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Deficit Hypothesis

Social science and medical literature, including research on mental health and counseling, has frequently been based on presuppositions that all individuals who differ from members of the sociopolitically dominant cultural group in the United States (i.e., male, heterosexual, Caucasian, Western European Americans of middle-class socioeconomic status and Christian religious affiliation) are deficient by comparison. This deficit hypothesis is particularly apparent in scientific literature presumptions that attribute psychological differences from Caucasians to deviance and pathology.

Deficit Hypothesis and Inferiority Premise

Regarding members of U.S. racial and ethnic minority groups (or people of color)—African American, Hispanic/Latino/a American, Asian American, and American Indian people—the inferiority model is one example of a deficit hypothesis. The inferiority model assumes that the dominant Caucasian group represents the standard for normal or ideal behavior and that cultural groups who differ from these norms are biologically limited and genetically inferior by comparison. In contrast, psychology literature includes critiques that cite how data have been distorted or fabricated to support the inferiority model.

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For example, based on the belief that smaller skull size and underdeveloped brains were biologically determined measures of the inferior intelligence of people of color, Samuel George Morton, in the 19th century, published research findings that supported the prevailing inferiority view. Subsequent scholars (e.g., Stephen Jay Gould) disputed these findings by examining Morton’s data and reporting errors of calculation and omission. Nevertheless, the inferiority deficit hypothesis persisted in the mental health and social science literature and practices of the 20th century. Eminent leaders in early American and British psychology perpetuated the inferiority belief of their times.

In 1904 G. Stanley Hall, the first president of the American Psychological Association, published his belief that Africans, American Indians, and Chinese people were in an adolescent or immature stage of biological evolution compared with the more advanced and civilized development of Caucasian people. Cyril Burt, an influential British psychologist whom many consider the father of educational psychology, published fabricated data to support his contention that Negros inherit inferior brains and lower intelligence compared with Caucasians. In 1976, Robert Guthrie presented a critique of the flawed scientific evidence offered by several researchers who had claimed to verify the inferior intelligence of American Indians and Mexican Americans. In part due to the conclusions drawn from an inferiority deficit hypothesis, people of color who exhibited symptoms of psychological distress were considered unworthy or incapable of benefiting from most psychological or educational interventions. Thus, they were ignored, jailed, or confined to segregated mental hospitals.

The inferiority premise has resurfaced in current times, for example, in the 1994 publication of Richard Herrnstein and Charles Murray’s The Bell Curve: Intelligence and Class Structure in American Life.

Similar to previous investigations based on an inferiority hypothesis, the research of these authors concluded that intelligence is largely inherited and correlated with race; that those who have inferior intelligence (i.e., people of color) should serve those who have superior intelligence (i.e., Caucasians); and that programs purported to promote the intellectual functioning of people of color (e.g., Head Start) are useless, and thus their resources and funding should be reallocated to serve people who are capable of benefiting (i.e., Caucasians of superior intelligence). Subsequently, scholars (e.g., Ronald Samuda, Franz Samelson, Alan Reifman) have refuted these findings and presented empirical evidence that challenges and rejects these conclusions.

Deficit Hypothesis and Cultural Deprivation Premise

In the context of the social activism of the 1950s and 1960s in the United States, the genetic inferiority premise of the deficit hypothesis shifted to a cultural deprivation premise. Similar to the inferiority model, the cultural deprivation model assumes that the dominant Caucasian group represents the standard for normal or ideal behavior. However, this model attributes psychological differences from Caucasians to the various ways in which people of color are socially oppressed, deprived, underprivileged, or deficient in comparison.

The term cultural deprivation emerged from scholars’ writing about poverty in the United States during the 1950s and 1960s (e.g., Frank Riessman’s 1962 book, The Culturally Deprived Child). The deficit hypothesis of cultural deprivation posits that poverty-stricken racial/ethnic minority groups perform poorly in psychological and educational testing and exhibit psychologically unhealthy characteristics because they lack the advantages of Caucasian middle-class culture (e.g., in presumably superior education, books, toys, and formal language). Not only does this premise mistakenly imply that people of color have no valuable cultures of their own, but it also infers that the destructive influences of poverty and racial/ethnic discrimination cause irreparable negative psychosocial differences in their personality characteristics, behavior, and achievement compared with more favorable middle-class Caucasian standards.

In rebuttal, scholars have criticized the scientific merit of the research design and interpretations of findings from studies claiming to support the cultural deprivation model. For example, Abram Kardiner and Lionel Ovesey published a book in 1951, titled The Mark of Oppression, in which they concluded that the basic Negro personality, compared with the general Caucasian personality, is a manifestation of permanent damage, in response to the stigma and obstacles of the social conditions faced by Negroes in U.S. society, which prevents them from developing healthy self-esteem and promotes self-hatred. Scholarly critiques have noted that the authors made these generalizations on the basis of 25 psychoanalytic interviews with African American participants, all of whom but one had identified psychological disturbances, in comparison to a so-called control group of one Caucasian man. Furthermore, Kardiner and Ovesey’s conclusions were disputed for failing to recognize that individuals may respond in a variety of ways (including healthy and unhealthy responses) to stress, hardships, and oppression.

One useful purpose served by studies based on the cultural deprivation premise was the attention paid to the psychosocial and environmental barriers facing people of color and their families. On the other hand, most studies focused only on abnormal and negative aspects in the lives of people of color (e.g., crime and juvenile delinquency). One detrimental implication for cross-cultural counseling is that counselors may similarly attend to and focus on only negative aspects in their assessment and interventions with clients of color. Thus (as noted by scholars such as Elaine Pinderhughes), counselors may misattribute as pathological these clients’ responses to oppression instead of recognizing aspects that may be positive, healthy, and resilient.

Deficit Hypothesis Applications to Other Nondominant Groups

In addition to applications with people of color, the deficit hypothesis may form the basis for some counseling research and practice with other nondominant groups (e.g., by gender, sexual orientation, or religious affiliation). In other words, the deficit hypothesis may be apparent in presumptions that attribute psychological differences from the dominant group in U.S. society (e.g., male, heterosexual, or Christian) to deficiency or pathology. For example, Carol Gilligan’s research findings have disputed an underlying deficit hypothesis regarding gender differences in moral development (i.e., that female participants are deficient in moral reasoning compared with males).

Her research has demonstrated that the moral reasoning of girls and women is different from, instead of inferior to, that of boys and men.

Alternative Premises

Two alternative premises to those that use only one standard of comparison (e.g., Caucasians) are models of counseling and psychotherapy based on cultural differences or diversity. Another alternative perspective to the deficit hypothesis is that of optimal human functioning. In contrast to presuming mental health deficiency in cultural group members who differ from the dominant group, the basic premise of optimal human functioning is that there are many ways to be human and promote healthy development in response to different cultural contexts and human conditions. One implication for cross-cultural counseling research and practice is that this model for conceptualizing healthy development includes both emic (culturally specific) and etic (universal) considerations. These alternative models of personality and human development offer propositions to explore beyond the ethnocentric limitations of the deficit hypothesis.

References:

• Gilligan, C. (1982). In a different voice: Psychological theory and women’s development. Cambridge, MA: Harvard University Press.
• Guthrie, R. V. (2004). Even the rat was White: A historical view of psychology (2nd ed.). Upper Saddle River, NJ: Pearson.
• Walsh, W. B. (Ed.). (2003). Counseling psychology and optimal human functioning. Mahwah, NJ: Lawrence Erlbaum.
• Counseling Theories

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What Are Twin Deficits?

• First Twin: Fiscal Deficit
• Second Twin: Current Account Deficit
• Current Account Deficit

Twin Deficit Hypothesis

The bottom line.

• Government Spending & Debt
• Government Debt

The Twin Deficits of the U.S.

Economies that have both a fiscal deficit and a current account deficit are often referred to as having "twin deficits." This means that government revenues are lower than the government's expenses and that the price of the country's imports is greater than the income from its exports.

The United States has had twin deficits since the early 2000s. The opposite scenario—a fiscal surplus and a current account surplus—is generally viewed as preferable, but much depends on the circumstances. China is often cited as an example of a nation that has enjoyed long-term fiscal and current account surpluses.

Key Takeaways

• The U.S.'s twin deficits usually refer to its fiscal and current account deficits.
• A fiscal deficit is a budget shortfall. A current account deficit, roughly speaking, means a country is sending more money overseas for goods and services than it is receiving.
• Many economists argue that the twin deficits are correlated, but there is no clear consensus on the issue.

The First Twin: Fiscal Deficit

A fiscal deficit , or budget deficit, occurs when a nation's spending exceeds its revenues. The U.S. has run fiscal deficits almost every year for decades.

Intuitively, a fiscal deficit doesn't sound like a good thing. But Keynesian economists argue that deficits aren't necessarily harmful, and  deficit spending can be a useful tool for jump-starting a stalled economy. When a nation is experiencing a recession , deficit spending on infrastructure and other big projects can contribute to aggregate demand. Workers hired for the projects spend their money, fueling the economy and boosting corporate profits.

Governments often fund fiscal deficits by issuing bonds . Investors buy the bonds, in effect loaning money to the government and earning interest on the loan. When the government repays its debts, investors' principal is returned. Making a loan to a stable government is often viewed as a safe investment. Governments can generally be counted on to repay their debts because their ability to levy taxes gives them a reliable way to generate revenue.

The combined current accounts deficit and budget deficit as a percentage of U.S. GDP, as of July 2023.

The Second Twin: Current Account Deficit

A current account is a measure of a country’s trade and financial transactions with the rest of the world. This includes the difference between the value of its exports of goods and services and its imports, as well as net payments on foreign investments and other transfers from abroad.

In short, a country with a current account deficit is spending more overseas than it is taking in. Again, intuition suggests this isn't good. Those countries must continually borrow money to make up the shortfall, and interest must be paid to service that debt. For smaller, developing countries, especially, this can leave them exposed to international investors and markets.

A sustained deficit of exports versus imports may indicate a country has lost its competitiveness, or reflect an unsustainably low savings rate among the deficit-running country's people.

Current Account Deficit: It's Complicated

But like budget deficits, the truth about current accounts isn't that simple. In practice, a current account deficit can reflect that a country is an attractive destination for investment , as is the case with the U.S. Consider that advanced economies such as the U.S. often run current account deficits while developing economies typically run surpluses.

Some economists believe a large budget deficit is correlated to a large current account deficit. This macroeconomic theory is known as the twin deficit hypothesis. The logic behind the theory is that government tax cuts, which reduce revenue and increase the deficit, result in increased consumption as taxpayers spend their new-found money. The increased spending reduces the national savings rate , causing the nation to increase the amount it borrows from abroad.

When a nation runs out of money to fund its fiscal spending, it often turns to foreign investors as a source of borrowing. At the same time, the nation is borrowing from abroad, its citizens are often using borrowed money to purchase imported goods. At times, economic data supports the twin deficit hypothesis. Other times, the data does not.

Which Country Has the Highest Budget Deficit?

According to World Bank data, Croatia has the highest level of public debt, with a total deficit of 688% of the country's GDP as of 2021. Note that for many countries, the most recent data was unavailable or out of date.

Which Country Has the Highest Trade Deficit?

According to World Bank data, Mozambique has the highest trade deficit as of 2022. The country's current account balance shows a deficit of 35% of the country's GDP. Note that many countries did not have recent figures to report.

Why Is a Trade Deficit Bad?

A trade deficit means that a country is importing more goods than it exports, resulting in high demand for foreign currency and low demand for domestic currency. A consistent trade deficit can be harmful to the domestic economy because local producers do not have enough demand for their goods.

Twin deficits refer to a combined shortfall between a country's government revenues and its export income. Some economists believe that these deficits are related, because low tax revenues can result in increased borrowing from abroad. The United States consistently runs both budget deficits and trade deficits, which some economists predict may lead to unexpected disruptions.

Reuters. " US Twin Deficits Matter for the Dollar, Just Not that Much ."

Cornell Law School. " Taxing Power ."

