on the twin deficits hypothesis: is malaysia different?

Pertanika J. Soc. Sci. & Hum. 12(2): 87-100 (2004) ISSN: 0128-7702© Universiti Putra Malaysia Press

On the Twin Deficits Hypothesis: Is Malaysia Different?

EVAN LAU & AHMAD ZUBAIDI BAHARUMSHAHDepartment of EconomicsUniversiti Putra Malaysia

43400 UPM, Serdang, Selangor, Malaysia

Keywords: Current account deficit, budget deficit, Granger non-causality, JEL classification: F30,H60, H62

ABSTRAK

Kajian ini membincangkan isu semasa berkaitan defisit berkembar di Malaysia. Teknik statistikyang dipelopori oleh Toda dan Yamamoto (1995) digunakan di dalam kajian ini untuk menganalisishubungan penyebab jangka panjang di antara defisit akaun semasa dan belanjawan kerajaan.Keputusan empirikal jelas menunjukkan bahawa terdapat hubungan penyebab dua hala di antarakedua-dua defisit di Malaysia. Keputusan ini menunjukkan dengan jelas bahawa Malaysia berbezasekali daripada kebanyakan negara-negara industri. Dari satu perspektif, keputusan inimencadangkan bahawa hubungan penyebab daripada defisit belanjawan kerajaan kepada defisitakaun semasa yang membuktikan fenomena defisit berkembar. Dari sudut lain, hubunganpenyebab daripada defisit akaun semasa kepada defisit belanjawan kerajaan mencadangkanelemen-elemen polisi pengukuhan akaun semasa. Oleh itu, masalah menguruskan akaun semasadefisit dalam akaun semasa tidak hanya boleh bergantung sepenuhnya pada mengurangkandefisit di dalam belanjawan kerajaan.

ABSTRACT

This paper discusses the on-going debates surrounding the issue of twin deficits in Malaysia. Thestatistical technique advocated by Toda and Yamamoto (1995) for handling economic variablesthat might spuriously move together is utilized to examine the long run causal relationshipsbetween budget and current account deficits. We examine more than the three decades of timeseries data to answer the question of whether the budget deficit had led to current accountdeficit. The empirical result reveals the presence of bi-directional causality between the twodeficits in Malaysia. It is this finding that makes Malaysia different from the major industrializedcountries. On the one hand, we find that the causal relationship is from budget to currentaccount deficits providing evidence of twin deficits phenomena. On the other hand, the reversecausation as detected in this study tends to suggest some evidence of current account targeting.Therefore, policy to curb 'chronic' current account deficit cannot be achieved if the policymarkers simply rely on curtailing budget deficit.

INTRODUCTION

The past two decades have witnessed large swingsin budget as well as large fluctuations inemployment, output, interest rates, exchangerate and the trade balance in the majorindustrialized countries. Economists view these

events as harmful to the economy. The bestknown events took place during the "Reaganfiscal experiment" in the 1980s which marked aperiod of strong appreciation of the dollar andan unusual shift in external balance not in favorof the United States. l In Europe, both Germany

In the period 1981-1985, budgetary deficits in US rose from almost zero to a total of USD140 billion in 1985. In thesame period, there was simultaneous depreciation of US dollar in real as well as nominal terms as well asdeterioration in current account balance from a current account surplus of USD6.0 billion in 1981 to a deficit ofUSD120 billion by the year 1985. The two deficits were called twin deficits because they move in the same direction(amount) and they derived from the same economic fundamentals.

Evan Lau & Ahmad Zubaidi Baharumshah

and Sweden faced similar problems in the earlypart of the 1990s where the rise in the budgetdeficits was accompanied by a real appreciationof their national currencies. This in tum adverselyaffects the current account balances. Developingcountries have also experienced severe problemswith external debts in the early 1980s. The hugebudget deficits during these periods widencurrent account deficits in these debt-crisiscountries. The emergence of current accountdeficit and budget deficit phenomena in manycountries in recent years has drawn increasingattention to the problem of "twin deficits".

