as

adjusted for inflation. The relationship between the inflation rate and the nominal

and real interest rates is given by the expression: (1+r) = (1+n)/ (1+i). However for

low levels of inflation we can use the much simpler Fisher Equation to calculate

the real interest rate as: r = n – i. where r, n and i represent real interest rate,

nominal interest rate and inflation rate respectively.

Real Gross Domestic Product Growth: RGDP will be proxied by the nominal

gross domestic product deflected with the GDP deflector to control for inflationary

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trend. Then the annual innovations in the real GDP provide approximation for real

GDP growth.

Openness (OPNESS): Openness refers to the degree of exposure of the domestic

economy to the external economic environment and can be proxied by the ratio of

total trade (exports + imports) to the gross domestic product (GDP).

3.4 Data Sources

The analysis covers time series data spanning across 1961-2011, and sourced

primarily from the IMF International Financial Statistics on-line, the Central Bank

of Nigeria (CBN) statistical bulletin (2010), the IMF International Financial

Statistics CD Rom (2011), The IMF Direction of Trade (DOT) and Government

Financial Data (GFD) on-line.

3.5 Econometric Procedure

Economic theory provides ample explanations of the possible interrelationships

between current account and budget balances. However, their validity appears to

be an empirical issue. Abstracting from recent literature we investigate the twin

deficits hypothesis by employing cointegration analysis.

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Unit Root Test

The first step in a cointegration analysis is to examine the stationary status of each

of the univariate series to avoid the problem of spurious regression. The

Augmented Dickey-Fuller (ADF) and Phillip-Perron (PP) unit root tests are

employed to test this integration level and the possible co-integration among the

variables, (Dickey and Fuller, 1981; Phillips and Perron, (1988). A test of

stationary that has become widely popular over the past several years is the unit

root test. The Augmented Dickey–Fuller (ADF) and Phillip Peron (PP) tests are

among the famous unit root tests to check the stationarity of economic variables

and these will be employed in this study. Many economic time series may be non-

stationary and therefore may need to be differenced (d) times till stationarity is no

more violated. To perform a formal test of stationarity, the Augmented Dickey

Filler (ADF) test will be utilized, employing and estimating the following standard

regression equation:

∆Y t = α0 + α1t + α2Yt-1 + ∑ αj∆Y t-j+1 + Ɛt (17)

where Yt is a macroeconomic variable at time t, εt is the disturbance term that is

generated from a white noise process and is assumed to be independently and

identically distributed with zero other words, the first difference of Yt is regressed

against a constant, a time trend (t = 1, 2 , ..., T), the first lag of Yt, and, if necessary,

q

j=2

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lags of ΔYt. Sufficient lags of ΔYt must be included to ensure no autocorrelation in

the error term. Hence, the Schwarz Information Criterion (SIC) test would be

utilized to confirm that autocorrelation is not present. If a unit root exists, then α2

would not be statistically different from zero. The test for a unit root is based on

the t-statistics on the coefficient of the lagged dependent variable Yt-1; α2. This has

to be compared with specific calculated critical values. If at level the calculated

value is greater than the critical value in absolute term, then the null hypothesis of

a unit root is rejected, and the variable is taken to be stationary. If the data set

indicates integration property of the order 1(1) for the employed variables, then we

proceed to test for cointegration among the variables employing Johansen (1991),

Johansen and Juselius (1994) test techniques.

Cointegration Test

An informal method could be used; by looking at a time plot of the variable and

checking if there is any obvious trend in the data. Co-integration means that

despite being individually non-stationary, a linear combination of two or more time

series can be stationary. There are three main approaches to testing for co-

integration: The Engle-Granger two-step method, the Johansen procedure, and the

Phillips-Ouliaris Co-integration approach. According to Alkswani (2000), the

Maximum Likelihood procedure suggested by Johansen (1988 and 1991) and

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Johansen and Juselius (1990), is favored when the number of variables in the study

exceeds two variables due to the possibility of existence of multiple co-integrating

vectors. Gonzalo (1994), in the same vein is still of the view that the advantage of

Johansen’s test is not only limited to multivariate case, but it is preferable than

Engle-Granger approach even with a two-variable model. Two statistic tests are

employed in determining the number of co-integrating vectors; the Trace test and

the Maximal eigenvalue test. The first one tests the null hypothesis that the number

of co-integrating vectors equals or less than (r). This test is calculated as follows:

Trace = -T ∑ In (1 - λt) (18b)

Where λt +1 ,…, λp are the (p – r) smallest estimated eigenvalues. The second test

(λmax), examines the null hypothesis that there is (r) of co-integrating vectors

against the alternative that (r + 1) co-integrating vectors. This will be estimated

from the equation:

λmax (r, r + 1) = -T In (1 - λt +1) (18b)

If co-integration is accepted, it suggests that the model is best specified in the first

difference of its variables with one period lag of the residual [ECM (-1)] as an

additional regressor. To this effect we will run the regressions in their first

differences. However by taking the first differences, we lose the long-run

relationship stored in the data which suggests that we have to use the variables at

q

j=2

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both their levels and first differences. The advantage of using error correction

models (ECM) is that it incorporate the variables at both their levels and first

differences and by so doing, ECM captures the short-run disequilibrium situations

as well as the long-run equilibrium adjustments between variables (Mukhtar et al.,

2007).

Let us consider variables GBBt and CABt, where GBBt is the actual budget deficit

in real terms, CABt, is the current account balance in real terms, and t stands for

time. If GBB and CAB are considered to be stochastic trends and if they follow a

common long-run equilibrium relationship, then GBB and CAB should be

cointegrated. Cointegration is a test for equilibrium between non-stationary

variables integrated of same order. According to Engle and Granger (1987),

cointegrated variables must have an ECM representation. The main reason for the

popularity of cointegration analysis is that it provides a formal background for

testing and estimating short and long-run relationships among economic variables.

Furthermore, the ECM strategy provides an answer to the problem of spurious

correlations. If GBB and CAB variables are co integrated, the corresponding error

correction representations must be included in the system so that by so doing, one

can avoid misspecification and omission of the important constraints, but on the

other hand, if the variables are not integrated of the same order or are not

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cointegrated, the VECM cannot be applied either (Granger, 1988). The ECM

representation could have the following form:

where 1 denotes the identity operator, which does not have any effect, L is the lag

operator and Ct–1 and Et–1 are error corrections term. The error correction term Ct–1

in Equation 19 is the lagged value of residuals from the co integrating regression of

GBBt on CABt and the term Et–1 in Equation 20 corresponds to the lagged value of

residuals from the cointegrating regression of CABt on GBBt. In Equations 19 and

20, ΔGBBt–i, ΔCABt–i, ut and et, are stationary, implying that their right hand side

must also be stationary.

1

It is obvious that Equations 19 and 20 compose a bi-variate vector auto-regression

(VAR) in first difference augmented by the error-correction terms C t–1 an d E t–1

1

94

indicating that ECM and co-integration are equivalent representations. According

to Granger (1988), in a co-integrated system of two series expressed by an ECM

representation, causality must run in at least one direction. In estimating the

models, we will therefore rely on the developments in the co-integration theory

otherwise referred to as the “error correction mechanism” (ECM). This was

developed to overcome the problems of spurious regression often associated with

the non-stationary times series and to generate valuable long-run relationship

simultaneously (Engle and Granger 1987; Hendry, 1986). The decision rules

within the ECM representation of Equations 12 and 13 are that: CABt does not

Granger cause GBB if all a3i = 0 and a1 = 0 and equivalently, GBBt, does not

Granger cause CABt if all b2i = 0 and b1 = 0.

It is also possible that the causality between GBBt and CABt estimated from the

ECM formulation could have been caused by a third variable. Such a possibility

may be explored within a multivariate framework by including other important

variables, for example, real output innovation, real exchange rate, real interest rate

and trade openness, which represent considerable determinants of government

budget and current account deficits. Thus, the causal relationship between GBBt

and CABt can be examined within the following ECM representation:

95

Where Xt could be a third variable such as GDP innovation, real exchange rate,

real interest rate and trade openness. In ECM Equations 21 and 22, Ct–1 and Et–1 are

the lagged values of the residuals from the co-integrating equations. Regarding

GDP innovations, real exchange rate, real interest rate and trade openness as

control variables, the system captures the response of GBBt and CABt to changes in

these variables creating an additional channel of causality between GBBt and CABt.

Thus, GBBt Granger cause CABt not only if the parameters b2i and b1 are jointly

significant, but also if the parameter b4i is statistically significant. Finally, we will

run the granger causality, forecast error variance decomposition (FEVD) and

impulse response function tests, to establish the direction of flows and the degree

of influence of the explanatory variables on the explained variable respectively.

96

But in event of identifying no co-integrating equation between the variables, the

equation (5) is estimated using the following VAR specifications employing two

lags for each of the endogenous variable, constants β10 & β20 to capture the effects

of exogenous variables including the spread between domestic savings and gross

private domestic investment. The choice of the lag length in the VAR models is

guided by the Akaike Information Criteria (AIC) and sample size.

Var1: ∆CABt = β10 + β11∆CABt-1 + β11∆GBBt-1 + α12∆CABt-2 + α12∆GBBt-2 + µ1t (23)

Var2: ∆GBBt = β20 + β21∆CABt-1 + β21∆GBBt-1 + β22∆CABt-2 + α22∆GBBt-2 + µ2t (24)

Where, ∆CAB represents first difference in current account balance, ∆GBB is the

change in government budget balance, β10 and β20 are the constants and µ1t and µ2t

are innovations for the ∆CAB and ∆GBB respectively. The innovations were

purged of any shared component before estimation by first differencing of the data.

Before estimating the VAR models, the endogenous variables will be subjected to

Granger Causality tests under the null hypothesis that there exists no Granger

causality. For the hypothesis to hold means that β11 = α12 = 0 & β21 = β22 = 0) and

the standard F- test static should be insignificant. Likewise, the twin deficit

hypothesis proposition is empirically validated if at least any of the estimated

coefficients of the lagged endogenous variables are positive and statistically

different from zero.

97

Granger Causality Test

Abstracting from Mukhtar et al., (2007), if a pair of data series is co-integrated,

and then there must be Granger Causality in at least one direction, which reflects

the direction of influence between the series. Theoretically, If the current and

lagged term of a time series variable, say Xt, determine another time series

variable, say Yt, , then there exist granger causality relationship between Xt and Yt ,

in which Yt is granger caused by Xt. From the above analysis, the model is

specified as follows:

∆Yt = β11∆Yt-1 +… + β1n∆Yt-n + β21∆Yt-1 + …+ β1n∆Yt-n - γ (Yt-1 - αX t-1 – δ) + ε1t (25)

∆Xt = β31∆Yt-1 + … + β3n∆Yt-n + β41∆Yt-1 + …+ β4n∆Yt-n - γ (Yt-1 - αX t-1 – δ) + ε1t (26)

The above two equations are used to test the null hypothesis that causality runs

neither from X to Y nor from Y to X.

