Pakistan Journal of Social Sciences (PJSS)

Vol. 40, No. 4 (2020), pp. 1617-1630

Examining Twin Deficit Hypothesis

Using Simultaneous Model in Pakistan
Asma Awan
Assistant Professor, Department of Economics
University of the Punjab, Lahore, Pakistan
Email: asma.eco@pu.edu.pk

Ismat Nasim
Lecturer, Department of Economics
Government Sadiq College Women University, Bahawalpur
Email: ismat.nasim@gscwu.edu.pk

Kashif Raza
Lecturer, Department of Economics
The Islamia University of Bahawalpur, Bahawalnagar Campus
Email: kashif.raza@iub.edu.pk

Abstract:
This research is an attempt to ferret out dynamics of twin deficit
hypothesis in Pakistan using annual data from 1974 to 2018, covering
45 years. To address empirical association between fiscal deficit and
current account deficit, simultaneous model consisting of two
stochastic equations is utilized. Hausman’s simultaneity test is utilized
to check endogeneity of the variables and stationarity of the variables
is confirmed through application of Ng-Perron unit root test. 3SLS
technique is used to empirically estimate the model. Our empirical
results strongly support significant positive two way association
between fiscal deficit and current account deficit. The key policy
prescription is that there is dire urgency of coordinated and prudent
monetary and fiscal policy to overcome pitfalls of rising twin deficits in
Pakistan.

Keywords: Fiscal Deficit, Current Account Deficit, Simultaneous Model

JEL Classifications Codes: H62, F32, C32

I. Introduction
The purported relation of twin deficit hypothesis energized extensive empirical
and academic debate especially during 1980’s when most of the countries around the
globe faced severe crises of escalated fiscal deficit and deteriorated current account
balance simultaneously due to International oil price hikes of 1970’s beside other
potential determinants. However, twin deficit literature traces back to pioneered work of
Fleming (1967) that shows positive linkages between fiscal deficit and current account
deficit, for details see, Fleming (1968) and Abell (1990).

The income-expenditure approach of Keynes provides rationale for this positive

association as increase in fiscal deficit due to tax cut will cause more domestic absorption
and domestic income level. The increased income in turn will induce more imports in
comparison to exports which will cause trade deficit and hence current account deficit.
1618 Pakistan Journal of Social Sciences Vol. 40, No. 4

Another significant rationale of twin deficit hypothesis can be explained with the help of
open economy model of Keynes. According to this, increase in budget deficit results in
rise of total demand which in turn causes rise in domestic interest rates. The increased
domestic interest rate attracts foreign investment which can substantially appreciate
domestic currency and makes exports expensive; imports cheap. Thus negatively affects
net exports and results in trade deficit or current account deficit. Proponents of Keynes
preposition includes Darrat (1988) and Bachman (1992) among others.

Furthermore, the Ricardian equivalence view in context of current account

literature does not support Keynes preposition and claims that government budget deficit
does not causes current account deficit, for details see, Enders and Lee, (1990), Kim
(1995), Kaufmann et al. (2002). According to Ricardian equivalence, a tax cut (keeping
expenditures constant) will not incline people to spend more due to increased income
because people will anticipate more future taxes and a decrease in current tax will be
equalized with an expected increase in future tax. Therefore consumption, interest rate
and investment remain unaffected and do not lead to worsen current account balance.

Recent advances in twin deficit hypothesis empirical literature came up with two
more conclusions on subject matter i.e. 1). There is reverse causality running from
current account deficit to fiscal deficit. 2). There is bi-directional relationship between
variables. The concept of reverse causality is mainly holds in case of small open
developing countries that excessively relied on external capital inflows to augment their
scarcity of finance and resources. The proponents of reverse causality includes Summer
(1988), Hatemi and Shukur, (2002) among others. The proponents of bi-directional
relationship levied severe criticisms on using of single equation framework to investigate
twin deficit hypothesis as results of single equation model suffers from simultaneity bias.

Table 1: Decade Wise Analysis of Fiscal Balance and Current Account Balance
(1970-2018)
Decade FB/GDP (%)1 CAB/GDP (%)2
1970’s -8.05 -4.6
1980’s -6.73 -3.13
1990’s -7.15 -3.16
2001-05 -3.56 1.61 (Surplus)
2006-10 -6.46 -4.78
2011-15 -6.86 -1.30
2016-18 -5.63 -4.62
Note: Author’s calculations

Historically, Pakistan remained victim of poor performance of fiscal and trade

sector which imposes serious constraints on its economic sovereignty. Pakistan’s fiscal
deficit, on average, constantly remained over 6 % of country’s GDP. This in turn shows
failure of government in mitigating revenue-expenditure gap. In fact Pakistan’s revenues
have been shrinking in comparison to rapidly increasing expenditures. The core
determinants of fiscal deficit are escalated debt, heavy defense expenditures and
inflationary pressure. The current account deficit was also observed in past except for
three years i.e. 2001–2003 when after the incidence of 9/11 event huge inflow of foreign
resources results in current account surplus. A cursory look of the historical data reported

1
Fiscal Balance as percent of GDP.
2
Current Account Balance as percent of GDP.
 1619
in table 1 strongly support that there is strong link between fiscal balance and current
account balance as periods of high fiscal gap are associated with periods of high current
account gap.

