Reverse Causality between Fiscal and Current Account Deficits in ASEAN: Evidence from Panel Econometric Analysis

Maran Marimuthu,Romana Bangash,Hanana Khan

doi:10.3390/math9101124

Abstract

This study aims to explore the causal relationship between fiscal deficit (FD) and current account deficit (CAD) along with policy recommendations based on long-run and short-run dynamics and sensitivities. A panel data span from 1990 to 2019 is analyzed based on panel unit root tests, panel co-integration with auto-regressive distributed lag (ARDL), panel co-integration regression with fully modified ordinary least squares (FMOLS) and dynamic ordinary least squares (DOLS), and causal analysis with the Dumitrescu and Hurlin (DH) technique. The results disclosed that all tested variables are stationary at the first difference I(1) except the real interest rate (IR), which is stationary at level I(0). The ARDL estimates suggested that there is a long-run relationship between tested variables and 92% annual convergence is possible for long-run equilibrium. The FMOLS and DOLS estimates indicated that the CAD is sensitive towards the FD and the exchange rate. The DH causality test showed that the CAD is significantly affecting the FD, supporting the current account targeting hypothesis. Furthermore, it is observed that the interest rate is acting as a moderating factor between the FD and the CAD because it causes both the deficits. Thus, reverse causality is concluded from the CAD to the FD. These results have macroeconomic implications for fiscal policy in the Association of South-East Asian Nations (ASEAN-10).

Highlights

IR has a positive relationship with CAD which supports Mundell and Fleming’s theory that when the interest rate is high, capital inflows are encouraged, and the exchange rate appreciates which in turn leads to an increase in imports and generates a current account deficit
A 1% increase in the exchange rate tends to increase by 0.01% in the current account deficit
This study contributes to a better understanding of the causal relationship between the current account deficit and government fiscal deficit in 10 ASEAN countries

Summary

Introduction

The existence of causal direction between current account deficit (CAD) and fiscal deficit (FD) raises questions in the international financial system. These questions are debatable among government and academic sectors. The association between CAD and FD is controversial, as the causal relationship between them is frequently examined in the literature. The twin deficit hypothesis has necessary implications for a country’s long-term economic growth. Fiscal expansion can worsen both the current account and the exchange rate appreciation [1]. This imbalance between CAD and FD can disrupt economic activities

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