World Bank. " Central Government Debt, Total (% of GDP) ."

World Bank. " Current Account Balance (% of GDP). "

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What is the Double Deficit in Dyslexia?

Oct 11, 2012 | DM News Blog | 0 comments

You will hear references to the “double deficit” in dyslexics. This is a theory that dyslexics both have a weak phonological awareness (of the sounds in words) and also a poor naming speed rate, when asked to recall words.

We see this pattern in a subset of the children we help learn to read. Phonological weakness is very common, but sometimes you can teach a child to decode confidently yet it never becomes automatic and fluent.

The reason we most commonly find for that is that there is some specialised cortex that can see patterns in apparently random combinations. In these children that is not being engaged. I have no data for it, but my suspicion is that they would be poor at rapid naming too. Anecdotally they tend to have difficulty with word recall.

We engage this bit of cortex with a game we call Word Mash. It forces them to try and spot an anagram of a word in a list of decoys.

When the cortex is engaged, this becomes surprisingly easy. One can scan the list and immediately spot the right word in 1-2 seconds. When you try to do it without engaging the cortex designed for the job, it takes 10-20 seconds.

By making the children try to do the task in a game setting, they seem to engage the cortex and then their reading becomes more fluent.

—–

David Morgan is CEO of Oxford Learning Solutions, publisher of the Easyread System. Easyread is an online course that helps children with dyslexia, auditory processing disorder, and highly visual learning styles improve their reading and spelling through short daily lessons. Find out more at www.easyreadsystem.com or on Facebook at www.facebook.com/easyreadsystem

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The double-deficit hypothesis: a comprehensive analysis of the evidence

Affiliation.

• 1 Department of Educational Psychology, University of British Columbia, Vancouver.
• PMID: 16512081
• DOI: 10.1177/00222194060390010401

The double-deficit hypothesis of developmental dyslexia proposes that deficits in phonological processing and naming speed represent independent sources of dysfunction in dyslexia. The present article is a review of the evidence for the double-deficit hypothesis, including a discussion of recent findings related to the hypothesis. Studies in this area have been characterized by variability in methodology--how dyslexia is defined and identified, and how dyslexia subtypes are classified. Such variability sets limitations on the extent to which conclusions may be drawn with respect to the double-deficit hypothesis. Furthermore, the literature is complicated by the persistent finding that measures of phonological processing and naming speed are significantly correlated, resulting in a statistical artifact that makes it difficult to disentangle the influence of naming speed from that of phonological processing. Longitudinal and intervention studies of the double-deficit hypothesis are needed to accumulate evidence that investigates a naming speed deficit that is independent of a phonological deficit for readers with dyslexia. The existing evidence does not support a persistent core deficit in naming speed for readers with dyslexia.

Publication types

• Research Support, Non-U.S. Gov't
• Dyslexia / etiology*
• Psychological Theory*

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• Open access
• Published: 20 August 2019

Twin deficit hypothesis and reverse causality: a case study of China

• Umer Jeelanie Banday 1 &
• Ranjan Aneja 1  

Palgrave Communications volume  5 , Article number:  93 ( 2019 ) Cite this article

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A Correction to this article was published on 01 October 2019

This article has been updated

This paper analyses the causal relationship between budget deficit and current account deficit for the Chinese economy using time series data over the period of 1985–2016. We initially analyzed the theoretical framework obtained from the Keynesian spending equation and empirically test the hypothesis using autoregressive distributed lag (ARDL) bounds testing and the Zivot and Andrew (ZA) structural break for testing the twin deficits hypothesis. The results of ARDL bound testing approach gives evidence in support of long-run relationship among the variables, validating the Keynesian hypothesis for the Chinese economy. The result of Granger causality test accepts the twin deficit hypothesis. Our results suggest that the negative shock to the budget deficit reduces current account balance and positive shock to the budget deficit increases current account balance. However, higher effect growth shocks and extensive fluctuation in interest rate and exchange rate lead to divergence of the deficits. The interest rate and inflation stability should, therefore, be the target variable for policy makers.

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Introduction

Fiscal and monetary strategies, when executed lucidly, assume a conclusive part in general macroeconomic stability. The macroeconomic theory which assumes an ideal connection between budget (or fiscal) deficit and trade balance is known as twin deficit hypothesis. The growing literature on twin deficit hypothesis (TDH) has been theoretically and empirically researched by researchers like Kim and Roubini ( 2008 ), Darrat ( 1998 ), Miller and Russek ( 1989 ), Lau and Tang ( 2009 ), Abbas et al. ( 2011 ), Bernheim and Bagwell ( 1988 ), Lee et al. ( 2008 ), Corestti and Muller ( 2006 ), Altintas and Taban ( 2011 ), and Banday and Aneja ( 2016 ).

A study by Tang and Lau ( 2011 ) found that a 1% increase in budget deficit causes 0.43% increase in current account deficit in the US from 1973 to 2008. After the currency crises and Asian financial crises, various countries simultaneously experienced budget deficit and current account deficit. Lau and Tang ( 2009 ) confirmed the twin deficits hypothesis for Cambodia based on cointegration and Granger causality testing. Banday and Aneja ( 2016 ) and Basu and Datta ( 2005 ) confirmed the twin deficits hypothesis for India by applying cointegration and Granger causality testing. Kulkarni and Erickson ( 2011 ) found that, in India and Pakistan trade deficit was driven by the budget deficit. Thomas Laubach ( 2003 ) found that for every one percentage increase in the deficit to GDP ratio, long-term interest rates increase by roughly 25 basis points. The recent study by Engen and Hubbard ( 2004 ) found that when debt increased by 1% of GDP, interest rate would go up by two basis points. China needs to take care of lower interest rate rather than higher interest rate especially on home loans which is very low in real estate market and has created a serious trouble in the economy.

The literature identifies that the FDI “crowding in effect” as an important source of China’s current account surpluses. In fact, the World Developmental Report (1985) demonstrated that a country can promote growth using FDI and technology transfers. China employed such strategies to a remarkable effect on foreign exchange reserves which increased from US$ 155 billion in 1999 to US$ 3.8 trillion by the end of 2013. Since then, there has been a sharp decline in the capital account surplus. The data from the State Administration of Foreign Exchange (SAFE) showed that in 2015, China recorded a deficit of US$142.4 billion on the capital and financial account. However, it posted a current account surplus of US$ 330.6 billion.

However, majority of the countries are facing both budget deficit and current account deficit. The increasing budget deficit alongside with current account deficit has been an imperative issue for policy makers in China. Besides, given the importance on free trade, decentralization and development there is a need to understand the association between budget deficit and trade imbalance in Chinese economy. Few researchers like Burney et al. ( 1992 ), Banday and Aneja ( 2015 ), Lau and Tang ( 2009 ), Corsetti and Müller ( 2006 ) and Ghatak and Ghatak ( 1996 ) have emphasized the issue emerged because of growing budget deficit and its relationship with macroeconomic factors likes interest rate, exchange rate, inflation, and consumption.

In the economic literature there are two distinct theories that show the linkage between budget deficit and current account deficit. The first theory is based on the traditional Keynesian approach, which postulates that current account deficit has a positive relationship with budget deficit. This means that an increase in budget deficit will lead to a current account deficit and a budget surplus will have a positive impact on the current account deficit. The increase in budget deficit will lead to domestic absorption and, thus, increase domestic income, which will lead to an increase in imports and widen the current account deficit. The twin deficits hypothesis is based on the Mundell-Fleming model (Fleming, 1962 ; Mundell, 1963 ), which asserts that an increase in budget deficit will cause an upward shift in interest rate and exchange rate. The increase in interest rates makes it attractive for foreign investors to invest in the domestic market. This increases the domestic demand and leads to an appreciation of the currency, which in turn causes imports to be cheaper and exports costlier. However, the appreciation of domestic currency will increase imports and lead to a current account deficit (Leachman and Francis, 2002 ; Salvatore, 2006 ). Conversely, the Ricardian Equivalence Hypothesis (REH) disagrees with the Keynesian approach. It states that, in a setting of an open economy, there is no correlation between the budget and current account deficits and hence the former would not cause the latter. In other words, a change in governmental tax structure will not have any impact on real interest rate, investments or consumption (Barro, 1989 ; and Neaime, 2008 ). The assumption here is that consumption patterns of consumers will be based on the life cycle model, formulated by Modigliani and Ando in 1957 , which suggests that current consumption depends on the expected lifetime income, rather than on the current income as proposed by the Keynesian model. Furthermore, the permanent income hypothesis developed by Milton Friedman in 1957, states that private consumption will increase only with a permanent increase in income. This means that a temporary rise in income fueled by tax cuts or deficit-financed public spending will increase private savings rather than spending (Barro, 1989 , p. 39; Hashemzadeh and Wilson, 2006 ). As private savings rise, the need for a foreign capital inflow declines. In this situation a current account deficit will not occur (Khalid and Guan, 1999 , p. 390).

This paper attempts to find out how strong is the relationship between budget and current account deficits in China? Addressing this question is relevant for both policy and academic perspectives. Policymakers would like to know to what extent fiscal adjustment contributes to addressing external disequilibria, especially in the case of increasing external and fiscal imbalances. Secondly, we examined the effects of budget deficit on the current account in the multivariate framework, and also have derived the general relationship among those variables. The study is based on ARDL model to investigate twin deficit hypothesis for china both in short-run and long-run. Further, we analyze the direction of causality if such a relationship exists. We utilize econometric methods for example, ARDL bound testing approach and Granger causality test to achieve these goals. In section “Theoretical Background and Literature Review” we explore the theoretical foundation of the twin deficits hypothesis. Section “Macroeconomics Aspects of the Chinese Economy” will give Macroeconomics Aspects of the Chinese Economy. Section “Data and Empirical results” describes data and empirical results. Section “Results and Discussion” provides empirical results and section “Conclusions”, provides conclusion to the study.

Theoretical background and literature review

The theoretical relationship between budget deficit and current account deficit can be represented by the national income accounting identity:

where IM stand for imports, EX for exports, S p for private savings, I for real investments, G for government expenditure, T for taxes, and TR for transfer payments. When IM is greater than EX, the country has current account deficit. From the right-hand side of the equation, when (G + TR − T) is greater than 0, the country is running a budget deficit. The difference between budget deficit and current account deficit must equal the private savings and investments which are shown below.

In the literature, various studies attempt to find the relationship between budget deficit and current account deficit for different countries or groups of countries using various methods depending upon the sample size and pre-testing of the data. The researchers have generally focused on the U.S economy because of its simultaneous budget and current account deficit since 1980s (Miller and Russek, 1989 ; Darrat, 1998 ; Tallman and Rosensweig, 1991 ; Bahmani-Oskooee, 1992 ). However, researchers from different countries have studied twin deficit hypothesis and obtained different results for different countries (Like India, U.S and Brazil) ((Bernheim, 1988 ; Holmes, 2011 ; Salvatore, 2006 ; Mukhtar et al. 2007 ; Kulkarni and Erickson, 2011 ; Banday and Aneja, 2016 ; Ganchev, 2010 ; Lau and Tang, 2009 ; Rosensweig and Tallman, 1993 ; Fidrmuc, 2002 ; Khalid and Guan, 1999 )). These studies do not support the REH but rather accept the Keynesian traditional theory, finding that budget deficit does have an impact on current account deficit in the long run. There are studies that support the Ricardian equivalence theorem which denies any correlation between budget deficit and current account deficit (Feldstein, 1992 ; Abell, 1990 ; Kaufmann et al. 2002 ; Enders and Lee, 1990 ; Kim, 1995 ; Boucher, 1991 ; Nazier and Essam, 2012 ; Khalid, 1996 ; Modigliani and Sterling, 1986 ; Ratha, 2012 ; Kim and Roubini, 2008 ; Algieri, 2013 ; Rafiq, 2010 ). These contradictory results may be due to differences in the sample period and the methods of measuring variables, which use different econometric techniques.

