THE RELATIONSHIP BETWEEN CURRENT ACCOUNT DEFICIT AND BUDGET DEFICIT : EMPIRICAL EDVIDENCE FROM SELECTED COUNTRIES

Abstract

In recent years, many economies experienced unprecedented increase in both the fiscal and current account (or trade balance) deficits. This observation has led many economists to suspect that the deficits are closely, and perhaps even casually, related. Indeed, national income accounting identities guarantee that budget deficits must create either an excess of private saving over investment or an excess of imports over exports. The conventional twin deficits concept asserts that the deficits are "twins" because fiscal budget is thought to put upward pressure on real interest rates and hence, induces incipient capital inflows. This, in tum, appreciates the real exchange value of the currency and leads to worsening of current account deficit. Hence, an implication of the twin deficits argument is that contractionary fiscal policy plays an important role in the adjustment of the massive current account deficit. However, this posited causal relationship does not command universal acceptance. Some economists argued that the connection between the deficits may not be a clear nor strong one. This is because the movement of real interest rates shows no systematic relationship to the overall balance between savings and investment flows in an economy. Also, the twin deficit argument collapses in an economy that is characterized by the Ricardian Equivalence Hypothesis. In addition, they contend that the effects of budget deficit on external balance cannot be analysed in isolation without considering changes in the external environment. Hence, if one takes all these factors into account, the link between the twin deficits therefore becomes too amorphous to justify anchoring fiscal policy decisions upon it. The objective of this paper is to identify if there exists a long-run equilibrium relationship between the twin deficits and the direction of causality between them through a selection of 5 developed and 5 developing countries, using the cointegration approach. The cointegration technique is useful in identifying long-run economic relationships when the data contain unit root(s). Examination of results not only indicates any possible correspondence between the twin deficits, but it also sheds light on the dependence of such correlation on the degree of economic development. Results show that the developing countries experienced higher association of the twin deficits, compared to the developed ones and the direction of causality in the former developing countries is bilateral, though it may run more predominantly in one direction than the other. Hence, the policy suggestion to deal with these problems is to formulate a coherent package of fiscal and monetary policies that aims to reduce both deficits simultaneously. In other words, policies that focus on improving competitiveness, productivity and saving-investment balance should complement the budget-cut policy.