Impulse Response Function

This practice involves measuring unforeseen innovations in one variable X,

referred as impulse, in time (t) and predicting its effect on the other variable Y in

subsequent times t, t+1, t+2, etc, referred to as responses. IRF, in a VAR model

identifies the response of the dependent variable to shocks in error term. In

economics, and especially in contemporary macroeconomic modeling, impulse

response functions describe how the economy reacts over time to exogenous

98

impulses, which economists usually call 'shocks', and are often modeled in the

context of a vector auto-regression. Impulses that are often treated as exogenous

from a macroeconomic point of view include changes in government spending, tax

rates, and other fiscal policy parameters; changes in the monetary base or other

monetary policy parameters; changes in productivity or other technological

parameters; and changes in preferences, such as the degree of impatience. Impulse

response functions describe the reaction of endogenous macroeconomic variables

such as output, consumption, investment, and employment at the time of the shock

and over subsequent points in time. The general form for impulse response

function for multivariate VAR would be:

yt = α + εt + Ѳ1εt-1 + Ѳ2εt-2 + ;…; + Ѳi εt-I (27)

where, y is the vector of the considered dependent variables, α is the vector of the

constant, ε is the vector of innovations for all the variables included in the VAR

model and Ѳ is the vector of parameters that measure the reaction of the dependent

variable to innovations in all variables included in the VAR model.

However, as in this study we intend to use both bi-variate and multi-variate VAR

models in investigating the twin deficit paradigm. It would be plausible that the

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structure of impulse response function equations in the case of two variables, say

Y t and Xt are defined as well:

Y t = α1 + εy,t + ή1εy,t-1 + ή2εy,t-2 + … ήiεy,t-I (28)

X t = α2 + εx,t + ǿ1εx,t-1 + ǿ2εx,t-2 + … ǿiεx,t-I (29)

The above equations articulate how the dependent variable, Yt or Xt, responds to

previous innovations that happened to the endogenous variables included in the

VAR model (εX’s and εY’s). However, the coefficients (φ’s and η’s) represent the

degree of responses.

Forecast Error Variance Decomposition

The structural VAR FEVDs are computed from conditional within-sample

forecasts for each of the variables in the system over one to ten period forecast

horizons. The FEVD explains the relative proportion of the movements in a

sequence due to its own shocks versus shocks to other variables. If own shocks

explain all of the forecast error variance (FEV) of a variable, the time series in

question may be considered exogenous to the other variables within the system.

However, if a large proportion of the FEV associated with the sequence of a

particular variable is explained by shocks to one or more of the other variables,

then the time series in question would be considered endogenous to the system

(Andrew et al., 2009) The approach also allows one to draw inferences as to the

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relative importance in terms of the magnitude and sequence of influence among the

system’s variables, and hence determine the final specification of models useful for

forecasting. Finally, VAR and multivariate AR models will be used to estimate one

to ten period out-of sample forecasts for each of the target forecast variables.

Yit = ci + Ti + ∑ [bi(k)] Yit – k + ∑ alDl + εit (30)

Where Yit represents each of the i =1 through the employed 5 variables and K is

the optimal lag order or length identified with the SBIC.

11

l=1

K

k=1

101

References Alkswani, M.A. (2000, October). The Twin Deficits Phenomenon in Petroleum Economy:


Andrew M. M., Harold L. G. Jr., & Rita I. C.(2009). Alternative model selection using forecast error variance decompositions in wholesale chicken markets. Journal of Agricultural and Applied Economics, 41(1), 227–240. Aqeel, A & Nishat, M. (2000). The twin deficits phenomenon: evidence from pakistan.

The Pakistan Development Review, 39 (4), 535–550 Bahmani – Oskooee. M., & Brook, T. (1999). Bilateral J-curve between U. S and her trading

partners. Weltwirt schaftliches Archive 135 (1), 156-165. Boyd, D., Caporale, G.M., & Smith, R. (2001). Real exchange rate affects the balance of trade:

cointegration and marshall-lerner condition. International Journal of Finance and Economics, 6, 187 – 200.

Dickey, D., & Fuller, W.A. (1981). Likelihood ratio statistics for autoregressive time series with unit root. Econometrica 49, 1057 -72.

Engle, R. F., & Granger, C.W. (1987). Cointegration and error correction: representation, estimation, and testing. Econometrica, 50, 987 – 276.

Gonzalo, J. (1994). Five alternative methods of estimating long-run equilibrium relationships. Journal of Econometrics, 60, 203 – 2033.

Granger, C. W. J. (1988). Some recent developments in a concept of causality. Journal of Econometrics, 39 (1/2), 199-211. Gupta-Kapoor, A., & Ramakrishnan, U. (1999). Is there a J-Curve? A new estimation for Japan.

International Economic Journal, 13(4), 71-79. Hendry, D. F. (1986). Economic Modeling with Coitegrated Variables. Special Issue, 48 (3), 1-

27. Higgins, M., & Klitgaard, T. (1998). Viewing the current account deficit as a capital inflow. Current Issues Economics and Finance, 4 (13), 1 – 5.

Johansen, S. (1988). Statistical analysis of cointegrating vectors," Journal of Economic Dynamics and Control, 12, 213-54.

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Johansen, S. (1991). Estimation and hypothesis testing of gaussian vector autoregression models. Econometrics 59. Johansen, S., & Juselius, K. (1994). Identification of long-run and short-run structure: An application of IS-LM model. Journal of Econometrics, 63, 7 – 36

Johansen, S.; & Juselius, K. (1990). Maximum likelihood estimation and inference on cointegration-with application to the demand for money. Oxford Bulletin of Economics and Statistics, 52, 169-210.

Mukhtar T, M. Z., & Ahmed, M. (2007). An empirical investigation for twin deficits hypothesis in Pakistan. Journal of Economic Corporation, 28 (4), 63 – 80. Nozar, H., & Loretta, W. (2006). The dynamics of current account and budget deficits in


Phillips, P.C.B., Perron, P., (1988).Testing for a unit root in time series regression. Biometrika 75, 335–346. Rincon, H. C. (1998). Testing the short-and-long-run exchange rate effect on trade balance: The

case of Colombia. Dissertation Paper (Ph.D), University of Illinois, Urbana-Campaign.

Tallman, E. W., & Jeffrey, A. R. (1991). Investigating U.S. government and trade deficits.

Federal Reserve Bank of Atlanta Economic Review,1, 1-11.

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CHAPTER FOUR

PRESENTAION AND ANALYSIS OF DATA

Data analysis and interpretation is intended to transform the data collected into

credible evidence about the development of the intervention. Data analysis

involves working to uncover patterns and trends in data sets while interpretation

involves explaining those patterns and trends. Data analysis is considered an

important step and heart of the research in any research work. When data has been

collected with the assistance of relevant tools and methods, the next logical step, is

to analyze and interpret the data with a view to arriving at empirical solution to the

problem. For this study, we employ descriptive statistical techniques like mean,

standard deviation and coefficient of variation, and co-integration analysis.

4.1 Summary Statistic of Variables used for Nigeria & South Africa

This is intended to provide the preliminary test on the observed economic variables

to enable us express opinion on the nature of innovations in each of the employed

data series. The data on LCAB, LGBB, LRER, LLENDRATE RGDP and

LOPNESS for the period of 1960– 2011 for Nigeria and South Africa are presented

in tables 1 & 2 as their means, standard deviations (SD) and coefficient of

variations (CV).

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Table 1: Summary Statistics of Variables Used for Nigeria

Variables Details Mean SD CV Lcab Current Account Balance 1.157 0.403 0.348 Lgbb GovernmentBudget Balance 1.062 0.643 0.605 Lrer Real Exchange Rate 99.634 50.043 0.502

Llendrate Real Lending Rate 13.565 6.913 0.510 Rgdp Real Gross Domestic Product 0.213 0.820 3.850

Lopness Opness 0.472 0.153 0.324 Source: Author’s calculation based on data from IMF-IFS, and CBN Statistical Bulletin, 2011. Table 2: Summary Statistics of Variables Used for South Africa Variables Details Mean SD CV

Lcab Current Account Balance 0.740 0.121 0.164 Lgbb Government Budget Balance 0.868 0.071 0.082 Lrer Real Exchange Rate 5.644 1.674 0.292

Llendrate Real Lending Rate 13.164 4.810 0.365 Rgdp Real Gross Domestic Product 0.046 0.038 0.826

Lopness Opness 0.542 0.072 0.133 Source: Author’s calculation based on data from IMF-IFS, and CBN Statistical Bulletin,2011.

Coefficient of Variation (CV) is the percentage variation in mean, standard

deviation being considered as the total variation in the mean. Coefficient of

Variation can be used to compare the unpredictability of two or more series. The

series of data for which the coefficient of variation is large indicates that the group

is more erratic and thus less stable or less uniform and vice versa. To this effect,

we analyze the coefficient of variations of the both economies; Nigeria and South

Africa as presented in tables 1 & 2 above with a view to establishing the degree of

variability or stability of their macroeconomic variables.

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From table1, it is observed that while for Nigeria, the percentage variation in mean

of current account balance, government budget balance, real exchange rate, lending

rate, real GDP innovations and trade openness (all in their logarithms excepting

for RGDP innovations because of some identified negative values in the series),

show 34.8%, 60.5%, 50.2%, 51%, 385% and 32.4% respectively, those of South

Africa, table 2, for the same observed variables indicate 16.4%, 8.2%, 29.2%,

36.5%, 82.6% and13.3% in that order. Variables of particular interest are the (CV)

of RGDP innovations of Nigeria of 385% as against 82.6% for South Africa. This

indicates that South Africa has experienced more stable and sustainable growth in

her real gross domestic product within the period under review as against Nigeria’s

erratic (meaning they can vary significantly from one year to another) and

unsustainable RGDP growth scenario indicated by the very high coefficient of

Variation. In the same vein, the low percentages of 16.4% and 8.2% as against

Nigeria’s 34.8% and 60.5% for current account and government budget balances

suggests that within the period under review, South Africa was running sustainable

internal and external balances in contrast to Nigeria’ s experience during the same

period. This must have accounted for the unpredictability of Nigeria’s economic

trends, resulting in several policy somersaults and reversals as being witnessed to

date.

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4.2 Unit Root Test

An implicit assumptions that underlie regression analysis involving time series

data is that such a data series is stationary (Gujarati, 1995). In this context, testing

for stationary or otherwise of the employed data sets becomes of essence in this

analysis. Hatemi-J, (2001) states that a stochastic process generating data is said to

be stationary or 1(0), ie integrated of the order zero, when the following

assumptions are not violated:

(1) E(yt) = μ, the mean value of yt is constant and independent of time trend, (2)

Var (yt) = σ2, the variance of yt is constant across time trend and (3) Cov (yt, yt-s) =

Ƿ s, the covariance is dependent only on the distance between the observation and

independent of time t. Hence, on the above note, Stationary means that the

marginal distribution of the process does not change with time. Otherwise stated,

implies that the mean and the variance of the time series data, stay the same over

time. So anything that violates it will be deemed non-stationary. It is common for

time series variables to demonstrate signs of non-stationary. This typically suggests

that both the conditional means and variances of macroeconomic variables trend

upwards over time (Rose, 1990). On this note we explicitly test for presence of

non-stationary, both as a first step in exploring the characteristics of the employed

data, and for the fact that the manifestation of such non-stationarity often has

significant econometric implications. A test of stationarity that has become widely

107

popular over the past several years is the unit root test. According to Ebrahim,

Alawin & Bashayreh (2012), Augmented Dickey–Fuller (ADF) test is one of the

famous unit root tests to check the stationarity of economic variables. Many

economic time series may be non-stationary and need to be differenced (d) times

until reaching stationary. Then, a time series (like X) is said to be integrated of

order (d), denoted by X~I (d). To carry out a prescribed test for stationary, the

Augmented Dickey Fuller (ADF) test is employed by estimating the following

regression equation.