Khalid ( 1996 ) researched 21 developing countries from the period of 1960–1988, taking three variables into consideration: real private consumption, real per capita gross domestic product (GDP) as a proxy of real disposable income and real per capita government consumption expenditure as a proxy of real public consumption. This was done using Johansen cointegration (1988) and full information maximum likelihood (FIML) for parameter estimates. The model gives us restricted and unrestricted parameter estimations when restricted parameters are used, meaning that parameter estimation is non-linear when testing the REH for the sample countries. The results did not reject the REH for twelve of the countries, but the remaining five countries do diverge from the REH. The rejection of Ricardian equivalence in the latter group of countries demonstrates lack of substitutability between government spending and private consumption. Ghatak and Ghatak ( 1996 ) studied variables such as private consumption, government expenditure, income, taxes, private wealth, government bonds, government deficits, investments, government spending and interest on bonds to test the Ricardian Equivalence hypothesis for India for the period from 1950 to 1986. The study employed multi-cointegration analysis and rational expectation estimation, and both the tests rejected the REH, finding evidence that tax cuts induce consumption. Thus, the results invalidate the REH for India.

Ganchev ( 2010 ) rejected the Ricardian equivalence theorem for the Bulgarian economy using monthly time series data for the period 2000–2010. The long-run results of the vector error correlation model (VECM) showed evidence of the structural gap theory, which states that fiscal deficit influences current account deficit. However, vector autoregression (VAR) results did not show any evidence of a short-run relationship between budget deficit and current account deficit. The study, therefore, found that fiscal policy should not be used, in the Bulgarian economy, as a substitute for monetary policies in maintaining the internal equilibrium.

Nazier and Essam ( 2012 ) studied the Egyptian economic data from 1992 to 2010. The data included five variables: GDP, government budget deficit (as primary deficit), current account deficit, real lending interest rate (RIR) and real exchange rate (RER). The study used structural vector autoregression (SVAR) analysis, which also gave an impulse response function (IRF) to capture the impact of budget deficit on current account deficit and real exchange rate. The findings support the twin divergence hypothesis. This contradicts the theoretical framework, which finds that a shock given to a budget deficit leads to an improvement in the current account deficit and exchange rate. Sobrino ( 2013 ) investigated the causality between budget deficit and current account deficit for the small open economy of Peru for the period 1980–2012 using the Granger causality and Wald tests, generalized variance decomposition and the generalized impulse-response function. The study found no evidence of a causal relationship between budget deficit and current account in the short run.

Goyal and Kumar ( 2018 ) investigates the connection between the current account and budget deficit, and the exchange rate, in a structural vector autoregression for India over the period 1996Q2 to 2015 Q4. The impact of oil stuns and the differential effect of consumption and venture propose compositional impacts and supply stuns rule the conduct of India's CAD, directing the total request channel. Ricardian hypothesis is not supported.

Afonso et al. ( 2018 ) studied 193 countries over the period of 1980–2016 using fixed effect model and system GMM model. The results find the existence of fiscal policy reduces the effect of budget deficit on current account deficit. When there is an absence of fiscal policy rule twin deficit hypothesis exists.

Bhat and Sharma ( 2018 ) examines the association between current account deficit and budget deficit for India over the period of 1970–1971 to 2015–2016 using ARDL model. The results accepts Keynesian proposition and rejects Ricardian equivalence theorem. The results find long-run relationship between current account deficit and budget deficit. Rajasekar and Deo ( 2016 ) find the long-run relationship and bidirectional causality between the two deficits in India. Garg and Prabheesh ( 2017 ) investigate the twin deficit for India by using ARDL model and confirm the twin deficit hypothesis. Badinger et al. ( 2017 ) investigated the role of fiscal rules in the relationship between fiscal and external balances for 73 countries over the period of 1985–2012. Their results confirm the twin deficits hypothesis. Litsios and Pilbeam ( 2017 ) investigates Greece, Portugal and Spain using ARDL model. The empirical results suggest negative relationship between saving and current account deficit in all three countries.

It is clear that the research so far has not yielded any concrete evidence regarding the causal relationship between budget deficit and current account deficit. As such there is a disagreement on the causality between the two deficits. In this paper we test the theory with the support of autoregressive distributed lag (ARDL) bounds testing approach using data for the emerging country China.

Macroeconomics aspects of the Chinese economy

The Chinese economy has experienced an unparalleled growth rate over the past few decades, with increases in exports, investments and free market reforms from 1979 and an annual GDP growth rate of 10%. The Chinese economy has emerged as the world’s largest economy in terms of purchasing power parity, manufacturing and foreign exchange reserves.

In 2008, the global economic crisis badly affected the Chinese economy, resulting in a decline in exports, imports and foreign direct investments (FDI) inflow and millions of workers losing their jobs. It is visible from the Fig. 1 that China’s current account surplus has dropped significantly from its boom during 2007–2008 financial crises. After the financial crisis, China’s exports fell by 25.7% in February 2009. Further, the exclusive demand for Chinese goods in the international market pushed up current account surplus to 11% of the GDP in 2007, in a global economy (Schmidt and Heilmann, 2010 ). It is said that China responded to the 2008 crisis with a greater fiscal stimulus in terms of tax reduction, infrastructure and subsidies when compared to the Organization for Economic Co-operation and Development (OECD) countries (Herd et al., 2011 ; Morrison, 2011 ).

Behavior of Macroeconomic variables. Overview of Budget Deficit (BD), Current Account Balance (CAB), Interest Rate (INT), Inflation (INF), Money Supply (MS) and Real effective Exchange Rate (REER) from 1985 to 2017. Source: Compiled based on data taken from the World Bank. BD and CAB are expressed as percentage of GDP

However, we draw an important inference from the Fig. 1 , when the budget deficit was lowest (−0.41% of GDP in 2008), the current account surplus increased to 9.23% of the GDP. The negative shock to the budget deficit reduces current account surplus and positive shock to the budget deficit increases current account surplus.

The deprecation of the exchange rate is directly related to the elasticity of demand which improves the exports of the country and finally enhances current account surplus. However, the negative shift in the current account is due to structural and cyclical forces. The cyclic forces can be seen from the trade prospective: the increasing prices of Chinese imports like oil and semiconductors, pulls the current account balance downwards. However, the structural shift can be seen from the financial side, which affects Chinese saving and investments. The investments got reduced to 40% and household savings has reduced from 50% to 40% of GDP.

Data and empirical results

For undertaking the empirical analysis, we use the World Bank data for the following variables. The study covers the period from 1985–2016 and is based secondary data.

Current account deficit (CAD) indicates the value of goods, services and investments imported in comparison with exports on the basis of percentage of the GDP

Budget deficit (BD) indicates the financial health in which expenditure exceeds revenue as a percentage of the GDP

Deposit interest rate (DIR) as a proxy of interest rate (INT) the amount charged by lender to a borrower on the basis of percentage of principals

Inflation (INF) is measured on the basis of consumer price index which reflects annual percentage change in the cost of goods and services

Broad money (MS) a measure of the money supply that indicates the amount of liquidity in the economy. It includes currency, coins, institutional money market funds and other liquid assets based on annual growth rate and real effective exchange rate (REER)

The basic model to find out the relationship among BD, CAD, INF, INT, REER, and MS is as follows:

where INF is inflation and DIR is direct interest rate.

Based on Fig. 2 we will estimate the two models in which CAD and BD is dependent variables and others are independent variables which is as below:

Relationship of the dependent variables (CAD and BD) with other macroeconomic variables

To estimate the above models we have employed various econometric techniques to achieve the objective of the study are as below:

Unit root test to check stationarity of the variables.

ARDL bound testing for long-run and short-run relationship among the variables.

Granger causality to check the causal relationship among the variables.

Empirical results

Unit root test.

As we are using time series data, it is important to check the properties of the data; otherwise, the results of non-stationary variables may be spurious (Granger and Newbold, 1974 ). To assess the integration and unit root among the variables, numerous unit root tests were performed. Apart from applying the unit root test with one structural break (Zivot and Andrews, 1992 ), we also employed a traditional Augmented Dickey-Fuller (ADF) unit root test ( 1981 ) and Phillips-Perron test (PP 1988 ).

To ascertain the order of integration, we first applied the ADF and PP unit root tests. The results of the unit root test suggest that the RER and INF series is integrated of order zero I(0), and other variables are integrated of order I(1). The Zivot and Andrews (ZA) unit root test begins with three models based on Perron ( 1989 ). The ZA model is as follows:

From the above equations, DU t ( λ ) = 1, if t  >  Tλ , 0 otherwise: DT t ( λ ) =  t  − T λ if t  > T λ , 0 otherwise. The null hypothesis for Eqs. 4 – 6 is α  = 0, which implies that ( Yt ) contains a unit root with drift and excludes any structural breakpoints. When α  < 0 it simply means that the series having trend-stationary process with a structural break that happens at an unknown point of time. DT t is a dummy variable which implies that shift appears at time TB, where DT t  = 1 and DT t  =  t  − TB if t  > TB; 0 otherwise. The ZA test (1992) suggests that small sample size distribution can deviate, eventually forming asymptotic distribution. The results of the unit root tests are given below.

The first step in ascertaining the order of integration is to perform ADF and PP unit root tests. Table 1 , above, provides the results of the ADF and PP tests, which suggest that four out of six variables are non-stationary at level and two variable is stationary at level. However, it is important to check the structural breaks and their implications, and the ADF and PP tests are unable to find the structural break in the data series. To avoid this obstacle, we applied a ZA (1992) test with one break, the results of which are given in Table 2 . The structural break test reveals four breaks in Model A. The first, in 1992, may be due to inflation caused by privatization; the second, in 1994 may be due to higher inflation which caused the consumer price index to shot up by 27.5% and imposition of a 17% value-added tax on goods; the third, in 2003, may be due to a 48% decline in state owned enterprises at the same time as a reduction on trade barriers, tariffs and regulations was put in place and the banking system was reformed; the fourth, in 2008, is probably due to the global financial crisis

The ZA test with one structural break gives different results, as all six variables are non-stationary at a 1% level.

ARDL bounds testing approach

We applied the ARDL bounds testing approach to check the cointegration long-run relationship by comparing F -statistics against the critical values for the sample size from 1985 to 2016. The bounds testing framework has an advantage over the cointegration test developed by Pesaran et al. ( 2001 ), in that the bounds testing approach can be applied to variables when that have different orders of integration. Thus, it is inappropriate to apply a Johansen test of cointegration, and we applied ARDL bounds testing to determine the long-run and short-run relationships. The F -statistics are compared with the top and bottom critical values, and if the F -statistics are greater than the top critical values, it means there is a cointegrating relationship among the variables Table 3 .

All values are calculated by using Microfit which defines bounds test critical values as “ k ” which denotes the number of non-deterministic regressors in the long-run relationship, while critical values are taken from Pesaran et al. ( 2001 ). The critical value changes as ‘ k ’ changes. The null hypothesis of the ARDL bound test is Ho: no relationship. We accept the null hypothesis when F is less than the critical value for I(0) regressors and we reject null hypothesis when F is greater than critical value for I(1) regressors. For t-statistics we accept the null hypothesis when t is greater than the critical value and reject the null hypothesis when t is less than the critical value.

As seen in Table 4 , the calculated F -statistic F  = 9.439 is higher than the upper bound critical value 3.99 at the 5% level. The results over the period of 1985 to 2016 suggest that there is a long run relationship among the variables and the null-hypothesis of no cointegration is rejected meaning acceptance of traditional Keynesian approach for China. The bounds test results conclude that there is strong cointegration relationship among budget deficit, current account deficit, interest rate, exchange rate, inflation and money supply. Since the F-statistic was greater than the upper bound critical value, we performed a diagnostic testing based on auto-correlation, normality and heteroskedasticity, the results of which were insignificant based on the respective P -values. The Fig. 3 gives the results of CUSUM and CUSUMSQ tests which check the stability of the coefficient of the regression model. The CUSUM test is based on the sum of recursive residuals, and the CUSUMSQ test is based on the sum of the squared recursive residual. Both the graphs are stable, and the sum does not touch the red lines. Hence there were no issue of serial corelation, Heteroscedasticity and normaility in this model see Table 5 .