The issues relating to the two deficits haveimportant policy implications on the economicperformance of a country. Large and persistentcurrent account deficits are troublesome due tothe transfer of a nation's wealth to foreigners.More importantly, countries with large deficitsface difficult economic problems that necessitatedsome kind of policy response if such tendenciesare expected to continue for a long period oftime. Suppose tp.at the basic reason for therising of current account imbalances is primarilydue to the escalating of government budgetdeficit, then the deficit in current account cannotbe remedied unless policies that addressgovernment budget deficit are put into place.The success of such policy measures of coursedepends upon whether budget deficit causescurrent account deficit or the other way round.If the causal link between the two variables isincorrect, then reduction in the governmentbudget deficit may not solve the dilemma ofcurrent account imbalances. In other words, todesign an appropriate policy stance, the essenceof the problems has to be examined thoroughly.2

It is worth noting that the experiences of adeveloping country can sometimes be verydifferent from large industrialized nations. Forinstance, the developing nations have poorinfrastructure, trade impediments and tightregulations in the financial sector, not to mentionpolitical uncertainty that usually follows theseproblems. We can expect some differences inthe macroeconomic dynamics governing budgetand current account deficits between developing

and developed economies. Therefore, lessonsfrom the industrialized countries may not applyto the emerging economies because thecircumstances may differ. In addition, thediscussion is also especially relevant given thebackdrop of the financial crisis that engulfedMalaysia. Malaysia and most of the crisis-affectedAsian countries recorded large current (andbudget) deficits. Indeed, due to the size of theexternal deficit, some economists havequestioned the sustainability of the deficit inperiods prior to the 1997 crisis (Lau andBaharumshah 2003).

Malaysia now belongs to the upper middleincome developing country with per capita G Pof usn 3,640 in 2001 (World Bank 2003).Following the recent Asian financial crisis, theringgit was pegged to the US dollar in September1, 1998. Prior to the financial crisis, the economyrecorded persistent current account deficits goingas far back as 1989. The current account deficitsgrew from 5% of GDP in 1993 to 8% in 1994and increased to 10.5% in 1995. Although thecurrent account deficits have alternated in thepast two decades or so with some years ofsurpluses it had, on average, a larger deficit(5%) compared to its neighboring countrieslike Thailand (2%) and Indonesia (2.5%) overthe same period.

Malaysia's current account deficits in thelast decade reflected the movements of foreigncapital inflow, mainly foreign direct investment(FDI) from the US, Japan and the NewlyIndustrialized Countries ( IEs). FDI accountedmore than 60% of the capital inflows in the1990s. The FDI boom provides the needed capitalfor investment, employment, managerial skills aswell as technology and therefore, acceleratesgrowth and development (DeMello 1997). Thenation's experience with budget deficits in the1990s differs somewhat from that of the previousdecade. Budget deficits, which exceeded 10% ofGDP in the early 1980s, were closely related tothe current account deficits. The current accountdeficits during these periods were closelyconnected to the imbalances in fiscal budgetlargely due to investments in large infrastructure

88

Some authors like Edwards (2001) and Megarbane (2002) address the twin deficits issue from the point of view ofmacroeconomic stability of the country. They underlined that the negative implications of a combination of adversefactors (e.g. twin deficits, high interest rates and exchange rate depreciation) would increase the vulnerability of acountry and that the fiscal instruments are crucial for sound macroeconomic policy for transition and developingcountries. Therefore, twin deficits should be avoided.

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projects. On the other hand, in the late 1980sand 1990s fiscal deficit shrank (sometimepositive) but external deficit was large suggestingthat the external imbalances in the recent yearswere mainly due to private saving-investmentdecisions. It is worth noting that Malaysia's savingrates are one of the highest in the world butthey were insufficient to close-up the savinginvestment gap because of the increase inmarginal propensity to invest. In other words,the gap between the national savings andinvestments were filled by the foreign savings.

