TESTING RELEVANCE OF TWIN DEFICIT FOR A TRANSITION ECONOMY LIKE PAKISTAN.

• Author: Hassan, Muhammad Shahid

1. Introduction

   The relationship between fiscal and trade deficit can be summarized into the Keynesian Proposition and the Ricardian Equivalence Hypothesis. The Keynesian Proposition states that fiscal deficit will have a significant and positive impact on trade deficit and argues that fiscal deficit comes into being due to expansionary fiscal policy which enhances local expenditures or absorption for imports, therefore, the continuous increase in imports will start increasing the trade deficit. It could be inferred that budget deficit may positively create trade deficit. There are studies which support the Keynesian Proposition, such as: Fleming (1962), Mundell (1963), Volcker (1987), Zaman and DaCosta (1990), Kearney and Monadjemi (1990), Bachman (1992), Smyth and Hsing (1995), Vamvoukas (1999), Aqeel and Nishat (2000), Lau and Haw (2003), Onafowora and Owoye (2006), Corsetti and Muller (2006), Mukhtar, Zakaria and Ahmed (2007), Kim and Roubini (2008), Muller (2008), Beetsma, Giuliodori and Klaassen (2008), Pantelidis et al. (2009), Bouhga-Hagbe et al. (2010), and Jawaid and Raza (2013). However, the findings of Monacelli and Perotti (2007) revealed that fiscal deficit will have a negative but significant impact on trade deficit. They further stated that as fiscal deficit is becoming the reason of the current account or trade deficit, government regulations must be aimed at bringing the balance between volume of exports and volume of imports. Consequently, trade deficit may decline and may achieve state of balance.

   The second view on the relationship between fiscal deficit and trade deficit is recognized as the Ricardian Equivalence Hypothesis and it is proposed by Barro (1989). This view reveals that fiscal deficit is not the cause of trade deficit and simply both deficits are neutral. The advocates stated the transmission mechanism for the neutral relationship between fiscal and trade deficits that because of expansionary fiscal policy government cuts taxes or may increase its expenditures. Consequently, as the disposable income of the masses increases, private savings will be enhanced and in turn this will encourage domestic investment; therefore, overall exports will increase in response to increase in domestic production and exhibiting no external deficit in the country. This view is supported by the findings of Miller and Russek (1989), Rahman and Mishra (1992), Evans and Hasan (1994), Wheeler (1999) and Kaufmann, Scharler and Winckler (2002). Moreover, there is another possibility of the relationship between fiscal deficit and trade deficit: trade deficit may have a significant impact on fiscal deficit or trade deficit may cause fiscal deficit. This relationship between the two deficits is investigated by Summers (1988), Islam (1998), Khalid and Guan (1999), and Alkhatib-Alkswani (2000); they found that unidirectional causality running from current account deficit to budget deficit prevails. The prime reason behind investigating the impact of trade deficit on fiscal deficit is to provide an answer for the question whether targeting current account deficit affects fiscal/budget deficit or not?

   Furthermore, the relationship between fiscal deficit and trade deficit could be bidirectional as well, meaning that both deficits could cause each other and may contradict the Keynesian Proposition (Summers, 1988). The studies of Laney (1984), Darrat (1990), Evans (1993), Ibrahim and Kumah (1996), Lau and Baharumshah (2004), Mukhtar, Zakaria and Ahmed (2007), Baharumshah (2007), Jayaraman and Choong (2007), Lau, Abu Mansor and Puah (2010), and Mehrara and Zamanzadeh (2011) have confirmed bidirectional causal relationship between trade and fiscal deficits. The coexistence of both deficits is referred to as twin deficit. The developing countries of the world have been experiencing twin deficit in the past years and the co-movement of both deficits is accelerating with time. Pakistan, as a transition economy, is also experiencing the simultaneous existence of both deficits and these deficits are also accelerating in Pakistan, further exhibiting many macroeconomic ills in the country. In the case of Pakistan, the causal relationship between trade and fiscal deficits has been tested by Burney and Yasmeen (1989), Burney and Akhtar (1992), Kazmi (1992), Aqeel and Nishat (2000), Mukhtar, Zakaria and Ahmed (2007), and Hakro (2009).