CUSUM and CUSUMSQ stability tests. Plot of cumulative sum of recursive residuals and plot of cumulative sum of squares of recursive residuals

Long-run and short-run relationship

After discovering the cointegrating relationship among the variables, it is important to determine the long-run and short-run relationships using the ARDL model.

The above Eqs. 7 , 8 of the ARDL model capture the short and long-run relationship among the variables. The model is based on Schwarz Bayesian Criteria (SBC) optimized over 20,000 replications. The lagged error correction term (ECM) is estimated from the ARDL model. The coefficient ECM t −1 should be negative and significant to yield the evidence of a long run relationship and speed of equilibrium (Banerjee et al. 1993). The results of Eqs. 7 , 8 are provided in Table 6 . The results find a strong long-run relationship among the variables for the period from 1985 to 2016.

At 5% level of significance the long-term estimates of the ARDL model find evidence of the twin deficits hypothesis for China, as all the variables are found to be significant at this level. Thus, our study upholds the empirical validity of the Keynesian proposition for China, while rejecting the Ricardian equivalence hypothesis.

The short-run results are significant; the coefficients of BD, CAD, INF, and INT are significant at a 5% level. This shows that a small change in the budget deficit has a significant impact on the current account deficit; similarly most of the macroeconomic variableshave a significant impact on the current account deficit. As we found evidence of a long-run relationship, we calculated the lagged ECM from the long-run equations. The negative (−0.95348) ECM coefficient and the high speed of adjustment brought equilibrium to the economy, with the exogenous shocks and endogenous shocks restoring it after a long period.

The Chinese economy is one of the most integrated economies in the world and has emerged as a powerful actor in the global economy. The pace of growth in china’s economy has accelerated since the decades in which there was a higher export promotion due to market liquidity and flexible governmental policies. In the early 1990s, it was reported in the Chinese print media that although the Chinese economy was expanding rapidly, the deficits still existed. These were called ‘hard deficits’ primarily because they were financed by expanding money supply and hence exerted inflationary pressure on the economy (People’s Daily, March 28, 1993). Deficit financing may also increase interest rates because once the monetary accommodation of the deficit is ruled out, the government has to incentivize consumers and firms to buy more government bonds. If the purchase of government bonds does not increase in direct proportion to the rise in deficit, government must borrow more money. This, in turn, crowds out private investment. Such a reduction in the private sector's demand for capital has been summarized by Douglas Holtz–Eakin, the director of the U.S Congressional Budget Office, as a “modestly negative” effect of the tax cut or budget deficits on long - term economic growth.

This study finds that a higher interest rate significantly affects the budget deficit and current account deficit in both the short-run and long-run. Chinese banks are increasing interest rates on home loans that had previously been very low; however, because of its economic bubble, especially in the real estate market, this is creating serious trouble in the economy. This is similar to the American bubble, in which most people were unable to repay loans, creating a financial crisis. Still, China must work within the existing bubble, even though it creates a lack of investments and can cause trouble for economies worldwide. The debt bubble is due to the elimination of loan quotas for banks in an attempt to increase small business. These companies are still struggling to repay that debt, which is almost half the amount of GDP of both private and public debt (The Economist, 2015).

While empirical research shows a statistically significant relationship between higher budget deficits and long-term interest rates, there are differences on the magnitude of the impact. Chinese needs to take care of lower interest rate rather than higher interest rate especially on home loans which was very low; in real estate market which has created a serious trouble in the economy.

It is also important to note that the concept of the deficit includes both hard and soft deficits. The “hard” part of the deficit, being financed by printing money, is inflationary. The “soft” part, being financed by the government's domestic and foreign debts, is non-inflationary. However, they are not reported by the Chinese government.

Moreover, hard deficits and consequent inflation increases capital inflows (to prevent interest rates from rising) and causes current account deficit. In China, deficits occurred as a result of overestimating revenues or underestimating expenditures (Shen and Chen, 1981 ) and contributed to the development of bottle-necks in sectors such as energy, transportation, and communications sectors that are of vital importance for the long-term growth of China. However, given the reluctance of the non-government investors to venture into such low pay-back sectors, the Chinese government’s policy to balance budgets by cutting its capital expenditure can severely restrict the development of these sectors (Luo, 1990 , and Colm and Young, 1968 ).

However, the natural explanation for the external surplus is that the economy follows an export-driven growth model by increasing FDI inflows. In the rising tide of economies, China’s demographic boom has created an economic miracle, allowing them to invest in education and skilled workers that will accordingly benefit the economy.

During the global financial crisis of 2008, the Chinese government combined active fiscal policy and loose monetary policy and introduced a stimulus package of $580 billion (around 20% of China’s GDP) for 2009 and 2010. The package partially offset the drop-in exports and its effect on the economy, so that the economic growth of China remained well above international averages. During this period (2008–2009) the current account surplus, as a percentage of GDP was at its highest and the budget deficit was at its lowest point of the entire decade. Our findings suggest that a strong long-run and short-run relationship exists among the variables. The empirical findings support the Keynesian proposition for Chinese economy.

Granger causality

In this section we attempt to estimate the causality from X t to Y t and vice versa. We apply Granger causality to check the robustness of our results and to detect the nature of the causal relationship among the variables based on Eqs. 9 , 10 .

Table 7 describes the results of Granger causality test. The reverse causality holds in light of the fact that budget deficit cause Granger to the current account deficit. For all the variables, the reverse causality from budget deficit to macro variables and current account deficit to macro variables holds at 5% level of significance. Thus, the results of Granger causality gives us more evidences in support of the Keynesian proposition for China in the light of above data. The reverse causality was not apparent because Chinese economy is one of the most integrated economies with higher capital outflows, export-led growth and export promotion due to market liquidity and flexible governmental policies. While the capital inflow determines a tight fiscal policy to avoid overheating of economy (see author Castillo and Barco ( 2008 ) and Rossini et al. ( 2008 ).

Results and discussion

The ambiguous verdict on the twin deficits hypothesis based on two competing theories: the Keynesian preposition and the Ricardian Equivalence theorem. In this paper we investigated the link between budget deficit and current account deficit with an emphasis on the impact of macro-variables shock on current account balance and budget deficit in the Chinese economy over the period 1985–2016.

The conclusion of this study is based on ARDL bound testing approach. The model is based on Schwarz Bayesian Criteria (SBC) optimized over 20,000 replications. With this data and analysis, we conclude that there is a long-run and short-run relationship among the variables. We accept the Keynesian hypothesis, which means we did not find evidence in support of the Ricardian Equivalence theorem in the Chinese economy. This was surprising because higher governmental expenditure and flexible governmental policies could have pushed up the current account deficit. We further applied Granger causality test the results concluded that there is a strong inverse causal relationship between budget deficit and current account deficit meaning that Keynesian preposition is more plausible than Ricardian Equivalence theorem in the light of above data. Our results are consistent with Banday and Aneja, ( 2019 ); Banday and Aneja, ( 2016 ); Ganchev, 2010 ; Bhat and Sharma ( 2018 ); Badinger et al. ( 2017 ), and Afonso et al. ( 2018 ).

The findings of the Granger causality test revealed that there exists bidirectional causality running from budget deficit to current account balance and vice versa in China. A similar movement of the budget deficit and the current account balance is the thing that one would expect when there are cyclic shocks to output. Detailed empirical findings highlight that the interest rate bubble and higher inflated housing prices are becoming a challenge for the Chinese economy, as they are now nearing the prices of the US bubble before the financial crisis popped it. If the US increases interest rates, the money will flow out of the Chinese market, which could cause a similar crisis in China. It will be a challenge for the monetary authority to bring stability in China where inflation, interest rate bubble and exchange rate volatility are of primary concern. Expenditure reduction for low payback sectors, such as energy and communication, could also be a worry in the future. Rising inflation can significantly increase the inflow of capital due to an increase in domestic demand; this can lead to a current account deficit, as it is now more than half of the GDP. The indebtedness in the economy is at its peak, and this can crush the financial cycle and cause financial crisis.

Conclusions

The cointegration investigation confirms the presence of a long-run relationship between the variables. The results propose that there is a positive connection between the current account deficit and fiscal deficit. Our outcomes show that increase in money supply and the devaluation of the exchange rate increases current account balance. The effects of the current account deficit and the exchange rate have been taken as exogenous. A long-run stationary association between the fiscal deficit, current account deficit, interest rate, inflation, money supply, and the exchange rate has been found for China. Granger causality tests reveal bidirectional causality running from budget deficit to current account balance and macroeconomic variables to budget deficit and current account balance.

A genuine answer for the issue of budget deficit and current account deficit lies with a coherent package comprising of both fiscal and monetary approaches. It must concentrate on stable interest rate, inflation target and monetary position will supplement the budget-cut policies. The findings of the paper will be helpful for future empirical models, which attempt to further highlight the transmission mechanism.

Data availability

For undertaking the empirical analysis, we use the World Bank data for the following variables. The study covers the period from 1985 to 2016 and is based on secondary data which are available at: https://data.worldbank.org/country/china .

Change history

01 october 2019.

An amendment to this paper has been published and can be accessed via a link at the top of the paper.

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Banday, U.J., Aneja, R. Twin deficit hypothesis and reverse causality: a case study of China. Palgrave Commun 5 , 93 (2019). https://doi.org/10.1057/s41599-019-0304-z

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DOI : https://doi.org/10.1057/s41599-019-0304-z

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A dynamic analysis of the twin-deficit hypothesis: the case of a developing country.

• Ibrar Hussain

Asia-Pacific Financial Markets (2024)

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A Dynamic Analysis of the Twin-Deficit Hypothesis: the Case of a Developing Country

Ibrar hussain.

1 Department of Economics, University of Malakand, Chakdara, Pakistan

2 Department of Economics and Development Studies, University of Swat, Swat, Pakistan

Md Shabbir Alam

3 Department of Economics and Finance College of Business Administration, University of Bahrain, Zallaq, Bahrain

4 Department of Finance, College of Business Administration, Prince Sattam Bin Abdulaziz University, Al kharj, Saudi Arabia

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The main economic challenge is rising aggregate demand, which leaves the economy short on resources and leads to expanding fiscal and external account deficits. The current study uses autoregressive distributed lag (ARDL) model to evaluate the twin deficit hypothesis in the context of Pakistan in an effort to find an answer to this question. The study uses augmented ARDL, popularized by McNown et al. (Appl Econ 50:1509–1521, 2018) and Sam et al. (Econ Model 80:130–141, 2019), to address the degenerate problems that might arise while applying the ARDL approach. Two separate models were estimated, one with the current account balance as the dependent variable and the other with the balance of trade. In the long run, both models confirm the conventional interpretation of twin deficit hypothesis in Pakistan, with the causality running only from the fiscal deficit to the balance of trade. Other control variables in both models are crucial in understanding the current account balance and balance of trade. According to models, an increase in the exchange rate, as measured by the log of the nominal effective exchange rate, improves both current account and trade balance, verifying the elasticity approach in the long run. The openness of the economy is found to worsen current account balance, and the result is statistically significant. Contrarily, openness has been improved trade balance, but the result is statistically insignificant. To control a large and persistent external deficit, the government has to reduce its fiscal deficit, and such a strategy would be successful when monetary policy is accommodative.

