Testing Twin Deficits Hypothesis using VARs and Variance Decomposition

Abstract

This paper examines the twin deficits hypothesis in Indonesia, Malaysia, the Philippines and Thailand (ASEAN-4 countries). The major findings of this paper are: (1) Long run relationships are detected between budget and current account deficits. (2) We found that the Keynesian reasoning fits well for Thailand since a unidirectional relationship exists which runs from budget deficit to current account deficit. For Indonesia the reverse causation (current account targeting) is detected while the empirical results indicate that a bidirectional pattern of causality exists for Malaysia and the Philippines. (3) We also found support for an indirect causal relationship that runs from budget deficit to higher interest rates, and higher interest rates lead to the appreciation of the exchange rate and this leads to the widening of current account deficit. (4) The results of the variance decompositions and impulse response functions suggest that the consequences of large budget and current account deficits become noticeable only over the long run.

An Empirical Investigation of the Twin Deficit Hypothesis: Evidence from Sri Lanka

“…Their findings suggest that the correlation between two deficits is complex and ambiguous and it is subject to change depending on the underlying tax system, trade patterns and barriers, the exchange rate, etc. Baharumshah et al (2006) examine the TDH for Indonesia, Malaysia, the Philippines and Thailand and find that the Keynesian reasoning fits well for Thailand since a unidirectional relationship exists that runs from budget deficit to current account deficit. For Indonesia, the reverse causation (current account targeting) is detected while the empirical results indicate that a bi-directional pattern of causality exists for Malaysia and the Philippines.…”

“…The connection between the budget deficit and current account deficit can be derived from the national account identity: 1 Baharumshah and Lau (2006) investigate twin deficits for a panel of South East Asian Central Banks (SEACEN) countries including Sri Lanka and consider the role of the two financial variables. However, as the investigation is based on panel data analysis, they do not explicitly provide evidence for Sri Lanka.…”

“…At the same time, current account deficits coupled with increases in budget deficits and resultant inflation could lower the country's sovereign ratings and trigger a capital flight while creating difficulties on external financing. Also, growing fiscal and current account imbalances cause macroeconomic imbalances and hence, affect long-term economic progress of a country (Baharumshah, Lau and Khalid, 2006). In this context, establishing and understanding the relationship between twin deficits would help to formulate appropriate macroeconomic policies for a country.…”

Twin Deficit in Nigeria: A Re-Examination

“…He concluded that twin-deficits theory holds in the short-run, but not in the long run for India. Baharumshah, et al (2006) examined the twin deficit hypothesis in Indonesia, Malaysia, the Philippines and Thailand using co-integration, impulse response function and variance decomposition of the VAR model. Their study found long run relationships between budget and current account deficits.…”

Budget Deficit and Fiscal Administration In Selected Sub-Saharan African Countries

“…In another study, Baharumshah, Lau, Khalid (2006) examined how fiscal and current account deficits were affected by interest and nominal exchange rates in Asia. Data from 1976 to 2000 of 4 countries (Philippines, Indonesia, Malaysia, and Thailand) were analysed by the Johansen co-integration test.…”