Assessing the non-linear impact of fiscal balance on current account balance in major SAARC economies: evidence from method of moments quantile regression

Abstract

PurposeIn the backdrop of persistent internal and external imbalances, the nexus between fiscal imbalance and current account imbalance remains a subject of debate among economists, policymakers, research scholars and governmental organisations. Nevertheless, there is no definitive consensus, either theoretical or empirical, especially within the SAARC region. This evident lack of unequivocal solid agreement underscores the pressing necessity for further empirical inquiry into the twin deficits hypothesis. In this regard, the present study makes a novel attempt to re-examine the twin deficits hypothesis for major SAARC economies in a non-linear fashion using a balanced data set from 1985 to 2021.Design/methodology/approachIn our empirical analysis, we addressed several methodological challenges in examining the relationship between fiscal balance and current account balance. Initially, we tackled cross-section dependency, heterogeneous slope coefficients and non-stationarity issues. We employed the panel Fourier unit root test by Nazlioglu and Karul to detect smooth breaks and non-linearity. Long-run cointegration was assessed using novel third-generation cointegration tests introduced by Westerlund and Edgerton (2008) and Banerjee and Carrion-i-Silvestre (2017). The non-linear dynamics were examined using the method of moments quantile regression (MMQR). Finally, to investigate the causal relationship between fiscal deficit and current account deficit within a panel framework, we employed the novel JKS test.FindingsThe MMQR analysis reveals that the fiscal balance has a positive and significant impact on the current account balance across all quantiles except the lower quantiles (first to third). The magnitude of the coefficient for fiscal balance increases from lower to higher quantiles, suggesting that countries with lower fiscal deficits manage their current account balances more efficiently. Likewise, a positive and significant impact of the saving-investment balance on the current account balance is observed across all quantiles, with the coefficient decreasing as quantiles increase. This indicates that a wider saving-investment gap leads to a more pronounced deterioration in the current account balance. The exchange rate also significantly influences the relationship, highlighting a strong exchange rate channel in transmitting fiscal policy shocks to the current account balance. These findings are corroborated by robustness checks using fully modified ordinary least squares (FMOLS) and dynamic ordinary least squares (DOLS) estimators. The JKS causality test confirms the bi-directional causality between fiscal and current account balances, further validating the results.Practical implicationsOur study has profound policy implications, suggesting that the “size” of fiscal deficit significantly impacts external balances and broader macroeconomic goals in SAARC economies. Policymakers are urged to implement prudent fiscal policies, enhance revenue generation, and promote fiscal discipline to achieve economic stability and sustainability. Minimising unproductive consumer spending and improving tax collections are also recommended to manage external imbalances effectively. Our research offers valuable insights for policymakers and researchers striving to foster sustainable economic development in the SAARC region.Originality/valueMost macroeconomic variables do not always behave symmetrically and linearly. As a result, it is likely that these variables exhibit asymmetric and non-linear behaviour in response to cyclical and structural changes. Therefore, employing asymmetric and non-linear econometric approaches, rather than the usual symmetrical analysis, to understand the behaviour of the current account and fiscal balance in SAARC economies is rational. Existing empirical studies predominantly focus on the twin deficits hypothesis, neglecting the influence of the saving-investment balance on both fiscal and current account balances. Our research aims to fill this gap by integrating the saving-investment balance into the twin deficits model, thus providing a pioneering analysis that expands our understanding of the relationship between internal and external imbalances. The methodological novelty of our study lies in the fact that this is the first study, at least in the SAARC region, to investigate the non-linear dynamics and causality direction in the twin deficits hypothesis using the MMQR and the JKS causality test.