Introduction

Pakistan’s economy underwent a significant transformation throughout the 1990s, with phases of expansion followed by deflation. To stabilize the economy during the periodic boom and bust cycles, which span three to four years each, fiscal and monetary measures are required. The economy is currently under increasing strain on both the fiscal and foreign fronts as a result of large budget and current account deficits (Hussain et al., 2021 , 2022 ). In order to pay off debt, which takes up a sizeable chunk of the federal budget, in light of declining foreign exchange reserves, the government allocates a sizeable portion of its budget to this purpose. Because of the slow pace of ineffective policy changes, the economy’s structural obstacles have mostly been overlooked for decades (Hussain et al., 2020 ). In contrast to the goal growth rate of 5.4%, the economy has grown at an average annual rate of 4.7% over the past five years, largely as a result of consumer-driven growth. The twin-deficit issue facing the nation is a result of low revenue growth, stagnant exports, and increasing imports. The economy grew at a pitiful 3.29% annual pace in fiscal year 2018–19, much below the optimistic prediction of 6.2%. In the year in question, total investments were 15.4% and total savings were 10.7% of gross domestic product (GDP), resulting in a 4.7% saving-investment difference. With average total revenues of 14.9% and average total expenditures of 20.5% of GDP for the last five years, the average fiscal deficit was 5.6%. The consumers price index (CPI) based inflation rate between July and April of this year averaged 4.8%, and the current account deficit for the 2017–18 fiscal year came to $19.897 billion, or 6.3% of GDP (Economic Survey of Pakistan, 2019 ). Pakistan is currently transitioning from indirect to direct taxation as a result of these reforms. This is why more research is needed on the topic at hand due to factors such as political unrest, erratic macroeconomic policies, natural disasters like flooding, and internal insurgency.

The COVID-19 pandemic outbreak in 2020 triggered an unprecedented global response to protect people and potential outcomes. To protect the public from an economic collapse, Pakistan’s government and central bank implemented accommodating budgetary and monetary policies. The required restrictions on movement and other aspects of social and economic freedom were very detrimental. However, a recession in 2020 was unavoidable because of the halt in economic activity and the ensuing negative growth (Economic Survey of Pakistan, 2022 ). Despite experiencing a 0.94% decline in fiscal year 2020, the economy is recovering from the pandemic and continued its V-shaped recovery by recording growth in real GDP of 5.97% in fiscal year 2022. However, this rapid expansion is unsustainable, and it has brought about both financial and macroeconomic instabilities (Economic Survey of Pakistan, 2022 ). Pakistan’s economic situation has been under pressure for the past three decades, and one of the contributing elements has been the power sector’s subsidies. Low national savings, rising government debt, unpredictable currency rates, persistent trade deficits, and inflation are all associated with a significant budget deficit at the pace of an unfavorable financing mix today. During the 1970s and 1980s, average budget deficits remained at 7.1% of GDP. In the 1990s, it dropped to 6.8%, and 4.8% in the 2000s. However, according to a report by the State Bank of Pakistan ( 2012 –13), the overall budget deficit in the fiscal year was only 4.7%, compared to 8.5% in the previous year. After a series of devastating energy crises, the country’s fiscal imbalance is seen as a major impediment to economic recovery and long-term prosperity (Amjad & Burki, 2013 ).

However, a substantial rise in commodity prices all over the world is increasing import payments, which is exerting pressure on imports. The growing imports were a result of a broad-based increase in global commodity costs, imports of the COVID-19 vaccine, and demand-side pressures. As a result, the trade imbalance increased by 49.6%. However, thanks to worker remittances, which nearly covered a huge trade deficit of $32.9 billion in fiscal year 2022, the current account showed a deficit of US$13.8 billion during the period under review, as opposed to a deficit of US$0.5 billion during the same period last year. Significant obstacles to long-term economic growth have been generated by the current account deficit’s expansion and the rise of inflationary pressures against the backdrop of the geopolitical environment, particularly the conflict between Russia and Ukraine (Economic Survey of Pakistan, 2022 ). Improvements in the balance of payments and the promotion of economic growth might be other goals that fiscal policy may be used to achieve. Although there is dispute over the goals of fiscal policy, there does not appear to be agreement on the instruments that are supposed to offer the best way to manage balance of payments. Regarding the importance of fiscal, monetary, and exchange rate policies as tools for macroeconomic management, opinions vary and typically evolve over time. This is largely because none of these tools is sufficient on its own to achieve the ultimate goal of the best possible management of the economy. However, there is only general agreement on avoiding monetary and fiscal excesses (Bird, 2001 ). Based on the Phillips curve hypothesis, fiscal policy for controlling aggregate demand evolved into stop–go strategies. Fiscal authority employs the strategy of stop in the form of fiscal contraction when the external deficit and inflation are considered to be the key challenges and would prefer the strategy of go in the form of fiscal expansion when the economy is suffering from high unemployment and poor growth (Bird, 2001 ).

Recently, macroeconomic imbalances caused by the fiscal deficit in Pakistan have attracted the attention of researchers and among these are the current account balance and inflation. The relationship between fiscal deficit and current account balance is known as the ‘twin-deficit hypothesis’ and has been through much empirical scrutiny across the world in general and Pakistan in particular. However, controversies exist among researchers on both theoretical and empirical grounds. Interestingly, it is the current account balance that indicates both the size and direction of a country’s international borrowings. A survey of empirical studies shows that there exists a lack of consensus over the twin-deficit hypothesis in the case of Pakistan. Many authors support the conventional view, while others evidence reverse causality or bidirectional relationship. However, few authors have explored the dynamic relationship between the two deficits over the long run, in the case of Pakistan. The limitations of the previous studies on the pace of contradictory findings appeal for more extensive research over the twin-deficit hypothesis in order to unveil the reasons as to why and when the causality runs from the fiscal deficit to the current account balance and vice versa. Pakistan’s trade balance is unstable, and its fiscal deficit is constantly expanding, both of which hinder the country’s capacity to experience inclusive economic growth. The budget and trade deficits should, therefore, be continuously monitored in order to achieve economic stability and sustained growth.

This study asserts that it is the first to look at how the fiscal balance and current account balance relate to one another in the context of a developing country like Pakistan. The current study is, therefore, anticipated to give intriguing insights into the dynamics between the fiscal balance and current account balance since the nation has suffered from the issue of a chronic deficit in the current account balance due to an unfavorable fiscal balance. The approaches used in the previous empirical investigations have several shortcomings, and it’s possible that they overlooked a more disintegrated analysis. Further investigation into the twin-deficit hypothesis is necessary in order to understand why and when the causation flows from the fiscal deficit to the current account balance and vice versa. A more flexible model has been developed and estimated using the autoregressive distributed lag (ARDL) techniques of Pesaran et al. ( 2001 ). To solve the issue of degenerate cases, the Sam et al. ( 2019 ) approaches would also be incorporated into the ARDL techniques. A special focus has been placed on the ARDL approach’s underlying assumptions. In the case of a single co-integrating vector, the assumption of weak exogeneity is validated using the Likelihood Ratio (L.R.) test. The empirical strategy has been calibrated using the empirical models of Duasa ( 2007 ), Phillips et al. ( 2013 ), Mohanty ( 2019 ), and Afonso and Jalles ( 2019 ). There were two different models developed, one with the current account balance as the dependent variable and the other with the balance of trade. These models ultimately support the prevalent perception of TDH in Pakistan. The test for causation indicates that there is no causality extending from the fiscal deficit to the current account balance; however, when the trade component was separated, a causal relationship extending from the fiscal deficit to the trade balance was observed. Several control variables are crucial in both models for explaining current account balance and trade balance. Both GDP growth and the expansion of the money supply cause a deterioration in both current account and trade balances, supporting Keynesian absorption and monetary approaches to the balance of payments in the context of Pakistan. Asides these, currency depreciation improves both current account and trade balances, thereby supporting the long-run elasticity theory of the balance of trade. Interestingly, we found that current account balance gets worse with the level of trade openness in the country, On the other hand, openness has enhanced the state of the trade balance, although the impact is statistically insignificant.

Review of Literature

There exist competing views regarding the strength of association between the two deficits based on the kind of transmission mechanism. Theoretical studies differentiate between intra-temporal (Mundell, 1960 ) and inter-temporal (Baxter, 1995 ) transmission mechanisms. The Mundell–Fleming model identifies the impact of fiscal expansion on the country’s external balance via higher capital inflows resulting from rising domestic demand and interest rates. Higher capital inflows cause real exchange rate appreciation, which weakens the current account balance. With the model’s level of financial openness and the sensitivity of the exchange rate to capital inflows, such a transmission mechanism is projected to be more successful. The Swan-Salter model, on the other hand, emphasizes the importance of exchange rate regulation in understanding trade balances. According to the model, expansionary fiscal policy would cause the real exchange rate to rise, worsening the trade balance. The model describes the exchange rate as the relative price of tradable to non-tradable items and illustrates how an artificial appreciation of the currency rate would shift manufacturing away from tradable to non-tradable goods in a situation where non-tradable products dominate public purchasing. Aside from that, such appreciation would shift spending away from tradable goods and services, worsening the trade deficit.

On the other hand, the inter-temporal approach (Baxter, 1995 ) focuses on a relatively different transmission mechanism. According to this approach, national savings will remain unaffected when public dissaving results in an equal increase in private savings. The forward-looking private agents will be motivated by the policy of deficit financing to save more of their current income. Aside from that, they will raise labor supply to mitigate the cost of future tax increases. As a result, the current account balance will improve, and the detrimental impact of deficit financing will be mitigated. The Keynesian absorption approach indicates a different channel. According to this approach, a higher budget deficit will increase disposable income, which would lead to higher domestic absorption and, consequently, import demand will increase, thereby worsening CAB (Mohanty, 2019 ). However, this traditional view regarding the twin-deficit hypothesis is challenged by Ricardian Equivalence Hypothesis. According to this approach, fiscal policy will not affect CAB in cases where the private sector is fully Ricardian. The policy of budget deficit by the government through tax cuts will be offset by the private sector’s decrease in current consumption. Such an offsetting effect will emerge from private sector expectations about the imposition of higher taxes in the future to finance the deficit. Consequently, this induces the private sector to save more of their current income, thereby making fiscal policy ineffective. Despite extensive research efforts, the verdict on Ricardian Equivalence Hypothesis remains largely undecided (Becker, 1997 ). Since, theoretically, the Ricardian Equivalence Hypothesis (REH) is based on certain restrictive assumptions that are rarely met in practice, it usually fails in situations like distortionary taxation, credit rationing, less than perfect foresight, and non-altruistic bequest motives. However, a host of empirical findings support REH, so it is not easy to reject it, although it is rarely found in its extreme form (Wyplosz, 2002 ).

The standard version of the twin-deficit theory is that the fiscal deficit and CAB have a linear and direct link, with causality passing from the former to the latter. Perhaps this phenomenon has not received much empirical scrutiny in the literature, with mixed results based on different case studies (Litsios & Pilbeam, 2017 ). According to Suresh and Tiwari ( 2014 ), for a country to enjoy a favorable position in external balance, it needs to ensure fiscal sustainability, which seems to be a necessary condition in this regard. Although the twin deficit hypothesis postulates a linear relationship (Ravinthirakumaran et al., 2015 ), there could, however, be a non-linear relationship between the two deficits. Such non-linearity may stem from structural features such as regime shifts in exchange rates, country size, trade openness, and international capital mobility that have not yet been considered by previous studies (Nikiforos et al., 2015 ). In recent empirical attempts, many authors have investigated the non-linear impacts of fiscal policy. These studies attribute non-linearity partly to inconsistent predictions of theoretical models in the case of certain macroeconomic aggregates. Beetsma ( 2008 ) provides an outline of such conceptual predictions. Another source of worry is the continued lack of agreement on the impact of various fiscal policy measures. This might be explained in part by the fact that fiscal policy is transmitted through several channels. Similar arguments apply not just to fiscal adjustment design but also to each adjustment category. In this context, Hemming et al. ( 2002 ) argue that fiscal policy provides a Keynesian outcome in a closed economy, but a non-Keynesian effect arises when the country becomes open to international trade. Corsetti and Müller ( 2006 ) in their analysis argue that fiscal policy shocks will worsen trade when the economy becomes more open, and the trade deficit will worsen when fiscal expansion becomes persistent. In a nutshell, the literature reviewed so far indicates contradictory views and disagreement exists over the direction and strength of association between two deficits.