∆X t = α0 + α1t + α2X t-1 + ∑ αj ∆X t-j+1 + Ɛt (31)

where Xt is a macroeconomic variable at time t, εt is the stochastic error term that

is generated from a white noise process and understood to be independently and

identically distributed with zero mean and constant variance. In other words, the

first difference of Xt is regressed against a constant, a time trend (t = 1, 2 , ..., T),

the first lag of Xt, and, if necessary, lags of ΔXt. Sufficient lags of ΔXt must be

included to ensure no autocorrelation in the error term. If a unit root (non-

stationarity) exists, then α2 would not be statistically different from zero.The test

for a unit root is based on the t-statistics on the coefficient of the lagged dependent

variable. This has to be compared with specific calculated critical values and in

q

j-2

108

event of the calculated value being greater than the critical value, then the null

hypothesis of a unit root is rejected, and the variable is taken to be stationary. The

Augmented Dickey-Fuller test though frequently and widely used because of its

ability to take into consideration the autocorrelation adjustments, it has the lapses

of arbitrary choice of the proper order of autocorrelation. It is in recognition of this

that we further employ the Phillip-Peron (1988) method which is robust to any

form of autocorrelation (Song, 1997). One advantage of the PP tests over the ADF

tests is that the PP tests are robust to general forms of heteroskedasticity in the

error term ut. Another advantage is that the user does not have to specify a lag

length for the test regression. The results of ADF and PP as presented in tables 3 &

4 below for Nigeria and South Africa respectively show that in all cases, all the

employed variables become stationary at least in their first difference.

Table3: Unit Root Test Results for Nigeria ADF PP Conclusion Variables Level/First

Diff. Intercept Trend/Intercept Intercept Trend/Intercept

LCAB

Level First Diff.

-4.523 -7.214

-4.773 -7.158

-4.439 -21.747

-4.619 -24.890

1(0) 1(0)

LGBB

Level First Diff.

-2.724 -4.190

-2.322 -4.443

-2.009 -8.347

-2.911 -8.258

1(1) 1(0)

LRER

Level First Diff.

-2.209 -5.854

-3.093 -5.790

-2.209 -5.774

-2.479 -5.703

1(1) 1(0)

LLendrate

Level First Diff.

-1.434 -7.880

-2.153 -7.805

-1.384 -7.891

-0.258 -7.818

1(1) 1(0)

RGDP

Level First Diff.

-2.892 -5.590

-0.1228 -6.580

-3.329 -5.579

-0.255 -6.564

1(1) 1(0)

LOPNESS

Level First Diff.

-1.623 -11.077

-4.463 -10.957

-2.247 -20.876

-4.374 -20.616

1(0) 1(0)

Notes: (i) Unit root tests performed using Eview 6.0 (ii) 95% critical value ADF/PP statistic (with intecept) = -2.923 (iii) 95% critical value ADF/PP statistic (with trend & intercept) =3.504

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The results of ADF and PP as presented in tables 3 above show that at 95% level

of significance, only LCAB and LOPNESS are found to be stationary at level,

while the rest of the employed variables in the study assume stationarity in their

first difference. This suggests that all the employed variables for estimation of the

equations are quiet suitable for purposes intended after at least one period lag.

Table4: Unit Root Test Results for South Africa

ADF PP Conclusion Variables Level/First

Diff. Intercept Trend/Intercept Intercept Trend/Intercept

LCAB

Level First Diff.

-2.603 -80661

-2.904 -8.721

-2.127 -8.673

-3.262 -8.905

1(1) 1(0)

LGBB

Level First Diff.

-30367 -7.793

-3.802 -7.707

-3.367 -9.428

-3.802 -9.261

1(0) 1(0)

LRER

Level First Diff.

-2.916 -6.648

-3.733 -6.576

-2.862 -10.645

-3.641 -10.418

1(0) 1(0)

LLendrate

Level First Diff.

-2.330 -6.407

-1.566 -6.082

-1.856 -5.695

-1.391 -9.013

1(1) 1(0)

RGDP

Level First Diff.

-2.449 -4.877

-0.782 -5.221

-2.029 -4.854

-0.489 -5.215

1(1) 1(0)

LOPNESS Level First Diff.

-2.376 -6.672

-2.452 -6.615

-2.391 -7.785

-2.430 -8.427

1(1) 1(0)

Notes: (i) Unit root tests performed using Eview 6.0 (ii) 95% critical value ADF/PP statistic (with trend) = -2.923 (iii) 95% critical value ADF/PP statistic (with trend & intercept) =3.504 The results of ADF and PP as presented in tables 4 above shows that at 95% level

of significance, only LGBB and LRER are found to be stationary at level, while

the rest of the employed variables in the study assume stationarity in their first

difference. This suggests that all the employed variables for estimation of the

equations are quiet suitable for purposes intended after at least one period lag.

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4.3 Test of Research Hypotheses

Hypothesis testing is the use of statistics to determine the probability that a given

hypothesis is true. The usual process of hypothesis testing consists of four steps as

follows: (i) Formulate the null hypothesis (commonly, that the observations are

the result of pure chance) and the alternative hypothesis (commonly, that the

observations show a real effect combined with a component of chance variation).

(ii) Identify a test statistic that can be used to assess the truth of the null hypothesis.

(iii) Compute the P-value, which is the probability that a test statistic at least as

significant as the one observed would be obtained assuming that the null

hypothesis were true. The smaller the P-value, the stronger the evidence against the

null hypothesis. (iv) Compare the P-value to an acceptable significance level

value, α (sometimes called an alpha value). If P ≤ α, then the observed effect is

statistically significant, the null hypothesis is ruled out, and the alternative

hypothesis is valid.

4.3.1 Hypothesis One:

There is no stable long-run relationship existing between Fiscal balance

innovations and developments in current account balance of Nigeria and South

Africa. We employ Johansen and Juselius Trace test for co-integrating vectors

between the explained and the explanatory variables in equation 8 with a view to

determining the number of co-integrating equations. The concept of co-integration

111

was first instigated by Granger (1981) and modified by Engle and Granger (1987),

Johansen (1988) and Johansen and Juselius (1990), amongst others. For this study,

we employ the Johansen and Juselius (1990) Trace test procedure. Therefore, with

the manifestation of unit root 1(1) by variables of interest, which is a precondition

for the existence of a stable linear steady-state relationship, we employ the trace

test, which is based on the comparison of Ho (r = o) against the alternative H1 (r ≠

o), where r indicates the number of co integrating vectors. The co integration test

provides an analytical statistical framework for ascertaining the long run

relationship between economic variables and the result of the trace test depends on

the lag length of the vector error correction model (Maylene and Agbola, n.d.)

4.3.1.1. Using Nigeria Data

i. Ho: For Nigeria, there exists no cointegrating equation

H1: There exists cointegrating equation for Nigeria

ii. The significance level is set at 5 percent benchmark.

If P-value < 0.05, we reject the Ho and accept H1

But, if P-value > 0.05, we reject the H1 and accept Ho

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iii. The Trace Test for number of cointegrating vectors as shown in table 5

indicates trace statistic, critical value and P-value of 71.32, 69.81 and 0.037

respectively for the Null hypothesis of “At most 2 cointegrating equations”.

iv. With the P-value of 0.037 < 0.05 leads us to the rejection of the Null hypothesis

(Ho) of non existence of cointegrating equations and hence not to reject the

Alternate hypothesis (H1) which postulates the existence of cointegrating vectors.

This suggests that for Nigeria there exist 2 cointegrating equations, meaning that

there exists long run equilibrium relationship between developments in fiscal

deficits and variations in current account balance in Nigeria.

Equation 10 is evaluated for co integration employing Nigerian data using trace

test estimation methodology for co integration. The results of the co integration test

are as scheduled in table 5 below:

Table 5: Test for Cointegration for Nigeria Hypothesized No. of CE(s)

Eigenvalue Trace Statistic 0.05 Critical value

Prob**

None* 0.4708 101.873 95.753 0.017 At most 1* 0.4454 71.3247 69.818 0.037 At most 2 0.3209 43.0262 47.856 0.131 At most 3 0.2377 24.444 29.797 0.182 At most 4 0.1594 11.411 15.494 0.187 At most 5 0.0620 3.075 3.841 0.079 Notes: (i) Cointegration tests performed using Eview 6.0 (ii) Trace test indicates 2 cointegrating equations at the 0.05 level (iii) * denotes rejection of the null hypothesis at the 0.05 level

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Results of Trace test for co integration to investigate the extent to which long-run

equilibrium relationship exists between budget and current account balances in

Nigeria are as scheduled in table 5 above. Starting with the null hypothesis of no

cointegration (r = 0) among the six variables of LCAB, LGBB, LRER,

LLENDRATE, RGDP and LOPNESS, the trace test indicates 2 co-integrating

vectors (r = 2). This suggests that the existence of long run equilibrium relationship

between the explained and explanatory variables cannot be rejected for Nigeria.

Table 6: Estimates of Long-Run Co-integrating Vectors (Linearised)

LCAB LGBB LRER LLENDRATE RGDP LOPNESS 1.000000 0.3702 -0.0099 -0.4694 0.1100 -3.3863 (0.1601) (0.0026 (0.1400) (0.0293) (0.9063) Note: 1. Figures in parentheses indicate standard errors. 4.3.1.2 Using South Africa Data

i. Ho: For South Africa, there exists no cointegrating equation

H1: There exists cointegrating equation for South Africa


If P-value < 0.05, we reject the Ho and accept H1

But, if P-value > 0.05, we reject the H1 and accept Ho

iii. The Trace Test for number of cointegrating vectors as shown in table 7

indicates trace statistic, critical value and P-value of 92.19.32, 95.75 and 0.085

respectively for the Null hypothesis of “No cointegrating equation”.

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iv. With the P-value of 0.085 > 0.05 leads us not to reject the Null hypothesis (Ho)

of non existence of cointegrating equation and hence to reject the Alternate

hypothesis (H1) which postulates the existence of cointegrating vectors. This

suggests that for South Africa, there are no cointegrating equations identified in the

model under consideration, meaning that there exists no long run equilibrium

relationship between developments in fiscal deficits and variations in current

account balance in South Africa.