   This study is an attempt to investigate whether the Keynesian Proposition or Ricardian Equivalence Hypothesis prevails in the case of Pakistan. This study will also test the causal relationship between fiscal deficit and trade deficit and will check which view point is more suitable or most relevant for Pakistan, so that it could help policy advisors in suggesting appropriate policy measures. In the present study we have considered unemployment, urbanization, money supply, foreign direct investment and human development index as explanatory factors of trade deficit along with fiscal deficit. This study is different from the other studies due to its control factors, the time span and the methodological framework used. This study applies Ng-Perron (2001) unit root test, ARDL Bounds Testing Approach, and VECM based Causality Test for investigating the relationship between trade deficit and fiscal deficit in addition to various controlled factors for the dataset ranging from 1972 to 2012.

   Section 2 offers a brief review of the previous researches, section 3 presents the methodological framework, section 4 reviews the empirical findings of the study, and the final section 5 reports the conclusions and policy implications.

2. Literature review

   Zaman and DaCosta (1990) investigated the causal relationship between budget deficit and current account deficit for the period ranging from 1971(Q1) to 1989 (Q4) and found unidirectional causality running from budget deficit to current account deficit. Bachman (1992), using VAR model on quarterly dataset for the period from 1974 to 1988, explored federal budget deficit as a factor that explained variations into current account deficit and confirmed evidence of twin deficit in the US. Beside Bachman (1992), Vamvoukas (1999) also examined the causal relationship between budget deficit and trade deficit for the Greek economy for the period from 1948 to 1993 and found unidirectional causality running from budget deficit to trade deficit. This study concluded that the Keynesian Proposition prevailed on the long run and short run in the Greek economy.

   Aqeel and Nishat (2000) who investigated the twin deficit hypothesis for Pakistan by considering a dataset from 1973 to 1998 found that fiscal deficit positively and significantly caused a current account deficit into long run, but it inversely caused a current account deficit on the short run. The findings further confirmed the evidences of unidirectional causality running from economic growth to current account deficit, running from money supply to current account deficit, and running from exchange rate to current account deficit in Pakistan. Lau and Haw (2003) also explored the twin deficit for ASEAN economies like Malaysia and Thailand by applying Vector Autoregressive model and Toda Yamamoto technique by covering a sample period for Thailand from 1976 (Q1) to 2000 (Q4) and for Malaysia from 1976 (Q1) to 1998 (Q2) and found evidence of unidirectional causality running from budget deficit to trade deficit for the case of Thailand (validating the Keynesian Proposition) but evidence of bidirectional causality was found for the case of Malaysia. The study concluded that the budget deficit consistently affects current account through exchange rate and interest rate channels. Lau and Baharumshah (2004) found evidence of twin deficit in the case of Malaysia for the period from 1976 (Q1) to 2000 (Q4). In another study, Onafowora and Owoye (2006) found positive effects of budget deficit on trade deficit into both long run and short run, and also found an evidence of unidirectional causality running from current account deficit to budget deficit in Nigeria for the period 1970-2001. The findings further exposed that money supply, exchange rate, output growth and interest rate were negatively affecting trade deficit in the long run. Besides this study, Mukhtar, Zakaria and Ahmed (2007) observed that budget deficit increases trade deficit in the long run but declines trade deficit into short run and also found evidence of bidirectional causality between budget and trade deficit for Pakistan for a quarterly dataset from 1975 to 2005. Pantelidis et al. (2009) also investigated the twin deficit hypothesis for the case of Greece for the 1960-2007 period and found an evidence of twin deficit; however, this evidence was weak and they relate it with Quintos Terminology, therefore, they remained with Keynesian Proposition for their findings regarding twin deficit. Additionally, they came up with the findings that public expenditures regarding aging will be a serious threat for the long run stability of social security financing.

   Ozturkler and Colak (2010) explored the relationship between trade deficit and unemployment and found that trade deficit significantly accelerates unemployment in Turkey for the period from 1960 to 2009. In another study, Waliullah et al. (2010) found income and money supply as important determinants of trade balance for both short and long term spans for Pakistan for the period from 1970 to 2005. The findings further exposed that money supply significantly decreases trade balance into both long run and short run. Mohammad (2010) found real effective exchange rate as more important determinants of trade deficit than...