A stream of empirical research has been published throughout the world to study the many facets of the twin-deficit relationship. Some studies (for instance, Baharumshah et al., 2019 ; El-Khishin & El-Saeed, 2021 ; Gaysset et al., 2019 ; Mohanty, 2019 ; Ravinthirakumaran et al., 2015 ) confirm the validity of the conventional view 1 of the hypothesis, while others (even the studies in the twenty-first century like Chunming & Ruo, 2015 ; Kaufmann et al., 2002 ; Mohammadi & Moshrefi, 2012 ) reject the hypothesis and support REH. Another strand of empirical literature (Nikiforos et al., 2015 ; Siddiqui, 2010 ; Sobrino, 2013 ) finds the phenomenon of reverse causality flowing from CAB to fiscal balance as against the established notion of the hypothesis. On the other hand, given the context of the US economy, several researchers (such as Kim & Roubini, 2008 ) note “twin divergence.” They explain the term “twin divergence” by possible endogenous movements of fiscal balance and CAB and associate it with the sensitivity of investment during recession. According to Okoli et al. ( 2021 ), the BRICS (Brazil, Russia, India, China, and South Africa) market exhibits twin divergence up to a certain point beyond which the hypothesis is valid. Using quarterly data for the years 1980–2018, Ahmad and Aworinde ( 2020 ) examine the causal relationships between budget deficits and current account deficits in a sample of 12 African nations. Five countries provide evidence in favor of the conventional view of the hypothesis, four countries confirm the non-conventional view, and a bi-directional causality is found in the case of two nations. In the instance of Middle East and North Africa (MENA) countries, Bousnina and Gabsi ( 2022 ) looked into the effect of public debt on the twin-deficit relationship. First, the model establishes a negative link between the budget balance and the current account if the public debt-to-GDP ratio is smaller than 36.71%. Only when the debt-to-GDP ratio is between 36.71% and 72.99% are twin deficits proven. If the public debt-to-GDP ratio is higher than 72.99%, a twin divergence is also proven. It is the sharp fall in investment as compared to national savings during the recession that prevents a positive relationship between the two deficits. On the contrary, a technical advancement might spur private sector investment, which might deteriorate the external position on the one hand while strengthening the government’s financial condition by boosting tax revenue on the other.

Bagnai ( 2006 ) discovers the influence of structural breaks on the direction of the link between budget balance and CAB in the instance of twenty-one Organization for Economic Co-operation and Development (OECD) nations. According to the study, the high level of financial integration among most OECD nations explains why the link between CAB and its influencing factors becomes apparent when unidentified structural disruptions over the long run are permitted. There hasn’t been much research that examines the twin deficit hypothesis in developing nations. For instance, research by Suresh and Tiwari ( 2014 ) in the context of the Indian economy utilizing vector auto regression (VAR) and structural VAR approaches for the years 1976 through 2012 validates the theory. Their research backs up the traditional interpretation of the concept. By utilizing the Johansen Co Integration and ARDL approaches, respectively, Parikh and Rao ( 2006 ) and Mohanty ( 2019 ) obtained similar findings in the Indian setting. The twin deficit relationship is supported by the research of Bianchi et al. ( 2015 ) in the context of the G-7 nations and Beetsma et al. ( 2008 ) in the context of fourteen European countries. The study by Ravinthirakumaran et al. ( 2015 ) shows conflicting results in the instances of five of the South Asian Association for Regional Cooperation (SAARC) member nations. They used the cointegration method and the Granger causality check on time series data from 1980 to 2012. In the settings of India, Nepal, and Bangladesh, the analysis discovers reverse causality, whereas Sri Lanka and Pakistan provide evidence in support of the conventional view. The study’s conclusions on the situations of Pakistan and Sri Lanka are consistent with well-accepted views in the literature (Ratha, 2012 ). The Toda-Yamamoto test, as used by Kim and Kim ( 2006 ), shows reverse causality in Korea. Other studies like Marinheiro ( 2008 ) in the context of Egypt, Sobrino ( 2013 ) in the case of Peru, and Nikiforos et al. ( 2015 ) in the context of Greece also confirmed reverse causality.

In contrast to the support for twin deficits, Mohammadi and Moshrefi ( 2012 ) in a panel of Malaysia, South Korea, Thailand, and Singapore, and Chunming and Ruo ( 2015 ) in a BRICS panel 2 show no relationship between the two deficits. Remarkably, these studies confirm the Ricardian effect. Baharumshah et al. ( 2019 ) in a panel of fourteen Asian countries, including Pakistan, employ the bootstrap Granger causality test. The authors highlight the influence of structural breaks on the link between the fiscal deficit and CAB, which resulted from the Asian financial crisis of 1997–1998. Before the crisis, the authors find direct causation running from the fiscal balance to the CAB, and after the crisis, they find reverse causality flowing from the CAB to the fiscal balance. In addition, the analysis illustrates how investment and capital inflows had a substantial impact on CAB before the crisis and how fiscal balance affected both investment and capital inflows in the post-crisis period. The impact of fiscal spillovers on the direction of the relationship between the two deficits was recently revealed by Gaysset et al. ( 2019 ) in a panel of southern Europe and the Middle East and North Africa (MENA) area. The study validates the conventional view of the hypothesis in the case of Europe while observing reverse causality in the case of MENA countries. The study further evidences significant fiscal spillovers from fiscal consolidation in the surplus regions (Germany and European Monetary Union) to the deficit regions of southern European and MENA countries. In the context of South Asian region, Rajakaruna et al. ( 2021 ) investigate the influence of a country’s public debt on its twin deficit relationship. Their study demonstrates a statistically significant non-linear relationship between the fiscal deficit and the current account balance when conditional on public debt levels.

Chinn and Ito ( 2007 ) note that developed financial markets with an effective legal system often lead to a smaller deterioration in external balance and find improvements in CAB due to improvements in fiscal balance. Phillips et al. ( 2013 ) in a panel of 49 countries analyze the factors which determine external balance. The analysis quantifies the impact of the real effective exchange rate, predicted real growth, and terms of trade in explaining the current account balance. In recent research, Afonso and Jalles ( 2019 ) seek to dissect the current account balance into cyclical and non-cyclical components. In a study of 19 Euro area countries, these authors uncover the negative effects of terms of trade on both components, while showing that employee wages, level of employment, and global financial crises have a negative impact on only the cyclical component. The analysis also demonstrates that the volatility of the real effective exchange rate exacerbates the cyclical component’s impact on financial crises. In a similar vein, other studies (Holmes, 2011 ; Nikiforos et al., 2015 ; Rafiq, 2010 ; Xie & Chen, 2014 ) attribute the divergence in findings to structural breaks arising from possible regime shifts in exchange rates, country size, trade openness, and international capital mobility that have not been considered in earlier analyses. However, contradictory signals exist despite extensive investigation carried on in empirical studies on twin deficit relationships, and the conclusion remains inconclusive over the use of diverse methodologies and time periods (Suresh & Tiwari, 2014 ).

For Pakistan, the research of Aqeel and Nishat ( 2000 ); Iram et al. ( 2011 ); Manzoor et al. ( 2019 ) and Rehman, Shamsher, and Shakir (2020) establishes unidirectional causality that goes from fiscal deficit to CAB, while Siddiqui’s ( 2010 ) findings suggest unidirectional causality that flows from CAB to fiscal balance. The findings of Siddiqui ( 2010 ) are confirmed by Rauf and Khan ( 2011 ), Saeed and Khan ( 2012 ), and Rehman and Saeed ( 2017 ) in their studies. Contrarily, Mukhtar et al. ( 2007 ) find a bidirectional causal relationship. With respect to the econometric methodologies used by these studies, Aqeel and Nishat ( 2000 ); Siddiqui ( 2010 ); Saeed and Khan ( 2012 ); and Tufail et al. ( 2014 ); Rehman et al. ( 2020 ) employ Johansen co integration and Granger causality; Mukhtar et al. ( 2007 ) use Angle Granger co integration; Rauf and Khan ( 2011 ) apply Granger causality and OLS; Iram et al. ( 2011 ) employ ARDL and Toda-Yamamoto causality test, while Rehman and Saeed ( 2017 ) adopt ARDL, Angle Granger, and Johansen co integration techniques. Similarly, Manzoor et al. ( 2019 ) using vector auto regression (VAR) and Granger causality test verify the hypothesis in the context of Pakistan. There are some flaws in these studies in terms of the methodologies applied, and perhaps they missed a more disintegrated analysis. Furthermore, the literature’s contradicting findings on the twin-deficit hypothesis call for more extensive research on the twin-deficit hypothesis in order to uncover why and when the causality runs from fiscal deficit to external balance and vice versa.

Materials and Methods

Analytical framework.

The empirical strategy is based on the Phillips et al. ( 2013 ) model, which is used by Afonso and Jalles ( 2019 ) and Mohanty ( 2019 ) to establish the link between fiscal policy and external balance, and specifically produces the equation as:

Here, the dependent variable (CAB) represents the current account balance; FP is the proxy for the fiscal policy; μ t represents error term; and X is a set of the other relevant variables, including the nominal effective exchange rate, proxy of monetary policy, GDP growth, and perhaps openness of the economy.

Conventional Versus Augmented ARDL: the Degenerate Problems

This section explains how to differentiate between the traditional ARDL of Pesaran et al. ( 2001 ) and the augmented ARDL popularized by McNown et al. ( 2018 ) and Sam et al. ( 2019 ) in order to discover degenerate situations.

The Conventional ARDL Technique

Following Afonso and Jalles ( 2019 ) and Mohanty ( 2019 ) models, the current study specifies the empirical model under the conventional ARDL is as follows:

The error correction model would take the form:

With λ 1 < 1 , it is assumed that there is no correlation among the disturbances ( υ t ). By design, the independent variable’s difference is also uncorrelated with the disturbance terms. It’s interesting to note that Eq.  3 is simple to estimate using least squares because the lag distribution is unrestricted.

The short-run estimations will be calculated using the following equation:

Several investigations have indicated that Pesaran et al.’s conventional ARDL offers benefits over rival cointegration approaches. The ARDL methodology outperforms other competing techniques such as Engle and Granger ( 1987 ), Phillips and Ouliaris ( 1990 ), and even Johansen ( 1992 ) due to its adaptability. Furthermore, unlike the Engle-Granger and Johansen procedures, the ARDL technique offers reliable long-run parameter estimations in small sample studies (Narayan, 2005 ). When a single underlying variable becomes stationary at a second difference and the weak exogeneity assumption is broken, the ARDL approach fails. Similarly, the technique will produce incorrect results in situations involving degenerate cases (Goh et al., 2017 ; McNown et al., 2018 ).

The Augmented ARDL Technique

Some influential researchers, such as McNown et al. ( 2018 ) and Sam et al. ( 2019 ), suggest a bootstrap ARDL approach to improve on the standard strategy. To detect degenerate situations, this methodology leverages re-sampling from ARDL methods. Degenerate events in the ARDL approach do not represent co-integration (Pesaran et al., 2001 ), and incorrect conclusions might be drawn if they are not addressed appropriately (Sam et al., 2019 ). To offer some insight into this novel technique, we propose the following:

Here, CAB and X are explained and explanatory variables with β 1i and β 2i are their coefficients respectively. The error terms are represented by the symbol ξ t . To proceed further, we present the ECM version as:

where η i and μ i are functions of the original parameters in the Eq.  5 with ϕ = 1 - ∑ t = 1 p α i and γ = ∑ j = 0 p β j . Pesaran et al. ( 2001 ) are of the view that co-integration implies that the F-test is rejected under the null hypothesis ( H 0 : ϕ = γ = 0 ) , but also proposes the rejection of the null hypothesis on the lagged dependent ( H 0 : ϕ = 0 ) via the bound t-test. However, recent studies by Goh et al. ( 2017 ), as well as McNown et al. ( 2018 ) and Sam et al. ( 2019 ), object and argue that such tests under the Pesaran framework would not be sufficient to demonstrate the true long-run relationship. These authors, therefore, propose an additional F-test on the lag of explanatory variables ( H 0 : γ = 0 ) . According to these authors, the standard co-integration test would be strengthened by such an extra test. The test will help discover degenerate cases in addition to separating co-integration from non-co-integration. The cited research highlights that Pesaran et al. ( 2001 ) have only addressed one of the two degenerate problems and have disregarded the possibility of the second degenerate problem. Degenerate case-1 and case-2 have been differentiated in this research. Sam et al. ( 2019 ) investigation has demonstrated that Pesaran et al. ( 2001 ) only paid attention to the degenerate case-2 and overlooked the likelihood of case-1.