Equation 10 is evaluated for co integration employing data for South Africa using

trace test estimation methodology for co integration. The results of the co

integration test are as scheduled in table 7 below:

Table 7: Cointegration Test for South Africa Hypothesized No. of CE(s)

Eigenvalue Trace Statistic 0.05 Critical value

Prob**

None 0.4974 92.191 95.753 0.085 At most 1 0.4441 58.475 69.818 0.285 At most 2 0.2675 29.699 47.856 0.734 At most 3 0.1315 14.440 29.797 0.815 At most 4 0.0898 7.527 15.494 0.517 At most 5 0.0577 2.913 3.841 0.087 Notes: (i) Cointegration tests performed using Eview 6.0 (ii) Trace test indicates no cointegrating equations at the 0.05 level (iii) * denotes rejection of the null hypothesis at the 0.05 level

4.3.2 Hypothesis Two: Developments in budget deficit do not significantly cause developments in current

account imbalance in the economies under consideration. The main object of this

study is to investigate the causal relationship between budget deficits and the

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current account balance for Nigeria and South Africa for the period of 1960 to

2011. Theoretically, we investigate four possible scenarios about the causal

relationship between budget and trade deficits: The first one is called the Twin

Deficit Hypothesis which posits positive and significant causal relation between

budget deficit and current account deficit with budget deficits causing current

account deficits. The second, which is referred to as current account targeting, just

like the Twin Deficit Hypothesis posits positive and significant causal relation

between budget deficit and current account imbalance, but this time, with current

account balance causing government budget deficit. The third is the scenario of bi-

directional causal correspondence between fiscal deficit and current account

imbalance, and finally, the Ricardian Equivalent proposition (REP) which predicts

that the two deficits share no significant causal relationship and therefore are

independent. Granger causality is a statistical concept of causality that is based on

prediction. According to Granger causality, if a signal X1 "Granger-causes" (or "G-

causes") a signal X2, then past values of X1 should contain information that helps

predict X2 above and beyond the information contained in past values of X2 alone

(Anil, 2007).

4.3.2.1 Using Nigeria Data Set Estimation of VEC Error Correction Model With the identification of a co integrating relation for Nigeria, error correction

models (VECM) estimates presents the best option for predicting the dynamic

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behavior of current account balance in response to fiscal balance adjustments. In

the same vein, the error correction model presents us with the veritable platform

for testing for long run granger causality between current account balance and

fiscal deficits to confirm the existence or otherwise of twin deficit hypothesis

which is the cardinal objective (focus) of this study. In this direction, we evaluate

the VAR (2) models specified in equations 11 – 16 augmenting each with its error

correction term (error term lagged one period) λet-1. This transforms each of the

VAR to VEC model of two period lags. For the purpose and the scope of this

study, models of interest are restricted to equations 11 & 12 as augmented.

In tables 8 & 9 below, equations 11 and 12 as adjusted with inclusion of λ1et-1 and

λ2et-1 respectively are evaluated for flow of long run causality from budget deficits

to current account deficits and vice – versa.

Test of Hypothesis 2

i. Ho: Developments in budget deficits do not significantly cause developments in

current account imbalance in Nigeria.

H1: Developments in budget deficits do significantly cause developments in

current account imbalance in Nigeria.


If the P-values of the coefficients of LGBB (-1), LGBB (-2), and E (-1) are equal

and all equal to zero (PVs >0.05), b11 = b12 = λ1 = 0, we accept Ho and conclude

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that there is no long run causal relationship running from budget deficits to current

account imbalance.

But if the P-values of the coefficients of b11 = b12 = λ1 ≠ 0 (ie at least 1 < 0.05), we

reject Ho, and conclude that there is long run causal relationship running from

budget deficits to current account balance in Nigeria.

If equation 11 as adjusted (VEC version) is evaluated and b11 = b12 = λ1 = 0,

indicates no long-run causal link running from budget deficits to current account

deficits, meaning that we cannot reject the Null Hypothesis (Ho) else reject Ho and

accept H1.

But, if equation 11(VAR version) is evaluated and b11 = b12 = 0 indicates no short

run causal link running from budget deficits to current account deficits, meaning

that we cannot reject the Null Hypothesis (Ho) else reject Ho and accept H1. We

therefore evaluate equation 11 for both long-run and short-run granger causalities

to test the above hypothesis.

iii. The results of equation 11 as adjusted (VEC version) estimation as shown in

table 8 below show the values of the parameter estimates (coefficients) of b11, b12

and λ1 as 0.220 (0.420), 0.087 (0.659) and -0.599 (0.005) respectively with the

figures in brackets indicating their respective P-Values.

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iv. These results indicate that the value of the coefficient of λ1 of -0.599 is

statistically different from zero judging from the fact that it’s P-value, 0.005 <

0.05. This suggests that the null hypothesis that, b11 = b12 = λ1 = 0 is violated,

meaning that b11 = b12 = λ1 ≠ 0 sustained. These results indicate the existence of a

significant causal link running from government budget deficits to current account

imbalance, in the long run. In effect, evidence of the twin deficits hypothesis is

identified in the long run in Nigeria.

Table 8: Granger Test for Twin Deficits Hypothesis for Nigeria. VECM Estimation (Equation 11 Augmented with λ1e(t-1))

Regressor Parameter Estimate T-Ratio P-Values Intercept 0.0177 0.2769 0.782 LCAB-1 0.091 0.436 0.663 LCAB-2 0.001 0.010 0.992 LGBB -1 0.220 0.807 0.420 LGBB -2 0.087 0.441 0.659 LRER-1 -0.004 -1.666 0.097 LRER-2 -0.004 -1.609 0.109 RGDP-1 -0.144 -2.096 0.037 RGDP-2 -0.090 -1.424 0.155 LLendrate -1 0.032 1.104 0.270 LLendrate -2 -0.000 -0.017 0.9859 Lopness-1 -0.386 -0.493 0.622 Lopness-2 -0.731 -1.072 0.782 λ1e(t-1) -0.599 -2.800 0.005 R2 = 0.37, D.W Statistic 2.39 The results of equation 11 (VAR version) estimation as shown in table 9 below

show the values of the parameter estimates (coefficients) of b11, and b12 as -0.130

(0.463) and -0.151 (0.388) respectively with the figures in brackets indicating their

respective P-Values. These results indicate that the value of the coefficient of b11

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and b12 of -0.130 and -0.151 are both not statistically different from zero judging

from the magnitude of their respective P-values: 0.463 > 0.05 and 0.388 > 0.05

respectively. This suggests that the null hypothesis that, b11 = b12 = 0 is sustained

meaning that b11 = b12 = λ1 ≠ 0 is violated.

These results indicate non existence of a significant causal link running from

government budget deficits to current account imbalance, in the short run. In

effect, evidence of the twin deficits hypothesis is not identified in the short run in

Nigeria.

Table 9: Causality Test for Current Account Targeting Scenario for Nigeria. Vector Autoregressive Estimates (Equation 11)

Regressors Parameter Estimate T-Ratio P-Values Intercept 1.270 3.710 0.000 LCAB-1 0.344 2.122 0.034 LCAB-2 -0.137 -0.780 0.435 LGBB -1 -0.130 -0.734 0.463 LGBB -2 -0.151 -0.864 0.388 LRER-1 -0.000 -0.223 0.823 LRER-2 0.002 0.968 0.333 RGDP-1 -0.081 -1.142 0.254 RGDP-2 -0.037 -0.523 0.601 LLendrate -1 -0.022 -0.807 0.420 LLendrate -2 0.001 0.054 0.956 Lopness-1 0.778 1.229 0.220 Lopness-2 -0.565 -0.882 0.378 Notes: R2 = 0.33, DW. Statistic = 2.12 4.3.2.2 Using South Africa Data

Test of Hypothesis

i. Ho: Developments in budget deficits do not significantly cause developments in

current account imbalance in the short-run in Nigeria.

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H1: Developments in budget deficits do significantly cause developments in

current account imbalance in the short run in Nigeria.


if equation 11(VAR version) is evaluated and b11 = b12 = 0 indicates no short run

causal link running from budget deficits to current account deficits, meaning that

we cannot reject the Null Hypothesis (Ho) else reject Ho and accept H1. We

therefore evaluate equation 11(VAR version) for short-run granger causalities to

test the above hypothesis.

iii. With South Africa data, we evaluate equation 11(VAR version) to test the

above hypothesis for only short-run granger causalities since the results of the co-

integration test on South African data identified no co integrating vectors between

the explained and explanatory variables. The results of the VAR estimation to

investigate the extent to which fiscal deficits cause current account deficits in the

short run as presented in table 10 below, show the values of the parameter

estimates (coefficients) of b11, and b12 as 0.011 (0.319) and 0.005 (0.655)

respectively with the figures in brackets indicating their respective P-Values.

iv. These results indicate that the value of the coefficient of b11 and b12 of 0.011

and 0.005 are both not statistically different from zero judging from the magnitude

of their respective P-Values: 0.319 > 0.05 and 0.655 > 0.05 respectively. This

121

suggests that the null hypothesis that, b11 = b12 = 0 cannot be rejected for South

Africa in the short run. These results suggest non existence of a significant causal

link running from government budget deficits to current account imbalance in the

short run in South Africa, meaning that twin deficits hypothesis is violated for

South Africa economy in the short run.

Table 10: Causality Test for Current Account Targeting for South Africa. Vector Autoregressive Estimates (Equation 11)

Regressors Parameter Estimate T-Ratio P-Values Intercept 0.066 0.349 0.727 LCAB-1 0.068 0.276 0.782 LCAB-2 0.028 0.107 0.914 LGBB -1 0.011 0.998 0.319 LGBB -2 0.005 0.446 0.655 LRER-1 0.000 0.142 0.886 LRER-2 -0.000 -0.024 0.980 RGDP-1 1.004 1.888 0.060 RGDP-2 -0.269 -0630 0.529 LLendrate -1 -0.832 -2.310 0.021 LLendrate -2 0.705 2.046 0.041 Lopness-1 0.641 4.171 0.000 Lopness-2 0.063 0.429 0.667 Notes: R2 = 0.67, DW. Statistic = 1.93

4.3.3 Hypothesis Three

Developments in current account imbalance do not significantly cause innovations

in fiscal deficit in Nigeria and South Africa. Here we test the second scenario

which is referred to as current account targeting. This, just like the Twin Deficit

Hypothesis, posits positive and significant causal relation between budget deficit

and current account imbalance, but this time, with innovations in current account

balance causing developments in government budget deficit.

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4.3.3.1Using Nigeria Data Set

With co-integration found among Nigeria data set, we evaluate equation 12 for

both long-run and short-run granger causalities to test the above hypothesis using

VEC and VAR versions of the model as presented in tables 11 and 12 below.

Test of Hypothesis 3 for Long run Causality

i. Ho: Developments in current account deficits do not significantly cause

developments in budget imbalance in Nigeria.

H1: Developments in current account deficits do significantly cause variations in

fiscal imbalance in Nigeria.


If the P-values of the coefficients of LCAB (-1), LCAB (-2), and E (-1) are equal

and all equal is to zero (PVs >0.05), a21 = a22 = λ2 = 0, we accept Ho and conclude

that there is no long run causal relationship running from current account deficit to

fiscal imbalance.

But if the P-values of the coefficients of a21 = a22 = λ2 ≠ 0 (ie at least 1 < 0.05), we

reject Ho, and conclude that there is long run causal relationship running from

current account deficits to budget deficit in Nigeria.

If equation 12 as adjusted (VEC version) is evaluated and a21 = a22 = λ2 = 0,

indicates no long-run causal link running from current account deficit to budget

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deficits, meaning that we cannot reject the Null Hypothesis (Ho), else reject Ho

and accept H1.

But, if equation 12(VAR version) is evaluated and a21 = a22 = 0 indicates no short

run causal link running from current account deficit to fiscal deficit, meaning that

we cannot reject the Null Hypothesis (Ho), else reject Ho and accept H1.

