Twin deficits in small open Baltic economies

Veronika Suliková,Denis Horváth,Marianna Sinicáková

doi:10.2298/pan1402227s

Abstract

This paper analyzes the twin deficit hypothesis - simultaneous current account deficit and budget deficit - in three small open Baltic countries (Estonia, Latvia and Lithuania) running under certain forms of the fixed exchange rate regime. The idea of twin deficits is tested using the vector error correction model (VECM), Granger causality tests and forecast variance decomposition, involving three variables: current account, budget balance, and investments. The new estimates confirm significant long-run positive relation between budget balance and current account in Estonia and Lithuania on one hand and the negative one in case of budget balance and investments in all three considered countries. The results of the analysis are specific to each country as they depend on their particular macroeconomic background. The contribution was elaborated within the project VEGA 1/0973/11.

Highlights

Latvia and Lithuania belong to transition economies; the foreign direct investments played an important role in their development during the last decades
The results indicate that current accounts in Estonia and Latvia are significantly influenced by the lagged budget balance and investments
The VEC Granger causality analysis indicates that the current account is explained by lagged budget balance and investments in Latvia and Estonia

Summary

Data and Methodology

We have chosen three Baltic countries, that is, Estonia, Latvia and Lithuania, for our analysis as they present a sample of the most successful countries in the field of public finance administration. It should be pointed out that chosen countries belong to small open economies with current trade openness ranging from 122.49% in Latvia to 180.52% in Estonia Their openness is incomparably higher than the European Union (EU-27) average value of 85.89%. Latvia and Lithuania belong to transition economies; the foreign direct investments played an important role in their development during the last decades. This is why we expect that in these countries, the hypothesis of twin deficits takes place. Note: CA - current account, BB - budget balance, INV - investments; data are expressed as % of GDP. The meaning of the remaining coefficients cj, bji, gji, and dji becomes clear through the context

Stationarity Testing and the VECM

Granger Causality and Variance Decomposition

Findings

Conclusion