Case-1 would be more likely to occur if the bound t-test on the lagged dependent fails to reject the null hypothesis, but both the bound F-test (Pesaran et al.) and Wald F-test on lagged independent variables reject their respective null hypotheses. Alternately, this implies that co-integration does not occur because the dependent variable is not accounted for in the co-integrating equation and is hence unresponsive to changes in the explanatory variable (Sam et al., 2019 ). The degenerate case-2 emerges when the t-test on the lagged dependent variable rejects the null hypothesis but the Wald F-test on the lagged independent variables fails to do so, provided that the overall F-test is significant. Pesaran et al. ( 2001 ) created a table for the critical values for case-2, but they did not supply such a table for case-1. However, the possibility of a degenerate case-1 is eliminated, provided that the dependent variable is likely to be I(1) (McNown et al., 2018 ). The augmented ARDL approach would seek to tackle this problem by running an additional test on the lagged independent variables (Sam et al., 2019 ). The augmented ARDL technique would attempt to address this issue by performing an extra test on the lag independent variables (Sam et al., 2019 ). Goh et al. ( 2017 ), McNown et al. ( 2018 ), and Sam et al. ( 2019 ) proposed a test on the lagged level of an independent variable to determine the degenerate case-1. Their study focuses on the bootstrap approach while modifying the assumption that the dependent variable is stationary at first difference. Because the bootstrap approach is difficult to utilize, Sam et al. ( 2019 ) give critical value tables for both asymptotic and small sample testing.

Results and Discussion

The current study bases the empirical model on the models developed by Duasa ( 2007 ) and Phillips et al. ( 2013 ), which have recently been adopted by Afonso and Jalles ( 2019 ) and Mohanty ( 2019 ). As a corollary, CAB as a percentage of GDP was regressed on primary fiscal balance (PFB) alongside control variables such as money supply, GDP growth, openness of the economy, and the nominal effective exchange rate index. The purpose of including the real effective exchange rate, money supply, and GDP growth is to test the traditional elasticity approach to the balance of payments, monetary approach, and absorption approach, as well as to avoid bias caused by omitted variables. Definitions, measurements of variables, and sources of data used in the model are presented in Table ​ Table1 1 .

Definition of variables, measurements, and sources

Relative to the US dollar, an increase in the exchange rate indicates depreciation, while a decrease in the rate represents an appreciation of the Pakistani currency

To ascertain an empirical model for testing the TDH in the case of Pakistan, the Mohanty ( 2019 ) model is specifically followed. Two models were estimated, with the first regressing CAB on PFB with other control variables. The Keynesian absorption approach and the Mundell–Fleming models provide the theoretical justification for the empirical model of this study. For a robustness check, another model is estimated with a merchandize trade balance instead of a current account balance with the set of explanatory variables of the first model. Following Bahmani-Oskooee and Brooks ( 1999 ) and Onafowora ( 2003 ), the current study takes the ratio of merchandize imports to merchandize exports 3 as a proxy for the balance of trade. This ratio is preferable because it has two advantages: first, it is not affected by the measurement unit; and second, it can measure changes in the trade balance in nominal or real terms (Bahmani-Oskooee, 1991 ). Similarly, the ratio allows researchers to model the relationship in log form to measure the rate of change via first-differenced variables (Bahmani-Oskooee & Brooks, 1999 ). This ratio has been used by Waliullah et al. ( 2010 ) in the case of Pakistan.

The linear-autoregressive distributed lag (LARDL) approach was used to estimate both models. The variables were tested for stationarity using the Dickey Fuller-GLS (ERS) or DF-GLS and Phillips–Perron (PP) tests before proceeding (see Table ​ Table2). 2 ). When “drift” is taken into account, the current account balance (CAB), GDP growth (denoted by GDPG), and openness of the economy (denoted by LOPEN) all remain stationary at their levels, whereas only GDPG remains stationary at its level when “drift & trend” is taken into account. CAB, PFB, and GDPG do not have unit roots at their levels when there is “drift”, and only GDPG remains stationary when there is “drift & trend”. In summary, both tests demonstrate that variables are a mix of I(0) and I(1), with none of the variables being I(2).

Checking stationarity of the variables

T stands for trend, and C stands for constant. Whereas LBM, LOPEN, LNEER and LBOT indicate log of these variables

It should be noted that the symbols *, **, and *** denote significance at 1%, 5%, and 10% probability levels, respectively

At a 5% level of significance for both models, the maximum Eigen value obtained using the Johansen cointegration approach verifies the existence of one co-integrating vector. The L.R. test indicates that the primary fiscal deficit is weakly exogenous at a 10% probability level, according to the weak exogeneity test reported in Table ​ Table3. 3 . GDP growth (GDPG) is weakly exogenous in both models at a 5% level of significance, whereas broad money (LBM) and the index of nominal effective exchange rate (LNEER) are weakly exogenous at a 10% level. However, even at a 1% probability level, the openness of the economy (LOPEN) is not weakly exogenous in either model.

Likelihood ratio: weak exogeneity test

Both models were estimated using LARDL, and a co-integration relationship is evident in the bound F-values provided in Table ​ Table4. 4 . The non-linear autoregressive distributed lag (NARDL) models were tested in both CAB and BOT cases, but the results were not reliable as they suffered from degenerate problems. Cointegration is justified by the determined F-value, which for the CAB-model predicted by LARDL is 6.724, which is over the upper critical bound value at a 1% probability level. Similarly, the bound F-value (14.5) for the BOT-model exceeds the upper critical values with a 1% probability, confirming the long-run equilibrium relationship. Moreover, both models pass degenerate-dependent and degenerate-independent tests, and there is no evidence of these problems in either model (see Table ​ Table5 5 ).

LARDL bound F-tests for CAB and BOT models

Note that in the CAB-model, the data generating process (DGP) is supposed to be case-V (constant and trend), and the lag selection criterion is Akaike’s information criterion ( AIC ), but in the BOT-model, the DGP is presumed to be case-III (constant)

Investigating the degenerate cases in CAB and BOT models

It is important to note that for Table ​ Table5, 5 , the lower and upper critical limit values for Wald-F under case-V are obtained from Sam et al. ( 2019 ) for the CAB-model, while those for t-stat are taken from Pesaran et al. ( 2001 ) for a small sample of 40. For DGP case-III, there existed a degenerate independent case with Wald-F = 2.476. The lower and upper critical limit values for Wald-F under the assumption of case-III were supplied for the BOT-model by Sam et al. ( 2019 ) for a sample of size 40, while those for the t-statistic were provided by Pesaran et al. ( 2001 ). There was a degenerate dependent case with t-stat = − 3.849 that was found between I(0) and I(1) at a 10% level of probability under case-V.

Reverting to the test of the twin-deficit relationship, it is found that a significant relationship between CAB and fiscal deficit holds in the long run. These long-run estimates have been reported in Table ​ Table6. 6 . The corresponding coefficient of PFB (0.450) in the CAB-model confirms the TDH, which is not only positive but also significant at the 10% level. This means that a worsening of primary fiscal balance (which indicates expansionary fiscal policy) will worsen external balance and vice versa. For the BOT-model, since the ratio of merchandize imports to merchandize exports has been used to proxy trade balance, the expected negative sign 4 of the fiscal deficit would be in line with the twin-deficit phenomenon. The coefficient associated with PFB in the BOT-model (− 0.281) is highly statistically significant and therefore validates the established notion of TDH in the long-run.

Long-run coefficients estimates

Furthermore, in the case of the CAB-model, the Granger causality test with one co-integrating vector under the assumption of weak exogeneity does not reveal any short-run causation between the two deficits. Tables ​ Tables7 7 and ​ and8 8 present the findings of the Granger causality test for the CAB-model and the BOT-model, respectively. This suggests that, when the twin-deficit is viewed conventionally, the Granger causality test indicates that there is no causation in either direction. However, the test revealed unidirectional causation flowing from the fiscal balance to the trade balance when the trade component was separated from the current account balance and primary fiscal balance was adjusted for business cycles and the model was re-estimated.

VEC granger causality Wald tests (Summary) of CAB Model

CAPB indicates cyclically adjusted primary fiscal balance

P -values are in parentheses

*Denotes significance at 1% level of probability

VEC granger causality Wald tests (summary) of BOT model

GBM indicates growth in broad money

Parentheses surround the P -values

Please take notice that the symbols * and ** signify significance at 1% and 5% levels of probability, respectively

The conventional view of TDH in the current study supports the findings of Aqeel and Nishat ( 2000 ), Hakro ( 2009 ), and partially with the findings of Siddiqui ( 2010 ) in the case of Pakistan. Besides this, the current study confirms the findings of Salvatore ( 2006 ), Ratha ( 2012 ), Endegnanew et al. ( 2013 ), Suresh and Tiwari ( 2014 ), Ravinthirakumaran et al. ( 2015 ), and very recent studies of Afonso et al. ( 2018 ), Bhat and Sharma ( 2018 ), Akalpler and Panshak ( 2019 ), Baharumshah et al. ( 2019 ), Banday and Aneja ( 2019 ), Gaysset et al. ( 2019 ), and Mohanty ( 2019 ), Ahmad and Aworinde ( 2020 ), Rehman et al. ( 2020 ), Rajakaruna et al. ( 2021 ), and Bousnina and Gabsi ( 2022 ). However, the study contradicts the findings of reverse causality running from CAB to fiscal balance by the studies of Rauf and Khan ( 2011 ), Saeed and Khan ( 2012 ), Rehman and Saeed ( 2017 ) in the case of Pakistan and the findings of other studies (like Kim & Kim, 2006 ; Marinheiro, 2008 ; Sobrino, 2013 ; and Nikiforos et al., 2015 ) other than Pakistan. Similarly, the study also contradicts the findings of Mukhtar et al. ( 2007 ), Iram et al. ( 2011 ), and Tufail et al. ( 2014 ), who found bidirectional causality in the case of Pakistan. The conclusion derived by the studies which found reverse causality cannot be relied upon as their estimation techniques are either irrelevant or less efficient in small sample data. The Granger causality test only reveals short-run causality, while the Johansen co-integration technique is unreliable in investigations with small sample sizes. Those studies which found bidirectional causality either used irrelevant estimation techniques or relied on poor proxies, and even failed to isolate the impact of monetary policy from the overall fiscal deficit due to interest burden. Hence, the results of these studies are not reliable. The conclusion reached in a paper by Rehman and Saeed ( 2017 ) on reverse causality is perplexing, as the authors conclude by recommending that the trade deficit be decreased by reducing the fiscal deficit. This recommendation is not in line with what the authors have shown. Moreover, the study applies Engle-Granger and Johansen co-integration techniques to small sample data sets, which are not reliable. The study even did not take care of degenerate cases and weak exogeneity assumptions in their application of the ARDL technique. Besides this, the study used the overall fiscal deficit instead of the primary fiscal deficit. In a nutshell, the weakness in all of these studies is that they either relied on the straightforward Granger causality test or made a significant exogenous fiscal deficit assumption. Since there can be a feedback effect from CAB to the fiscal deficit, as fiscal authorities often consider deteriorating external balance in their strategy of fiscal policy, the assumption of strong exogeneity would lead to either reverse causality or sometimes indicate bi-directional causality.