Figs. 1 and 2 plot Malaysia's current accountand budgetary positions from 1975 to 2000. Inthe early 1980s and the most part of the 1990sthe current account balance is in deficit and sois the budgetary position. Visual inspection ofthe plot suggests that fiscal deficits areaccompanied by wide current account deficits,reflecting the twin deficit phenomena asexperienced in the industrialized countries. Thisobservation is also supported by the highcorrelation (r=0.801) between the two deficitsfor the sample period under investigation.3 Thetwo variables appear to move closely togetherovertime, but the budget deficits appear to bemore volatile than the current accountimbalances, especially as one moves to the recentyears. In spite of the importance of the effect of

fiscal (budget) policy on current account deficit,the subject on twin deficits is under research inMalaysia. The reason is partly because Malaysiahas not experienced any difficulty in managingthe two deficits in the past except in the early1980s due to the collapse of the commodityprices and the recent 1997/98 Asian financialcrisis.

The aim of the paper is to investigate thecausal link between the two deficits. To this end,the Toda and Yamamoto (1995) Granger noncausality test is utilized to examine the long runrelationship of the two deficits. Based on theexperience of Malaysia, this present work aimsto seek and contribute to the debate on the twindeficit phenomena in emerging economies,which we find is still lacking in the literature.Specifically, the purpose is to identify the causaldirection of the relationship between the twovariables. This in our view is important as it willprovide the right policy option (or mix) tocombat the above-mentioned issue.

The present paper differs from all previousstudies in the following ways: First, we utilizedan alternative testing methodology, endorsed byToda and Yamamoto (1995) which has verygood power properties against the causality testbased on vector error correction model (VECM).Importantly, the Toda-Yamamoto overcome the

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76 78 80 82 84 86 88 90 92 94 96 98 00Time(Year)

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cv~~ O-bc:::::::::-=-.;:-----:;;:o..r--~-+-----_+-__t

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Fig. 1: Malaysian current account Fig. 2: Malaysian budgetary position

The correlation coefficient analysis measures the strength or the degree of linear association between two variables.In this study, we are interested in finding the correlation between current account and budget deficits. The twovariables are treated in a symmetrically fashion where there is no distinction between the dependent and theexplanatory variable. Mter all, the correlation between current account and budget deficits is the same as thatbetween budget and current account deficits. We like to express gratitude for the anonymous referee for providingthis insight.

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pretest bias associated with unit root andcointegration tests. 4 Second, the empiricalevidence on the link between the two deficits isdrawn from the experience of an emergingmarket economy - Malaysia. Few studiesinvestigated the twin deficit hypothesis based onthe data from emerging market economies(exceptions are Anoruo and Ramchander 1998and Khalid and Teo 1999). In this way, we hopeto add to existing literature on the host subject.

The remainder of this paper is structured asfollows. Section II provides the relevant literaturein the research area. A simple theoreticalframework for analyzing the causal relationshipbetween the budgetary and current accountdeficits is also given in Section III. In section IV,we briefly outlined the methodology and dataused in the analysis. Section V presents ourempirical results. We also included the furtheranalysis of the multivariate setting in this section.The concluding remarks and policy implicationsare contained in the final section.

PREVIOUS liTERATURE

The connection between budget deficit andcurrent account deficit has sparked aconsiderable amount of interest amongeconomists in the past few decades. Thediscussion has mainly centered on two majortheoretical models. The first view is based on thepopular Keynes proposition. By using the wellknown Mundell-Fleming framework, Keynesshowed that an increase in budget deficit wouldinduce upward pressure on interest rates, causingcapital inflows and what follows the appreciationof exchange rates. According to this absorptiontheory, an increase in budget deficit wouldinduce domestic absorption and hence importexpansion, causing current account moves intodeficit. Therefore, Keynes suggests aunidirectional Granger causality that runs frombudget deficit to current account deficit.Research that used modern statistical technique

includes authors like Vamvoukas (1999), Piersanti(2000) and Leachman and Francis (2002) whohave all found convincing evidence to supportthe Keynesian view that the budget deficits causethe current account deficits.5