We therefore evaluate equation 12 for both long-run and short-run current account

targeting to test the above hypotheses.

iii. The results of equation 12 as adjusted (VEC version) estimation as shown in

table 10 below show the values of the parameter estimates (coefficients) of a21, a22

and λ2 as 0.046 (0.762), -0.040 (0.769) and -0.243 (0.122) respectively with the

figures in brackets indicating their respective P-Values.

iv. These results indicate that the P-values of the coefficient a21, a22 and λ2 are all

greater than the 5 percent significant level (0.762 > 0.05, 0.769 > 0.05 and 0.122 >

0.05). This suggests that the Null hypothesis of a21 = a22 = λ2 = 0, cannot be

rejected. This suggests that the null hypothesis that, a21 = a22 = λ2 = 0 is sustained,

meaning that a21 = a22 = λ2 ≠ 0 is violated. These results indicate the non existence

of a significant causal link running from current account deficits to fiscal

imbalance, in the long run. In effect, evidence of current targeting hypothesis is not

identified in the long run, in Nigeria.

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Table 11: Granger Non Causality Test Results for Nigeria.

VECM Estimation (Equation 12 Augmented with λ2e(t-1)) Regressor Parameter Estimate T-Ratio P-Values Intercept -0.042 -0.916 0.360 LCAB -1 0.046 0.302 0.762 LCAB -2 -0.040 -0.293 0.769 LGBB-1 -0.148 -0.743 0.457 LGBB-2 0.162 1.122 0.263 LRER-1 -0.001 -0.474 0.635 LRER-2 -0.002 -0.795 0.427 RGDP-1 -0.078 1.542 0.124 RGDP-2 -0.044 -0.964 0.335 LLendrate -1 -0.007 -0.330 0.741 LLendrate -2 0.006 0.291 0.771 Lopness-1 -0.309 -0.538 0.590 Lopness-2 -0.128 -0.257 0.797 λ2e(t-1) -0.243 -1.552 0.122 R2 = 0.27, D.W Statistic = 2.04 Test of Hypothesis 3 for Short run Causality

i. Ho: Developments in current account deficits do not significantly cause

developments in fiscal imbalance in the short-run in Nigeria.

H1: Developments in current account deficits do significantly cause variations in

fiscal imbalance in the short run in Nigeria.


if equation 12(VAR version) is evaluated and a21 = a22 = 0 indicates no short run

causal link running from current account deficits to budget deficits, meaning that

we cannot reject the Null Hypothesis (Ho), else reject Ho and accept H1. We

therefore evaluate equation 12(VAR version) for short-run granger causalities to

test the above hypothesis.

125

iii. With Nigeria data, we evaluate equation 12(VAR version) to test the above

hypothesis for short-run granger causalities. The results of the VAR estimation to

investigate the extent to which current account deficits cause fiscal deficits in the


estimates (coefficients) of a21, and a22 as -0.187(0.124) and 0.026(0.840)


iv. These results indicate that the value of the coefficient of a21 and a22 of -0.187

and 0.026 are both not statistically different from zero judging from the magnitude

of their respective P-Values: 0.187 > 0.05 and 0.840 > 0.05 respectively. This

suggests that the null hypothesis that, a21 = a22 = 0 cannot be rejected for Nigeria in

the short run. These results suggest non existence of a significant causal link

running from current account deficits to fiscal imbalance in the short run in

Nigeria, meaning that current accounting hypothesis is violated for Nigeria

economy in the short run.

126

Table 12: Granger Non Causality Test Results for Nigeria. Vector Autoregressive Estimates (Equation 12)

Regressors Parameter Estimates T-Ratio P-Values Intercept 0.438 1.714 0.087 LCAB -1 -0.187 -1.544 0.124 LCAB -2 -0.026 -0.201 0.840 LGBB-1 0.695 5.250 0.000 LGBB-2 0.071 0.547 0.584 LRER-1 0.001 0.545 0.584 LRER-2 0.000 0.116 0.586 RGDP-1 -0.049 -0.934 0.351 RGDP-2 0.005 0.102 0.918 LLendrate -1 -0.029 -1.451 0.148 LLendrate -2 0.023 1.369 0.172 Lopness-1 -0.169 -0.357 0.720 Lopness-2 0.195 0.408 0.683 Notes: R2 = 0.83, DW. Statistic = 2.28 4.3.3.2Using South Africa Data Set

Test of Hypothesis 3 for Short run Causality

i. Ho: Developments in current account balance do not significantly cause

developments in fiscal imbalance in the short-run in South Africa.

H1: Developments in current account balance do significantly cause

developments in fiscal imbalance in the short run in South Africa.


if equation 12(VAR version) is evaluated and a21 = a22 = 0 indicates no short run

causal link running from current account deficits to fiscal deficits, meaning that we

cannot reject the Null Hypothesis (Ho) else reject Ho and accept H1. We therefore

evaluate equation 12(VAR version) for short-run granger causalities to test the

above hypothesis.

127

iii. With South Africa data, we evaluate equation 12(VAR version) to test the

above hypothesis for only short-run granger causalities since the results of the co-

integration test on South African data identified no co integrating vectors between

the explained and explanatory variables. The results of the VAR estimation to

investigate the extent to which current account deficits cause fiscal deficits in the


estimates (coefficients) of a21, and a22 as 0.663 (0.000) and -0.196(0.316)


iv. These results indicate that the value of the coefficient of a21 of 0.663 is

statistically different from zero judging from the extremely low P-value of 0.000 <

0.05. The results further indicate that the value of the coefficient of a22 of -0.196 is

not statistically different from zero judging from the high P-value of 0.316 > 0.05.

These suggest that a21 = a22 ≠ 0. This leads us to the rejection of the null hypothesis

that, a21 = a22 = 0 for South Africa in the short run.

These results indicate the existence of a significant causal link running from

current account deficits to fiscal imbalance in the short run in South Africa,

meaning that current account targeting proposition is identified for South Africa

economy in the short run.

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Table 13: Vector Autoregressive Estimates (Equation 12) Regressors Parameter Estimates T-Ratio P-Values Intercept 0.331 2.387 0.082 LCAB -1 0.663 3.618 0.000 LCAB -2 -0.196 -1.004 0.316 LGBB-1 0.012 1.479 0.140 LGBB-2 -0.003 -0.452 0.651 LRER-1 -.0.002 -0.672 0.501 LRER-2 0.002 0.405 0.682 RGDP-1 0.243 0.620 0.535 RGDP-2 -0.252 -0.726 0.468 LLendrate -1 -0.199 -0.752 0.452 LLendrate -2 0.0267 1.052 0.293 Lopness-1 -0.051 -0.455 0.649 Lopness-2 0.117 1.080 0.281 Notes: R2 = 0.50, DW. Statistic = 2.13 4.3.4 Hypothesis Four:

Fiscal expansions do not exact significant influence on private consumption in

Nigeria and South Africa. This concept is of the view that since people are rational,

they know that the reduction in taxes, resulting from the government expansionary

fiscal policy of tax cut, is temporal and so they will save the extra disposable


will not be affected because the decrease in government savings represented by

increased fiscal deepening will be equitably compensated by the additional

precautionary private savings for expected future increase in taxes.

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4.3.4.1. Using Nigeria Data Set.

Test of Hypothesis 4 for Ricardian Equivalent (Long-run)

i. Ho: Fiscal expansions do not exact significant influence on private consumption

in the long run in Nigeria.

H1: Fiscal expansions do exact significant influence on private consumption in

the long run in Nigeria.

ii. The significant level is set at 5 percent benchmark

If the calculated probability value (P-value) of the estimation coefficient is lower

than the significant level benchmark of 5 percent, reject the Null Hypothesis, Ho,

but where the calculated P-value is higher than the 5 percent significant

benchmark, do not reject the Null Hypothesis.

iii. Results of equation 11 as adjusted (VECM version) as shown in table 8, show

that the values of the parameter estimates (coefficients) of b11, b12 and λ1 are 0.220

(0.420), 0.087 (0.659) and -0.599 (0.005) respectively with the figures in brackets

indicating their respective P-Values.

iv. These results indicate that the value of the coefficient of λ1 of -0.599 is

statistically different from zero judging from the magnitude of it’s P-value of 0.005

< 0.05. This suggests that the null hypothesis that, b11 = b12 = λ1 = 0 is violated and

the alternate Hypothesis that b11 = b12 = λ1 ≠ 0 sustained.

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The results suggest that, there exists a significant causal link from government

budget deficits to current account imbalance, in the long run, meaning that

Ricardian equivalence proposition is not characterized in Nigeria economy in the

long run.

Test of Hypothesis 4 for Ricardian Equivalent (Short-run)

i. Ho: Fiscal expansions do not exact significant influence on private consumption

in the short run in Nigeria.

H1: Fiscal expansions do exact significant influence on private consumption in

the short run in Nigeria.

ii. The significant level is set at 5 percent benchmark

If the calculated probability value (P-value) of the estimation coefficient is lower

than the significant level benchmark of 5 percent, reject the Null Hypothesis, Ho,

but where the calculated P-value is higher than the 5 percent significant level

benchmark, do not reject the Null Hypothesis.

iii. The Results of equation 11 (VAR version) estimation for short-run causality to

test for twin deficits as shown in tables 9, show that the values of the parameter

estimates (coefficients) of b11, and b12 are -0.130 (0.463) and -0.151 (0.388)

respectively with the figures in brackets indicating their respective P-Values. These

results indicate that the value of the coefficient of b11 and b12 of -0.130 and -0.151

131

are both not statistically different from zero as 0.463 > 0.05 and 0.388 > 0.05

respectively.

iv. These results suggest non existence of a significant causal link from

government budget deficits to current account imbalance in the short run for

Nigeria.

Abstracting from the above results, it is established that in the long-run, that twin

deficits hypothesis is confirmed for Nigeria. In effect, Ricardian equivalence

proposition (REP) is violated for Nigeria on the long-run. Furthermore, evidence

from the results of estimating equations 11 (VAR) for short-run causality as shown

above suggest that twin deficits hypothesis is not identified for Nigeria in the short-

run. These by implication suggest that Ricardian equivalent hypothesis which

denies any significant causal link from budget deficits to current account deficits

cannot be rejected for Nigeria in the short-run.

4.3.4.2 South Africa.

For equation 11 (VAR), the Results of the estimation to test for short-run causality

using South African data as shown in table 10, indicate that b11 = b12 = 0. The

values of the parameter estimates (coefficients) of b11, and b12 are 0.011 (0.319)

and 0.005 (0.655) respectively with the figures in brackets indicating their

respective P-Values. These results indicate that the value of the coefficient of b11

132

and b12 of 0.011 and 0.005 are both not statistically different from zero even at

10% level of significance judging from their respective P-Values. These results

suggest non existence of a significant causal link from government budget deficits

to current account imbalance in the short run, which indicate that twin deficits

hypothesis is violated for South Africa in the short run. In effect, the null

hypothesis that, b11 = b12 = 0 cannot be rejected for South Africa in the short run.

These by implication suggest that Ricardian equivalent hypothesis which denies

any significant causal link from budget deficits to current account deficits cannot

equally be rejected in the short-run for South Africa.

4.3.5 Hypothesis Five:

There exists no significant bi-directional causality between the twin anomalies.

With the confirmation of: (i). Ricardian equivalence hypothesis (REH) for both

Nigeria and South Africa in the short-run, (ii). identification of twin deficits

proposition for Nigeria in the long-run only, (iii). current account targeting for

South Africa in the short-run, any evidence of bi-directional significant causal

relationship is completely ruled out. In effect the null hypothesis of no significant

bi-directional link amid the twin deficits cannot be rejected.