According to a growing body of data, the strength of the association between the two deficits in the short term differs from that in the long run (Bagnai, 2006 ). According to De Cos and Morel-Benito ( 2013 ), applying strict exogeneity in the instance of a fiscal deficit would result in reverse causation; instead, they chose to assume weak exogeneity to enable feedback from the dependent variable (CAB) to the fiscal deficit (PFB). Similarly, the Mundell–Fleming model predicts that an expansionary fiscal policy supported predominantly by borrowing will boost domestic interest rates. Such an increase would attract foreign capital inflows, leading the domestic currency to rise. The current account deficit gets worse as a result of the currency’s rising value, which discourages exports and increases imports. Furthermore, currency crises caused by capital account liberalization in developing countries like Pakistan, where the financial systems are weak, make the current account vulnerable to foreign capital flows (Baharumshah et al., 2019 ). According to Mohanty ( 2019 ), fiscal deficits would indirectly cause trade deficits through pathways including interest rates and currency rates (Abell, 1990 ). Reverse or bidirectional causation may also explain the net factor income and net unilateral transfer CAB components.

In many developing nations, including Pakistan, the path of causality between the two deficits may be influenced by the net international investment position (NIIP). A country’s NIIP is determined by changes in the market value of its assets and liabilities as a result of currency appreciation or depreciation, as well as changes in stock prices. Despite the fact that Pakistan has had huge budget deficits in the past, the problem has developed in recent years due to an unfavorable financing mix. Previously, cheap external sources filled 50% of such deficits, but this has dropped to just 7.3% in recent years. Similarly, non-bank borrowing is declining, with non-bank financial institutions’ investments in treasury bills accounting for a large portion of this source. Aside from that, the amount of savings available through national savings schemes has been reduced. Due to these unfavorable changes in the financing mix, the domestic banking sector has become the primary source of funding for the budget deficit. As a result, the cost of government borrowing has risen, crowding out private investment. The State Bank of Pakistan has become a key partner in funding the deficit within the banking system, which is not a positive indicator for the country’s macroeconomic stability (ESP, 2013 –14). As a result, fiscal deficits appear to be a probable source of CAB, and fiscal authorities should take such external deficits into account when planning their fiscal strategy in the future. Another underlying element that may disrupt the conventional relationship between the two deficits is the taxation structure. Because of the low tax-to-GDP ratio, there is a fiscal deficit, which leads to a trade deficit.

When we turn to the other explanatory factors, it is clear that they are crucial in explaining both CAB and BOT. The effects of GDP growth (GDPG) are consistent with what the Keynesian absorption theory predicts, and they dramatically worsen CAB and BOT with time. This may suggest that increasing GDP promotes imports more so than exports, which leads to a worsening of the current account balance. This conclusion is consistent with those made by Duasa ( 2007 ), Shah and Majeed ( 2014 ), Tufail et al. ( 2014 ), and Mohanty ( 2019 ) in the contexts of Pakistan, India, and Malaysia, respectively. Similarly, the conclusion verifies Guechari’s ( 2012 ) findings in the context of Algeria. However, in the case of Pakistan, the finding contradicts those of Waliullah et al. ( 2010 ) and Hassan et al. ( 2017 ), who found a positive influence of GDP growth and concluded that the Keynesian absorption strategy is not warranted.

The influence of money supply on CAB implies that the study justifies the monetary approach to balance of payment forecast. In the long run, at the rate of steady demand for money, an expansionary monetary policy would lower interest rates, discouraging capital inflows and weakening CAB. This finding contradicts the findings of Waliullah et al. ( 2010 ) and Hassan et al. ( 2017 ). In the long term, the exchange rate has a positive and statistically significant impact. A rise in the exchange rate (a depreciation of the national currency) would benefit both the CAB and the BOT. This demonstrates that the Marshall–Lerner precondition is valid. The study also confirms the findings of Waliullah et al. ( 2010 ) and Hassan et al. ( 2017 ) in Pakistan, as well as Mohanty ( 2019 ) in India. In Pakistan, economic openness has been proven to aggravate CAB in the long run. Because openness implies deregulation of both goods and services trade, it favors imports over exports of commodities and services, exacerbating CAB. The openness coefficient in the CAB-model is considerable. On the contrary, economic openness was discovered to enhance trade balances, although this effect was statistically insignificant. This finding backs up Ibhagui’s ( 2018 ) conclusion based on a panel survey of Sub-Saharan Africans. The author argues that as an economy becomes more open, the current account balance falls, which in turn slows down the process of adjusting the current account for foreign debt.

In Table ​ Table9, 9 , both models’ rates of adjustment toward equilibrium as determined by the error correction model (ECM) term are listed. For the CAB-model, 79.4% of disequilibrium is corrected each year when a shock occurs, while 78.8% of adjustment takes place under the BOT-model. At a 1% probability, both statistics are significant. Table ​ Table10 10 displays the short-run estimates of the CAB and BOT models. Under the CAB-model, the coefficient associated with D(PFB) in the first period is 0.69 and is statistically significant. This suggests that a one-unit decrease in the budget deficit results in an average 0.69-unit improvement in the current CAB and vice versa.

ECM bound t -test of CAB and BOT models

Short-run estimates (ECM) of CAB and BOT Models

The asterisk (*) denotes that the P -value is not relevant. The critical values have been reported in Table ​ Table9 9

This shows that TDH holds in the short-run. This result under the BOT-model indicates that in the first period, improvement in fiscal balance improves BOT, while in the second and third periods, such improvements become insignificant. In the fourth period, the fiscal deficit even significantly deteriorates the current account balance. Diagnostic checking reported in Table ​ Table11 11 reveals that both models do not endure the conventional problems of non-normality, auto correlation, and heteroskedasticity.

Diagnostic Checking CAB and BOT Models

The CUSUM and square of CUSUM tests demonstrate the dynamic stability of model parameters. Figures  1 and ​ and2 2 show the results of stability testing using CUSUM and the square of CUSUM for the CAB-model and BOT-model, respectively.

CUSUM and square of CUSUM tests of CAB model

BOT model CUSUM and square of CUSUM tests

Conclusion and Policy Implications

The aim of this study was to use the ARDL technique to test the twin-deficit hypothesis (TDH) in Pakistan. The assumptions of the ARDL approach have been given special attention. The Likelihood Ratio (L.R.) test is used to verify the assumption of weak exogeneity in the presence of a single co-integrating vector. The study found no evidence of such issues in both models after testing degenerate cases. The empirical models of Duasa ( 2007 ), Phillips et al. ( 2013 ), Mohanty ( 2019 ), and Afonso and Jalles ( 2019 ) have been used to calibrate the empirical strategy. Two separate models were estimated, one with CAB as the dependent variable and the other with BOT as the dependent variable. In the long run, both models confirm the conventional view of TDH in Pakistan, with causality running from CAPB to BOT. In both models, other control variables play an important role in explaining CAB and BOT. Both GDP growth and the expansion of the money supply cause a decline in CAB and BOT, supporting Keynesian absorption and monetary approaches to the balance of payments. The CAB and the BOT in both models improve with a rise in the exchange rate as determined by the log of the nominal effective exchange rate, supporting the long-run elasticity theory of the balance of trade. Alternatively, this is consistent with the Marshall-Lerner hypothesis. We find that CAB gets worse with more openness, as measured by the trade to GDP ratio, and this finding is statistically significant. On the other hand, openness has enhanced the state of the trade balance, although the impact is statistically insignificant.

The assessment of the “twin-deficit hypothesis” in the context of Pakistan shows unequivocally that fiscal deficits cause current account deficits. To deal with a significant and continuing trade deficit, the government must reduce its fiscal deficit. The outcomes of economic policies in other nations may also be influenced by the economic spillover effects of one country’s policies. Therefore, while examining the effects of the fiscal deficit on the current account balance, future research should concentrate on and take into account the spillover effects of the economic policies of Pakistan’s key trading partners.

Besides this, the dynamic analysis shows that the deficits from the previous year have an impact on the present level of deficit. Another underlying issue that can have an impact on the established link between the two deficits is the taxation system. The maximum statutory tariff rate has been reduced from 125% in fiscal year 1988 to 20% in fiscal year 2016. This has encouraged imports and, as a consequence, deteriorated the balance of trade. Aside from this, the government has been deprived of revenue in the form of low customs collections. The share of custom duties in federal board of revenues tax collection, which stood at 45.7% in fiscal year 1991, has fallen to 15.8% in fiscal year 2018 (ESP, 2018 –19).

This switch in the composition of indirect taxes has encouraged imports in general and luxury items in particular, and has deteriorated the trade balance. Additionally, the analysis shows that both Keynesian absorption and monetary approaches hold in Pakistan. Therefore, to overcome the problem of a sustainable deficit in the current account balance, monetary policy needs to be accommodative with fiscal policy. The openness of the economy is another factor that has encouraged imports more than exports, thereby deteriorating the current account balance. In the face of fiscal austerity measures, the policy of separating luxury products from necessary imports by imposing a discriminatory customs tariff against the latter is predicted to lower the current account balance to a manageable level and is likely to relieve foreign exchange constraints. Both the budget deficit and the current account balance may be impacted by the net international investment position (NIIP). The market value of a country’s assets and liabilities, which is affected by changes in stock prices and currency appreciation or depreciation, determines the country’s net international investment position.

Exchange rate volatility and a nascent stock market have an impact on assets and liabilities, which in turn affect the nation’s NIIP. In this sense, fiscal austerity is anticipated to be more successful in lowering the current account balance thanks to initiatives to stabilize the exchange rate and grow the stock market. Further currency depreciation is anticipated to boost exports as the Marshall–Lerner condition is met. To gain in the long run from higher export revenues, effort should be made to stabilize the currency rate following devaluation. Additionally, the financial system must be improved to lessen the negative impacts of liberalized capital accounts and the ensuing capital outflows on external balances, which is predicted to increase the visibility of the consequences of fiscal austerity. Since there is a dearth of data on several fiscal policy indicators and trade over a quarterly time period in Pakistan, this analysis has relied on yearly data. Over longer periods of time than it does over shorter ones, there may be differences in the relationship between fiscal and current account deficits. Furthermore, the analysis was primarily conducted in the context of Pakistan, a country with unique institutions and a government system, and should thus be interpreted as a result of only being conducted in that country.

Authors Contribution

IH—wrote the introduction, conclusion and compile the whole paper-UH—developed the methodology, discuss the results and compile the original draft-MSA—wrote the literature review and collected the data. UK—supervise, reviewed and compile the paper.

No funding was received from any source.

Data Availability

Declarations.

The author declares no competing interests.

Not applicable.

1 The conventional view indicates that a fiscal deficit causes current account balance, while the non-conventional view reveals reverse causality flowing from current account balance to fiscal balance.

2 BRICS is an association of emerging countries, including Brazil, Russia, India, China, and South Africa.

3 When this ratio rises, the trade balance is becoming worse, and when it falls, it is getting better.

4 CAB [which is the sum of net exports (X-M), net factor income, and net unilateral transfer] is a reversed score variable like PFB, while the balance of trade is defined as the ratio of merchandize imports to merchandize exports and is not a reversed score variable.

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Contributor Information

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Umar Hayat, Email: kp.ude.tawsu@tayahramu .

Md Shabbir Alam, Email: [email protected] .

Uzma Khan, Email: moc.liamg@idirfanahkamzu .

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U.S. Trade Deficit Unexpectedly Widens To $68.9 Billion In February

(RTTNews) - A report released by the Commerce Department on Thursday showed the U.S. trade deficit unexpectedly widened in the month of February.

The Commerce Department said the trade deficit increased to $68.9 billion in February from a revised $67.6 billion in January.

Economists had expected the trade deficit to narrow to $67.0 billion from the $67.4 billion originally reported for the previous month.

The report said the value of imports surged by 2.2 percent to $331.9 billion, while the value of exports shot up by 2.3 percent to $263.0 billion.

RELATED EXCHANGE RATES

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Inhibitory Deficit Hypothesis

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Zhen, S. (2019). Inhibitory Deficit Hypothesis. In: Gu, D., Dupre, M. (eds) Encyclopedia of Gerontology and Population Aging. Springer, Cham. https://doi.org/10.1007/978-3-319-69892-2_827-1

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DOI : https://doi.org/10.1007/978-3-319-69892-2_827-1

Received : 29 July 2019

Accepted : 08 August 2019

Published : 05 September 2019

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