Second, the more controversial and probablyleast accepted view is the Ricardian EquivalenceHypothesis (REH)6, initially developed by Ricardo(Buchanan 1976). According to this hypothesis,an intertemporal shift between taxes and budgetdeficits does not matter for the real interest rate,the quantity of investment or the current accountbalance. In fact, neither a crowding-out effect ofdomestic investment nor a trade deficitnecessarily emerges from a budget deficit. Hence,non-Granger causality relationship between thetwo deficits would be in accordance with theREH. Meanwhile, the empirical evidence foundin Seater and Mariano (1985), Enders and Lee(1990), Evans and Hasan (1994), among othersare supportive of REH. Moreover, the validity ofthe REH is questionable for an emergingeconomy like Malaysia.

Khalid (1996) examined the effectiveness ofthe policy applied on the developing countries.He argued that if the REH is a validapproximation for developing economies, thenthe International Monetary Fund (IMF) shouldrevise their policies to curtail problems like fiscaldeficits and the misalignment of exchange rate.The empirical results support for the validity ofREH is rejected for most LDCs. For Malaysia,the findings suggest the presence of largeproportion of income subject to liquidityconstrained individuals is the main source ofdeviation from Ricardian neutrality. Ghatak andGhatak (1996) examine the validity of REH forIndia. They found that imperfect credit marketsin India are inconsistent with the assumption ofREH.

Third, a unidirectional causality that runsfrom current account to budgetary variable ispossible. This outcome may occur when the

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In most application as in ours, it is not known a prior of which order of integration the variables are and whetherthey are cointegrated or not. Consequently, unit root and cointegration are normally required before estimating theVAR model and the hypothesis therefore conditional on these pretests. As the power of unit root test are known tobe low and test of cointegration are known not to be very reliable for small sample, these pretest biased might besevere (see Toda 1995).Some earlier work that attempted to resolve the issue includes Hutchison and Pigott (1984) and Bachman (1992).These studies also identify a causal relationship running from budget to current account deficits.For a comprehensive understanding on the REH, interested reader could refer to Barra (1974), Barro (1989) andSeater (1993).

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CURRENT ACCOUNT ANDFISCAL BALANCE IN NATIONAL

ACCOUNTS FRAMEWORKThe national account identity provides the basisof the relationship between budget deficit andcurrent account deficit.8 The model starts withthe national income identity for an openeconomy that can be represented as:

Lastly, a bi-directional causality between thetwo deficits is also possible. The results obtainedby Darrat (1988), Islam (1998) and Normandin(1999) are supportive of this outcome. Islam(1998), for example, analyzed the relevance oftwin deficit hypothesis in Brazil for the period1973-1991. He found a bi-directionallink betweenbudget and trade imbalances. This finding is inaccordance with the result reported by Darrat(1988). These authors went on to argue that inthe case of a bi-directional relationship, budgetcut will not be effective to overcome the problemwith current account deficit. In fact,complementary options such as interest ratepolicy, exchange rate policy, trade policy with abudget cut are a better option. The abovediscussion identified four direct possible linksbetween budget and current account deficits.?

The body of evidence, however, does notyield a consensus on the causal relationshipbetween the two deficits. The results were foundto be affected by the sampling period as well asthe method used in the investigation. To sumup, the role of fiscal deficit in correct currentaccount imbalances is not without controversy.Henceforth, the issue has become very importantin developing nations and we are motivated toreexamine the relationship between the two, ifany, for Malaysia.

deterioration in current account leads to slowerpace of economic growth and hence increasesthe budget deficits. This outcome is possible fora small open developing economy (e.g. Malaysia)that depends largely on foreign capital inflowsto finance economic developments. Thebudgetary position of a country is usually affectedby large capital inflows or through debtaccumulations from a donor country and withthat the host country will eventually run intobudget deficits. The experience of LatinAmerican and to some extent East Asiancountries illustrate this point (Reisen 1998). Forinstance, in the 1980s most of the Latin Americandomestic investment is growing more than thedomestic savings that have adverse effects oncurrent account. The fiscal position hadexacerbated the private sector imbalances. Thisreverse causality usually observed in LDCs istermed as 'current account targeting' bySummers (1988), where he argued that externaladjustment may be sought via fiscal policy.

