The twin deficits hypothesis: A revisited case of six Asian emerging market economies

Abstract

Objectives The main objectives of this study was to inspect the validity of the twin deficits hypothesis in the context of six Asian emerging market economies. In addition to this, the study aims to identify any long-run and short-run relationship between the government fiscal deficit and the current account deficit in the selected countries. If such a relationship exists, the study goes on to assess possible directions of causality between the two deficits. Any form of causality would carry significant macroeconomic implications because it allows policymakers to fathom out the transmission mechanism of this economic phenomenon and devise a coherent package of fiscal and monetary policy for dealing with it.

Summary This study employed the real effective exchange rate and the real interest rate as the mediating factors of the dynamic nexus between the government fiscal deficit and the current account deficit in China, India, Indonesia, Malaysia, the Philippines, and Thailand over the period 1982-2019. The ARDL bounds testing approach was adopted in detecting the long-run and short-run relationships among these variables. The study applied the modified Wald test to assess the direction of causality of these relationships. A number of diagnostic tests were performed to check the model’s robustness and stability.

Conclusions The government fiscal deficit was found to Granger-cause the current account deficit in the long run for India and in the short run for Thailand while reverse causality was evident for China, Malaysia, and the Philippines. The test results for Indonesia suggested a bidirectional causal relationship between the two deficits. The real effective exchange rate constituted an important mediator of the dynamic nexus between the government fiscal deficit and the current account deficit whereas the mediating effect of the real interest rate was insignificant.