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4.4 Complementary Results 4.4.1 Impulse Response Function for Nigeria and South Africa

The results of the granger non causality tests are complimented with Impulse

response functions. This describes the reaction of endogenous macroeconomic

variables such as output, consumption, investment, and employment at the time of

the shock and over subsequent points in time (Lutkepohl, 2008, Hamilton, 1994).

In a VAR (1) model of the form: Yt = A1Y t-1 + ut

The impulse response functions can be used to trace the time path of the dependent

variables in a VAR, to shocks from all the explanatory variables. If the system of

equations is stable, any shock should decline to zero while an unstable system

would produce an explosive time path. This technique involves measuring

unexpected changes in one variable X (the impulse) in time t and predicting its

effect on the other variable Y in time t, t+1, t+2, etc. (the responses). The impulse

response function (IRF) defines the response of the dependent variable in the VAR

model to shocks in the error terms. In other words, the IRF detects the impact of a

onetime shock in one of the innovations on current and future values of the

endogenous variables (Ebrahim, Mohammad & Ala (2012).

Figures 1 and 3 display the impulse response functions of a multivariate model

comprising of six macroeconomic variables on Nigeria and South Africa. The

variables of interest include: Current Account Balance (LCAB), Government

134

Budget Balance (LGBB), Real Exchange Rate (LRER), Lending Rate

(LLENDRATE), Real Gross Domestic Product Growth (RGDP) and Trade

Openness (LOPNESS). We discuss results for the Impulse Response Functions

(IRFs) separately for Nigeria and South Africa.

Nigeria

For Nigeria, figure 1 in the appendix, the impulse responses support literally, the

conventional view of many macroeconomic dynamics. A LCAB shock shows a

significant positive effect of over 38% and about 13% on it’s own self for the first

and second periods respectively, after which, such effect kept a downward trend

tending towards zero and slipping into marginal negativity to a maximum of -3.3

percentage points by period four. From this point, it picked up towards the origin

and tends to equilibrium (near zero effect) in period seven and remained persistent

over the response period under consideration. A positive government budget

balance (LGBB) shock leads to a persistent negative innovation in the current

account balance (LCAB) all through the time horizon under consideration, after

one period lag delayed effect. Such negative effect remained inconsequential all

through the time band of interest. Furthermore positive shocks to LRER,

LLENDRATE and RGDP exhibited similar scenarios of one period delayed effect,

initial negative response of LCAB, followed by some periods of positive effect on

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the current account balance over time. Positive LOPNESS shock shows 1 year

delayed effect lag, followed by positive effect in the second year of about 6

percentage points on LCAB, beyond which negative impact on LCAB featured for

the duration of the specified time horizon or range. Worthy of note is the fact that

the innovations in current account balances (LCAB) sequel to a positive shock on

trade openness (LOPNESS), whether positive or negative are not significantly

different from zero and therefore inconsequential.

South Africa

For South Africa, we interpret the results in the upper row of figure 2 in the

appendix, representing our area of interest in this study. A positive LCAB shock

shows a positive non significant effect of about 8% and 5% on it’s own balance for

the first and second periods respectively, after which, such non inconsequential

effect maintain a downward positive trend tending towards zero and tinning down

to 0.4% at the end of period. A positive government budget balance (LGBB)

shock leads to persistent positive innovations in the current account balance

(LCAB) all through the time horizon under consideration, though such effects are

found not to be significantly different from zero. The same scenario is observed for

the response of current account balance to a one standard deviation (S.D)

innovation in real gross domestic product. The results further indicate that

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introduction of a positive shock to the trade openness variable would affect current

account balance negatively, though insignificantly, within the time frame under

consideration. In the same vein, a positive shock to LRER, impacts CAB positively

throughout the periods under consideration excepting for period 2 that the effect is

negatively signed though such effects are of no consequence. And on the final

note, a positive shock on the LLENDRATE triggered mixtures of positive and

negative non significant responses from the current account balance for the periods

of interest.

4.4.2 Forecast Error Variance Decomposition Test

To further compliment the granger causality test, we employ another way of

characterizing the dynamic behavior of a VAR system, the Forecast Error Variance

Decomposition (FEVD). FEVD separates the variation in an endogenous variable

into the component shocks to the VAR. It simply apportions the variance of

forecast errors in a given variable to its own shocks and those of the other variables

in the VAR (Olusegun, 2008). In effect, a variance decomposition or forecast error

variance decomposition is used to aid in the interpretation of a vector auto-

regression (VAR) model once it has been fitted. The variance decomposition

indicates the amount of information each variable contributes to the other variables

in the auto-regression. It determines how much of the forecast error variance of

each of the variables can be explained by exogenous shocks to the other variables.

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The results of the variance decomposition analysis are presented in tables 14 & 15

in the appendix for Nigeria and South Africa respectively.

Nigeria

In Table 11, the current account balance variance decomposition analysis reveals

that the variance in current account balance is significantly explained by the own

variance, which accounts for approximately 93% in the 2nd year period and

decreased to about 83% in the 5th period and further to about 81% in the 10th

period. However, the largest share of shock, to current account balance (LCAB)

innovation, apart from its own shock, is government budget balance (LGBB),

which after two years of delayed effect, accounted for about 3% in the 3rd year

period. This remained increasingly persistent to about 8% at the end of period 10,

though such effects are not significantly different from zero. These results lend

further credence or support to the exposition of the pairwise granger non causality

test for Nigeria. Next is the real output contribution, which amounts to about 3% in

the 3rd year period, the percentage point which was sustained all through the period

of interest. The results further show that the explanatory contributions to the

innovations in LCAB by lending interest rate (LLENDRATE) and trade openness

(LOPNESS), though insignificant, maintained about 3% and 2% effects

respectively and was constant over the entire time horizon under consideration.

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Meanwhile, the results further revealed that real exchange rate (LRER) contribute

the least shock to the innovation in the current account balance of between .6% and

about 2% after 1st year period lag.

South Africa

Looking at the variance decomposition of current account balance for South Africa

in table 12, reveals increasing trends of the contributions of government budget

balance, real gross domestic output and trade openness to the current account

balance innovation, with RGDP exerting the largest influence. Meanwhile, the

contribution of real exchange rate and lending rate shocks to LCAB variation

remain inconsequential, while that of lending interest rate (LLENDRATE)

represents an infinitesimal portion of about 0.57% in the 10th year period under

estimation. However, the innovation in current account balance is significantly

explained by the own shock, which accounts for approximately 89%in the 2nd year

period and keeps a declining profile to about 73% in the 5th period and 62% in the

final year period under consideration.

4.5 Stability Test

To test for structural stability of the estimated coefficients and functional

misspecification, we also plot the cumulative sum (CUSUM) and cumulative sum

squares (CUSUMSQ) using the information contained in the estimated residuals.

139

According to the CUSUM (fig.3) and CUSUM OF SQUARE (fig. 4) test results in

the appendix, the recursive residuals wander within the critical 5% significant

lines, which indicate the absence of structural change or misspecification in the

estimated model. These suggest that the stability of the parameter estimates is

verified.

4.6 Discussion of Results

In table 5, the trace test indicates 2 co-integrating vectors (r-2). This suggests the

existence of long-run equilibrium relation between the explained and the

explanatory variables. That LCAB and LGBB are co-integrated by implication

means that the two variables cannot wander off in opposite directions for very long

period without reversion to a mean distance (equilibrium) eventually. The

coefficient of error correction term lagged one period in a VEC model provides the

speed of this adjustment which for this study stands at about 60 percent per year

for Nigeria. Table 7 clearly indicates no evidence of co-integration was identified

among South African data set. This implies that though the data sets for South

Africa may be trending together (correlated), equilibrium relationships among

them are not identified. This is clearly evident in the lack of significant causality

from fiscal deficit to current account stance in the short-run as observed for both

Nigeria and South Africa.

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In table 8, the PV of the coefficient of e (t-1), λ of 0.05%, for the null hypothesis that

LGBB does not significantly granger cause LCAB (b11 = b12 = λ1 = 0) indicates

that the null hypothesis is rejected as the coefficient of -0.599 is statistically

different from zero judging from its P-Value as stated above. This suggests that

b11 = b12 = λ1 ≠ 0 which indicates that twin deficits hypothesis is confirmed for

Nigeria on the long-run. In effect, this means that in Nigeria, fiscal deficits fuel

current account deficits in the long-run time frame. The results further support

Keynesian absorption theory which postulates that budget deficits and the current

account imbalance significantly trend together in the same direction at least in the

long run. The implication of this finding is that for Nigeria to cut down on the level

of current account deficit, economic policies aimed at fiscal consolidation in

addition to strict budget discipline should be pursued. The Results of the estimation

of equation 12 (VEC) as shown in table 13 above indicate the P-Values of the

parameter estimates (coefficients) of LCAB-1, LCAB-2 and e(t-1) as 0.762, 0.38 and

0.122 respectively. This suggests that none of the coefficients of the parameter

estimates is statistically different from zero even at 10% level of significance. With

the null hypothesis that, a11 = a12 = λ2 = 0 therefore not violated, means that the

existence of a significant long-run causal link from current account imbalance to

government budget deficits is not confirmed for Nigeria. This by implication

141

suggests that for Nigeria, the current account balance may not provide a veritable

policy instrument for predicting fiscal balance position in the long-run.

Furthermore, results of estimations of equations 11 and 12 (VARs) to test for

short-run granger non causalities from fiscal deficits to current account imbalance

and vice versa suggest that no significant causal relationship is detected between

LCAB and LGBB in either way. These results indicate that Ricardian equivalence

is verified for Nigeria in the short-run, which by implication suggests that fiscal

balance may not be a good predictor of current account position for Nigeria. On the

other hands the results further suggest current account targeting is not identified for

Nigeria in the short-run, which by implication indicates that current account

balance cannot significantly predict fiscal imbalance in Nigeria even in the short

term.

In the same vein, the results of short-run VAR granger non causality test for South

Africa as scheduled in table 10 above show the Probability Values (PVs) of about

32% and 66% for the coefficients of LGBB-1 and LGBB-2 respectively. This

supports the null hypothesis of b11 = b12 = 0. These results indicate non existence of

a significant causality from LGBB to LCAB in the short term. This means that

twin deficits proposition is not supported for South African economy in the short

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term. In effect, government budget balance is not a reliable instrument for the

prediction of current account position for South Africa in the short-run. However,

this result contradicts the findings of Sadullah and Pinar (n.d) who with panel data

analysis identifies the presence of twin deficits hypothesis for six emerging

economies of Czech Republic, Brazil, Mexico, Colombia, Republic of South

Africa and Turkey.

Furthermore, for South Africa, the Results of the estimation as shown in table 13

above indicate the P-Values of the parameter estimates (coefficients) of LCAB-1

and LCAB-2 as 0.000 and 0.316 respectively. This suggests that the coefficient of

the current account balance (a11) lagged one period is statistically different from

even at 1% level of significance. With the null hypothesis that, a11 = a12 = 0

therefore violated, means that the existence of a significant causal link from current

account imbalance to government budget deficits is confirmed for South Africa in

the short run. This by implication suggests that for South Africa, the current

account balance may prove to be a veritable policy instrument for predicting fiscal

balance position. In effect, prudent current account management may provide the

panacea for fiscal consolidation for South Africa at least in a short term.