Motivated by the large and unprecedentedcurrent account deficits as well as massive federalbudget deficits in the developing countries,Anoruo and Ramchander (1998) examine thetwin deficits issue in five developing Asiancountries includes India, Indonesia, Korea,Malaysia and Philippines. They found aunidirectional Granger causal link running fromcurrent account to budget deficits for all thesample countries investigated, except for Malaysiawhere a bi-directional causality is documented.Recently, Khalid and Teo (1999) documentedthe reverse causality for Indonesia and Pakistanwhile Alkswani (2000) reported the reversecausation between the two deficits for SaudiArabia. According to them, this will occur if thegovernment of a country utilized their budget(fiscal) stance to target the current accountbalance.

Y=C+I+C+X-M (1)

Studies by Haug (1996) and Cardia (1997) found contradict perspective of the REH when they nested Ricardianequivalence within a non-Ricardian equivalence. Their simulation results also show that the lack of a strongrelationship between the current account deficit ratio and budget deficit ratio has been found for the G-7 countries.A low correlation exists between the two series in the nested and non-nested hypothesis. Moreover, they did notsupports any testable hypothesis presented in this study.We adopt a simple bivariate model discussed in Khalid and Teo (1999), Vamvoukas (1999) and Akbostanci and Tunc(2001) to identify a casual relationship between the two deficits in developing countries. Similarly, Piersanti (2000),Hatemi and Shukur (2002) and Leachman and Francis (2002) also use the same framework to identify the causalitybetween current account and budget deficits for developed nations. As such, the bivariate analysis adopted in thisstudy well is accepted in the previous literature on the subject matter.



TABLE 3Generalized variance decompositiona

Percentage of Horizon due to innovation in:

variations in (Quarters) L\CAD LillD L\IR L\EXC L\CU

Quarters Relative Variance in: L\CAD

1 85.674 8.760 3.251 2.315 14.3264 81.710 10.186 4.755 3.350 18.2908 80.721 10.858 4.455 3.965 19.27924 80.218 11.196 4.363 4.223 19.782

Quarters Relative Variance in: L\BD

1 4.653 94.658 0.647 0.042 5.3424 11.556 82.326 3.688 2.430 17.6748 16.599 70.776 7.213 5.412 29.224

24 24.048 54.231 12.725 8.996 45.769

Quarters Relative Variance in: L\IR

1 6.566 7.070 76.134 10.230 23.8664 5.908 17.518 63.188 13.386 36.8128 6.020 20.970 59.938 13.072 40.06224 6.190 22.782 58.064 12.964 41.936

Quarters Relative Variance in: L\EXC

1 2.333 0.173 7.705 89.789 10.2114 1.008 0.080 8.217 90.694 9.3068 0.708 0.076 8.627 90.589 9.411

24 0.498 0.070 8.960 90.471 9.529

The last ~olumn provides the. percentage of forecast error variances of each variable explained collectively by theother vanables. The column m bold represent their own shock.

CONCLUSION AND POLICY

IMPliCATIONS

Economists have long argued that for developingcountries to reduce 'chronic' current accountdeficits, national savings must rise by reducingthe budget deficits and/or increasing the rate ofprivate savings. The results of this study point tosuggest bi-directional causality between budgetdeficits and current account deficits. This is nota surprising result for an emerging economylike Malaysia. On the one hand, governmentscan have large budget deficits by heavilyborrowing in international markets. Furthermore,even the deficits financed by excessive moneycreation, these are more likely to affect thecurrent account. Excessive monetary expansionin an economy with fixed exchange rate willcause disequilibrium in the money market andwill in turn lead to increase in import demandand a larger current account deficit, other thingsbeing equal. Therefore, we would expect toobserve causality running from budget deficitsto current account defici ts.

