Abstract
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.
Highlights
Fiscal and monetary strategies, when executed lucidly, assume a conclusive part in general macroeconomic stability
The model is based on Schwarz Bayesian Criteria (SBC) optimized over 20,000 replications
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
Summary
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. 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. 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. 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. 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
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