143

The above results provide evidence that for both Nigeria and South Africa, the

consumers appear to be Ricardians in the short-run. This suggests that short term

fiscal measures designed to stimulate aggregate demand may prove ineffective as

consumers may reduce their consumption in order to save in anticipation of future

tax increase. In effect, the results suggest that Ricardian equivalence hypothesis

holds for both Nigeria and South Africa in the short-run. This proposition,

articulated by a classical economist, David Ricardo (1817) and popularized by

Barro (1974), is of the view that policy shifts in the composition of public

financing, (that is whether through debt or tax cuts) has no significant impact on

real interest rates, aggregate demand, private spending, the exchange rate or the

external accounts. Proponents of this view point out that while tax cuts have the

effect of reducing public saving and enlarging the budget deficit, they increase

private saving by an amount equivalent to the expected increase in the tax burden

in the future years. This suggests that government budget deficits may not alter

aggregate domestic savings and economic growth or the level of aggregate demand

including demand for imports for the fact that far-sighted individuals fully

capitalize the implied increase in future taxes associated with current tax cut.

Otherwise stated, the theory implies that there is no visible correlation between the

two anomalies. This has very serious implications for fiscal policy decisions for

Nigeria and South Africa, because if this assertion is right, it may render fiscal

144

policy impotent in the short-run. While South African economy still maintain the

Rcardian equivalence hypothesis in the long-run, twin deficits hypothesis is

verified for Nigeria in the long-run. This suggests that, for Nigeria, policy shifts in

the composition of public financing, (that is whether through debt or tax cuts) in

the long-run will have significant impact on real interest rates, aggregate demand,

private spending, the exchange rate or the external accounts.

The results of the impulse response function as presented in table 14 in the

appendix, indicate that a one percentage basis point standard deviation innovation

in government budget balance (LGBB), shows negative and persistent effect on

current account balance (LCAB), though such effect remains grossly

inconsequential over the time horizon of interest. In the same vein, in table 15 for

South Africa, the response of LCAB to one basis point shock on LGBB, though

positive and consistent, is equally too meager to be considered to be of any

consequence.

Furthermore, the results of the Forecast Error Variance Decomposition for Nigeria

as presented in table 16 in the appendix show that the contribution of government

budget balance variable to the current account balance variation for the period

under review, ranged from zero percent in period one to a meager 7% in period ten.

145

Similar experience was observed for South Africa in table 17 which shows that

LGBB only accounts for just between zero percent in the 1st period and about 10%

in the 10th period of the innovations in LCAB within the time frame of interest. The

results of both the IRF and FEVD for Nigeria and South Africa indicate that LGBB

has little explanatory power for the development in LCAB. With LCAB

accounting for the highest proportion of its own error variance all through the

forecast horizon for the both countries, it would appear that there is no significant

correlation between current account balance and the rest of the employed

independent variables. Therefore, both the IRF and FEVD results lend supports to

and are consistent with the granger causality evidence of Ricardian Equivalence for

the both economies. The results suggest that the relationship between the two

deficits appear to be a complex one and that fiscal policy should not be used in

isolation to supervise developments in current account stance.

4.7 Comparative Analysis and Justification of Results

The inclusion of a trading partner is not just for the purpose of comparison and

references, but for the fact that the current account balance of each country

depends not only on its own budget deficit, but also on the budget deficits of its

trading partners (Douglas, 1988). To this effect we consider it plausible for a

146

comparative analysis of the results with recourse to some identified country

specifics that may influence the outcomes.

Many reasons, may account for Ricardian equivalence not holding exactly so that

the important issue is to determine the extent of departure from the Ricardian

equivalent proposition (REP). In the short-run, South African consumers appear to

be more Ricardians than their Nigerian counterparts as economic agents. This is

clearly demonstrated by the magnitude of the P-Values of the parameter estimates

for the both countries as exhibited in tables 9 and 10. The scenario presented for

Nigeria is quiet normal for a country with installed capacity utilization of just

about 57.87% in 2012 with high unemployment rate of 33.8% (CBN statistical

Bulletin, 2012), which in all must have contributed significantly to an output gap.

The association between fiscal policy and the current account balance is

significantly affected by the level of the output gap, defined as actual output less

potential output (Ali et al., 2010). While in the long-run scenario, twin deficits

hypothesis is adequately identified for Nigeria, Ricardian equivalence remained

adequately verified for South Africa. This has divergent policy impletions for the

management of the both economies.

147

Furthermore, according by World Development Indicator (2012) the percentage of

Nigerian population living below $2 per day grew from 83.1% in 2004 to 84.5 by

2010 and for South Africa, the report of survey from the same source shows

reduction in poverty rate of the South African population, gauged by those living

below $2 per day, from 35.7% in 2006 to 31.3% by 2009. Also, an indication of

the average income level in an economy can be proxied by the gross national

income per capita. The values of this variable as at 2010, with the world ranking in

bracket, show $1,180 (168) and $6,090 (102) for Nigeria and South Africa

respectively. This suggests stronger income base and thus higher marginal

propensity to save by private consumption agents for South Africa than Nigeria.

148

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Maylene, Y.D.,& Agbola, F. W.(n.d). Estimating the long-run effects of exchange change rate devaluation on the trade balance of South Africa. School of Business and Economics, Monash University South Africa Campus. Nozar, H., & Loretta, W. (2006). The dynamics of current account and budget deficits in


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150

CHAPTER FIVE

SUMMARY OF FINDINGS, CONCLUSION AND RECOMMENDATIONS

This study investigates the relationship between budget and current account

balances and most importantly to identify which one to target in order to effect

adjustment in the other. To achieve these fits, we opt to deploy the relevant

variables with current account deficit (CAB) as the explained variable, and budget

deficit (GBB) as explanatory variables, and augmented with real exchange rate

(RER), real gross domestic product (RGDP), real interest rate (RIR), real trade

openness (OPNESS)) as control variables. To gauge the suitability of these

variables for purposes intended, we employ the ADF and PP test procedures. The

results for Nigeria and South Africa respectively show that in all cases, the

variables become stationary at most in their first difference at 1% level of

significance for all the employed data series. This suggests that all the employed

variables for estimation of specified equations are quiet fit for purposes intended.

5.1 Summary of Findings

The twin deficits hypothesis has expressed a much professed tie between domestic

budget deficit and current account imbalance. This has engendered extensive

academic debate and empirical testing in the 1980’s and the early 1990. According

151

to Nozar & Loretta (2006) the causal relationship of the twin deficits provides five

competing scenarios as: that budget deficits cause current account deficits; budget

deficits and current account deficits are not casually related (Rcardian

equivalence); there is bi-directional causality between the two macroeconomic

variables; current account deficits cause budget deficits (current account targeting)

and finally the scenario which suggests that the twin anomalies trend apart (twin

divergence). These formed the basis of our research questions, objective and thus

the hypothesis. The objective of this study in general term is to empirically

determine the positions of Nigeria and South Africa in the context of the above

scenarios. To this end, long-run (VEC) and short-run (VAR) Granger Non

Causality Tests are performed on the time series macroeconomic variables of

interest for Nigeria and South Africa and the results obtained elucidate the

following findings in line with the specific objectives of the study:

1. The result of the co integration test (Trace) between variables of equation 5

suggests that the null hypothesis of no co integration cannot be rejected for

South Africa, as they indicate no co integration among the variables of the

model. This suggests that for South Africa, there is no long run steady-state

relationship between the dependent and explanatory variables in the

expressed equation. In contrast, result of Trace test for co integration

between the data set for Nigeria is a departure from the South Africa’s

152

evidence as the results indicate two (2) co-integrating vectors. This

indication suggests that for Nigeria, the existence of steady state long run

equilibrium relationship between the explained and explanatory variables

cannot be rejected and that the dynamic behavior of current account balance

in response to innovations in fiscal deficits suggests that the system corrects

its previous period disequilibrium by 60 percent a year.

2. The results provide empirical evidence that twin deficits hypothesis does not

hold in the case of both Nigeria and South Africa in the short-run as the null

hypothesis that developments in government budget deficits do not

significantly influence innovations in current account imbalance in the

economies under consideration cannot be rejected. But evaluation of the

VEC model for long-run significant causal relationship between fiscal

deficits and current account imbalance suggests that twin deficits hypothesis

cannot be rejected for Nigeria on the long-run. Twin deficits hypothesis

posits positive and significant causal relation between budget deficits and

currents account deficits with budget causing current account.

3. In the same vein, the results further provide empirical evidence that current

account targeting scenario does not hold for Nigeria in both short-run and

153

long term scenarios. But for South Africa, the null hypothesis that

developments in current account balance do not significantly cause

innovations in fiscal deficits can out rightly be rejected in the short-run, even

at 1% level of significance. Current account targeting scenario posits

positive and significant causal relation between budget deficits and currents

account deficits with current account balance causing budget balance.

4. The results further reveal that in the short-run, economies of Nigeria and

South Africa are both characterized by Ricardian equivalence hypothesis as

it provides compelling evidence that the null hypothesis that innovations in

fiscal deficits do not significantly cause developments in current account

imbalance is true. Ricardian equivalence proposition (REP) predicts that the

two deficits share no significant causal relationship and therefore are

independent.

5. Finally, the results further reveal that the scenario of a significant bi-

directional relationship between current account balance and budget deficits,

in all cases, cannot be verified for both Nigeria and South Africa.

154

The responses of current account imbalance to shocks in the independent variables

for both Nigeria and South Africa remain inconsequential, just as the results of the

current account balance variance decomposition analysis for Nigeria and South

Africa reveals that the variance in current account balance is significantly

explained by it’s own innovation, which accounts for approximately 93% in the 2nd

year period and decreased to about 83% in the 5th period and further to about 81%

in the 10th period with the independent variables contributing meagerly. The results

of both the impulse response function and the variance decomposition tests lend

supports to the outcome of causality tests in the short-run.

5.2 Major Contribution to Knowledge

A critical look at the above macroeconomic indices of unemployment rate,

average installed manufacturing capacity utilization, the GDP per capita and

poverty rates at national poverty lines for the both countries under review; suggest

that intensity of Ricardian equivalence in any economy may further be dependent

on the poverty level of its citizens and per capita income. All these factors must

have provided the basis for the disparity between the levels of intensity of the

Ricardian equivalence for Nigeria and South Africa. Ricardian equivalent predicts

that the two deficits share no significant causal relationship and therefore

independent. This is quite evident in the result of no cointegration and supported

155

by rejection of twin deficits hypothesis in the short-run for South Africa with lower

poverty level and higher per capital income.

5.3 Conclusion

This study examines the empirical relationship between fiscal deficit and current

account imbalance employing data for Nigeria and South Africa for the period of

1960 to 2011. We employ co-integration analysis and, VEC and VAR granger non

causality process to investigate the existence of long-run and short term causalities

for the economies under consideration and complimented with impulse response

function and forecast error decomposition estimates. The results indicate no

evidence of twin deficits hypothesis for both Nigeria and South Africa in the short-

run. For Nigeria, evidence of twin deficits hypothesis is identified in the long-run.