On the other hand, higher export prices(or export volumes) generated by increase in

world demand will not only raise export earningsand improve the current account but also reducethe budget deficit (since taxes on export earningsare a significant portion of governments' revenuefor a small economy that depends on exportsectors like Malaysia). Also, an increase in exportprices (or volume) will raise domestic incomefor expansionary or countercycle fiscal policy. Inboth cases, the improvement in the currentaccount could be reflected in an improvementin fiscal balance suggesting the causal relationshipfrom current account deficits to budget deficits(reverse causation). Since both mechanisms areat work in the case of Malaysia, this explainedthe main results recorded in this study.

It is evident from the finding of this paperthat the decision to curb the problem withcurrent account imbalances cannot be achievedby simply relying on fiscal cuts. Policy measuresfocusing on monetary and productivityenchantment may have to be complementedwith the budget cut policy. Monetarists claimthat fiscal policy cannot correct thediseq~ilibriumin external account. The findingsof thIS study reject this claim but our research

96 PertanikaJ. Soc. Sci. & Hum. Vol. 12 0.22004


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also suggests fiscal policy (government spendingand taxes) by itself cannot be used to correctcurrent account imbalances. This is because theresults suggest budget deficit is not an exogenousvariable in the policy equation. Given the degreeof openness of Malaysia and how sensitive thecurrent account to foreign interest rate is, wemay expect the current account to be affectedby the budget deficit in the long run. In otherwords, even with budget cuts, external imbalancesin current accounts may lead to deterioration inbudget deficits.

From the dynamic analysis, we foundsufficient evidence to show that the causalrelationships between budget and currentaccount deficits are transmitted through interestrate and exchange rate (BD~IR~EX~CAD).

These results strengthen the causality chain inthe bivariate model and lends further support tothe body of literature that suggests that budgetdeficit does indeed have a causal relationshipwith current account.

Finally, our study focuses on Malaysia andhence the results may not be generalized to theother developing countries. Further examinationusing data from other countries may be requiredto understand the twin deficit phenomena indeveloping economies particularly the AsianDeveloping Economies (ADE). We realize theneed for more empirical work in this area ofacademic interest and it is in our next researchagenda.

ACKNOWLEDGEMENTThe authors would like to thank the twoanonymous referees of this journal for providinguseful comments on the earlier draft of thispaper. The findings of this research have beenpresented in APEB (2002) Conference. Thesecond author would like to acknowledge thefinancial supports from MOSTE [IRPA grantsNo: 05-02-04-0532].

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(Received: 3 April 2002)



APPE DIX A

Quarterly interpolation of GDP from annual observations

Let us assume that Y1' Y1_ 1, Y/+ 1 be three consecutive annual observations of continuos flow variables of

year y( t). In deriving the interpolation formulae, the observed values are actually integrals. Thus, therule of thumb is to integrate the quadratic function in order to obtain the quarterly formulae. Thequarterly formulae after satisfying each of the conditions in any year t are as follows:

Y?) = 0.0546875Y/_l + 0.234375y/ - 0.0390625Y1+1

Y?) = 0.0078125Y1_

1+ 0.265625Y1 - 0.0234375Y/+l

y/3) = 0.0234375YI_I + 0.265625y/ - 0.0078125Y/+l

y/4) = 0.0390625Y/_l + 0.234375y/ - 0.0546875Y/+I

(1)(2)(3)(4)

where Y1' Y

H, Y/+ 1 are the current, lag and lead values of the variables in question at time t

(annual). In other words, three continuous annual observations of variable y( t) are adopted in eachof the equations. In order to calculate the value for the first quarter, we apply the formulae for thefirst quarter and subsequently for the remaining quarters. For example, one may substitute the GDPvalues for Y

1' Yt-I' Y/+ 1 in Equation 1 to obtain the calculated value for the first quarter. One advantage

of the interpolation technique is being able to generate the higher frequency data series for the timeseries analysis. Thus, we adopted the Gandolfo (1981) interpolation technique of extracting thequarterly observations based on the annual GDP in this study.

100 PertanikaJ. Soc. Sci. & Hum. Vol. 12 No.2 2004

on the twin deficits hypothesis: is malaysia different?

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