The absence of evidence of the twin deficits phenomenon for both Nigeria and

South Africa in the short-run time frame, suggests that the Ricardian equivalence

proposition (REP) holds for the economies under consideration within such time

horizon. This concept is of the view that since people are rational, they know that

the reduction in taxes, resulting from the government expansionary fiscal policy of

tax cut or increase in public debt, is temporal and will save the extra disposable


position will be sustained because the decrease in government savings represented

156

by increased fiscal deepening will be equitably compensated by the additional

precautionary private savings for expected future increase in taxes. This designates

fiscal balance variable as exogenous to current account balance model and

indicates lack of responsiveness of private consumption to fiscal impulse. This

casts doubts on the efficacy of the use of fiscal policy in the management of

external balance.

5.4 Recommendations

1. Abstracting from the above results, we are of the view that fiscal policy should

not be intended for improvement in current account balance or in the least should

not be used in isolation to supervise developments in current account stance in the

short-run for both Nigeria and South Africa.

2. The identification of twin deficits hypothesis for Nigeria in the long-run

suggests that use of fiscal policy in the management of external balance may be

effective and indicates that fiscal policy may be intended for improvement in

current account balance.

5.5 Suggestions for Future Research

For the purpose of further contributing to geography, there is an ample prospect of

getting more germane results when other countries’ data are employed using the

157

same econometric technique as featured in this study. Also, alterations in the scope

of the study in terms of time frame using other countries’ or the same countries’

data will still provide relevant verdict that might be of interest. We suggest that

readers use this topic for their research varying geography and in time frame.

158

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Appendix

- .04

.00

.04

.08

.12

2 4 6 8 10

Response of LCAB to LCAB

- .04

.00

.04

.08

.12

2 4 6 8 10

Response of LCAB to LGBB

- .04

.00

.04

.08

.12

2 4 6 8 10

Response of LCAB to LRER

- .04

.00

.04

.08

.12

2 4 6 8 10

Response of LCAB to LLENDRATE

- .04

.00

.04

.08

.12

2 4 6 8 10

Response of LCAB to RGDP

- .04

.00

.04

.08

.12

2 4 6 8 10

Response of LCAB to LOPNESS

- .04

.00

.04

.08

2 4 6 8 10

Response of LGBB to LCAB

- .04

.00

.04

.08

2 4 6 8 10

Response of LGBB to LGBB

- .04

.00

.04

.08

2 4 6 8 10

Response of LGBB to LRER

- .04

.00

.04

.08

2 4 6 8 10

Response of LGBB to LLENDRATE

- .04

.00

.04

.08

2 4 6 8 10

Response of LGBB to RGDP

- .04

.00

.04

.08

2 4 6 8 10

Response of LGBB to LOPNESS

-0.5

0.0

0.5

1.0

2 4 6 8 10

Response of LRER to LCAB

-0 .5

0 .0

0 .5

1 .0

2 4 6 8 10

Response of LRER to LGBB

-0.5

0.0

0.5

1.0

2 4 6 8 10

Response of LRER to LRER

-0.5

0.0

0.5

1.0

2 4 6 8 10

Response of LRER to LLENDRATE

-0.5

0 .0

0 .5

1 .0

2 4 6 8 10

Response of LRER to RGDP

-0.5

0.0

0.5

1.0

2 4 6 8 10

Response of LRER to LOPNESS

-1

0

1

2

3

2 4 6 8 10

Response of LLENDRATE to LCAB

-1

0

1

2

3

2 4 6 8 10

Response of LLENDRATE to LGBB

-1

0

1

2

3

2 4 6 8 10

Response of LLENDRATE to LRER

-1

0

1

2

3

2 4 6 8 10

Response of LLENDRATE to LLENDRATE

-1

0

1

2

3

2 4 6 8 10

Response of LLENDRATE to RGDP

-1

0

1

2

3

2 4 6 8 10

Response of LLENDRATE to LOPNESS

- .02

-.01

.00

.01

.02

.03

2 4 6 8 10

Response of RGDP to LCAB

- .02

-.01

.00

.01

.02

.03

2 4 6 8 10

Response of RGDP to LGBB

- .02

-.01

.00

.01

.02

.03

2 4 6 8 10

Response of RGDP to LRER

- .02

- .01

.00

.01

.02

.03

2 4 6 8 10

Response of RGDP to LLENDRATE

- .02

- .01

.00

.01

.02

.03

2 4 6 8 10

Response of RGDP to RGDP

- .02

-.01

.00

.01

.02

.03

2 4 6 8 10

Response of RGDP to LOPNESS

- .04

-.02

.00

.02

.04

2 4 6 8 10

Response of LOPNESS to LCAB

- .04

-.02

.00

.02

.04

2 4 6 8 10

Response of LOPNESS to LGBB

- .04

-.02

.00

.02

.04

2 4 6 8 10

Response of LOPNESS to LRER

- .04

- .02

.00

.02

.04

2 4 6 8 10

Response of LOPNESS to LLENDRATE

- .04

- .02

.00

.02

.04

2 4 6 8 10

Response of LOPNESS to RGDP

- .04

-.02

.00

.02

.04

2 4 6 8 10

Response of LOPNESS to LOPNESS

Response to Cholesky One S.D. Innovations

FIGURE 1: Impulse Response Functions Multiple Graphs for South Africa

170

- .2

.0

.2

.4

.6

2 4 6 8 10

Response of LCAB to LCAB

-.2

.0

.2

.4

.6

2 4 6 8 10

Response of LCAB to LGBB

-.2

.0

.2

.4

.6

2 4 6 8 10

Response of LCAB to LRER

- .2

.0

.2

.4

.6

2 4 6 8 10

Response of LCAB to LLENDRATE

- .2

.0

.2

.4

.6

2 4 6 8 10

Response of LCAB to RGDP

- .2

.0

.2

.4

.6

2 4 6 8 10

Response of LCAB to LOPNESS

- .1

.0

.1

.2

.3

2 4 6 8 10

Response of LGBB to LCAB

-.1

.0

.1

.2

.3

2 4 6 8 10

Response of LGBB to LGBB

-.1

.0

.1

.2

.3

2 4 6 8 10

Response of LGBB to LRER

- .1

.0

.1

.2

.3

2 4 6 8 10

Response of LGBB to LLENDRATE

- .1

.0

.1

.2

.3

2 4 6 8 10

Response of LGBB to RGDP

- .1

.0

.1

.2

.3

2 4 6 8 10

Response of LGBB to LOPNESS

-20

0

20

40

2 4 6 8 10

Response of LRER to LCAB

-20

0

20

40

2 4 6 8 10

Response of LRER to LGBB

-20

0

20

40

2 4 6 8 10

Response of LRER to LRER

-20

0

20

40

2 4 6 8 10

Response of LRER to LLENDRATE

-20

0

20

40

2 4 6 8 10

Response of LRER to RGDP

-20

0

20

40

2 4 6 8 10

Response of LRER to LOPNESS

-1

0

1

2

3

2 4 6 8 10

Response of LLENDRATE to LCAB

-1

0

1

2

3

2 4 6 8 10

Response of LLENDRATE to LGBB

-1

0

1

2

3

2 4 6 8 10

Response of LLENDRATE to LRER

-1

0

1

2

3

2 4 6 8 10

Response of LLENDRATE to LLENDRATE

-1

0

1

2

3

2 4 6 8 10

Response of LLENDRATE to RGDP

-1

0

1

2

3

2 4 6 8 10

Response of LLENDRATE to LOPNESS

0.0

0.5

1.0

2 4 6 8 10

Response of RGDP to LCAB

0.0

0.5

1.0

2 4 6 8 10

Response of RGDP to LGBB

0.0

0.5

1.0

2 4 6 8 10

Response of RGDP to LRER

0.0

0.5

1.0

2 4 6 8 10

Response of RGDP to LLENDRATE

0.0

0.5

1.0

2 4 6 8 10

Response of RGDP to RGDP

0.0

0.5

1.0

2 4 6 8 10

Response of RGDP to LOPNESS

-.04

.00

.04

.08

.12

2 4 6 8 10

Response of LOPNESS to LCAB

- .04

.00

.04

.08

.12

2 4 6 8 10

Response of LOPNESS to LGBB

- .04

.00

.04

.08

.12

2 4 6 8 10

Response of LOPNESS to LRER

-.0 4

.0 0

.0 4

.0 8

.1 2

2 4 6 8 10

Response of LOPNESS to LLENDRATE

-.0 4

.0 0

.0 4

.0 8

.1 2

2 4 6 8 10

Response of LOPNESS to RGDP

- .04

.00

.04

.08

.12

2 4 6 8 10

Response of LOPNESS to LOPNESS

Response to Cholesky One S.D. Innovations

FIGURE 3: Impulse Response Functions Multiple Graphs for Nigeria

171

Table 14: Current Account Balance Variance Decomposition for Nigeria.

Period S.E. LCAB LGBB LRER LLENDRATE RGDP LOPNESS

1 0.3814 100.0000 0.000000 0.000000 0.000000 0.000000 0.000000

2 0.4183 93.15183 0.265648 0.610554 1.149584 2.609927 2.212460 3 0.4322 87.52360 3.309375 0.748420 2.495873 3.670178 2.252549 4 0.4395 85.20456 4.845782 1.166744 2.731682 3.603785 2.447445 5 0.4443 83.46896 5.904005 1.881458 2.692386 3.604505 2.448687 6 0.4465 82.63617 6.616511 2.069478 2.665485 3.574460 2.437894 7 0.4475 82.28316 6.991335 2.060950 2.653999 3.575063 2.435496 8 0.4482 82.02998 7.234940 2.093796 2.646643 3.564697 2.429940 9 0.4488 81.80034 7.429838 2.144674 2.644821 3.557123 2.423205 10 0.4494 81.60714 7.585810 2.186445 2.649631 3.553536 2.417440

Table 15: Current Account Balance Variance Decomposition for South Africa Period S.E. LCAB LGBB LRER

LLENDRATE RGDP LOPNESS

1 0.079579 100.0000 0.000000 0.000000 0.000000 0.000000 0.000000

2 0.098309 89.21609 0.070040 0.004561 0.001055 3.860310 6.847942 3 0.108926 85.99516 0.400280 0.178578 0.046221 5.568422 7.811336 4 0.117039 78.52295 2.399620 1.350123 0.044707 9.623966 8.058631 5 0.122325 73.96171 4.946171 2.144947 0.280328 10.49039 8.176447 6 0.126880 69.56649 7.320332 2.526568 0.400952 11.64281 8.542854 7 0.129763 67.13885 8.700444 2.643528 0.466061 12.10564 8.945481 8 0.132047 65.17824 9.500295 2.697617 0.452302 12.78655 9.384993 9 0.133618 63.88346 9.959056 2.696942 0.474832 13.19518 9.790530 10 0.134982 62.68580 10.26717 2.666169 0.572871 13.62640 10.18159

172

-20

-10

0

10

20

70 75 80 85 90 95 00 05 10

CUSUM 5% Significance

FIGURE 2: Cusum Test for Equation Stability for South Africa

-20

-10

0

10

20

70 75 80 85 90 95 00 05 10

CUSUM 5% Significance

FIGURE 4: Cusum Test for Equation Stability for Nigeria

Documents

OGBONNA CHUKWUMA BIG-BEN · 2016-02-09 · iii investigating the causal relationship between fiscal deficits and current account imbalance: evidence from nigeria and south africa,