Therefore, rising twin deficit of Pakistan calls researchers to come forward and
to undertake in-depth analysis of subject matter. The primary objective of this paper is to
contribute in empirical literature through joint estimation of twin deficit dynamics in
Pakistan over longer time period. This research significantly differs from past empirical
research done on subject matter. Firstly, it addresses deficiency in econometric
methodology by adopting simultaneous structural model instead of relying on a single
stochastic equation model. Secondly, it also explores direct and indirect effects of all
exogenous variables. Thirdly, full information method i.e. 3SLS is utilized as an
estimation strategy after ensuring its pre-requisites.

II. Review of Literature

Researchers, practitioners and social scientists extensively tried to empirically
investigate causal association between current account deficit (trade deficit) and budget
deficit. However, during 1960’s, 1970’s and 1980’s focus of the researchers is to check
only two paradigms of twin deficit i.e. fiscal deficit causes trade deficit (Keynesian view)
and fiscal deficit has no impact on trade deficit (Ricardian view). Later on focus is shifted
towards two other possible prepositions i.e. there is reverse causality (Summer’s view)
and there is bi-directional relationship between the variables including Darrat (1988) and
Monsouri (1998).

With regard to preposition of Recardian equivalence, Barro (1974) claimed

absence of any significant positive association between budget deficit and current
account deficit and argued that decline in government savings (because of increased
fiscal deficit) will be equal to increase in private savings (due to anticipated future taxes)
thus leaving variables unchanged. For details see, Barro (1989). Furthermore, Dewald
(1983), Dwyer (1983), Wheeler (1989), Miller and Russek, (1989), Winner (1993), Evans
and Hasan, (1994), Barlett (1999), Kaufmann et al. (2002) all have supported Ricardian
view of twin deficit hypothesis. They argued that since change in interest rate is not
affected by fiscal deficit therefore there is no causal relationship between budget deficit
and current account deficit. With regard to Keynesian preposition, Laney (1984), Ahmed
(1986), Islam (1998), Abell (1990), Vomvoukas (1997) all have asserted positive
relationship between budget deficit and current account deficit.

With regard to reverse causation i.e. current account deficit causes budget
deficit, there exists number of empirical evidences. Few of them includes Khalid and
Teo, (1999), Alkswani (2000). The bi-directional relationship between variables is
reported in work of Normandin (1999) among others. A review of empirical evidences on
subject matter during 1990-2020 is reported in tabular form in order to have quick bird’s
eye view.
1620 Pakistan Journal of Social Sciences Vol. 40, No. 4

Table 2: Summary of Empirical Literature on Twin Deficit Hypothesis

1990-2020
Study Sample Methodology Key Findings
Khan and Guan, (1999) Developed Country Johansen High positive
Developed Countries (US, 1950-1994 Co-integration relationship in
UK ,France, Canada Developing Country Test developing countries
,Australia) 1955-1993 than developed
Developing Countries countries.
(Pakistan, India, Egypt, Pakistan: CAD3→BD4
Mexico, Indonesia) (reverse causality)
Alkswani (2000) 1970-1999 Co-integration Long run association.
Saudi Arabia (Annual data) and ECM5 Confirms CAD→BD
(reverse causality)
Co-integration, Significant long run
Nishat and Aqeel, (2000) 1973-1998 Granger positive impact
Pakistan (Annual data) causality of fiscal deficit on
and ECM trade deficit.
However, short run
causal effect is
negative.
Chin and Prasad, (2000) 1971-1995 Panel Confirms BD→CAD
71 Developing and 18 (Annual data) Regression (Keynesian view)
Industrial Countries analysis
Ali (2006) 1975-2003 UECM6 and Co- Trade deficit causes
Pakistan (Annual data) integration budget deficit
(reverse causality)
Baharumshah et al.(2006) 1976:Q1 to VAR8 and Thailand: (Keynes
Thailand, Indonesia, 2004:Q4 Variance view)
Malaysia7, Philippines (Quarterly data) Decomposition Indonesia: (Reverse
causality)
Malaysia: (Bi-
directional)
Philippine : (Bi-
directional)
Ahmed et al. (2007) 1975:Q1 to Co-integration Co-integration test
Pakistan 2005:Q4 and Granger supports long
(Quarterly data) causality run relationship and
granger
causality reports bi-
directional
relationship.
Ahmad (2009) 1948:Q1 to VAR model Direction of causality
Pakistan 2005:Q4 is:
(Quarterly data) Budget deficit→trade
deficit.
Iram et al. (2011) 1972 – 2008 ARDL and Toda- BD →CAD (Keynesian
Pakistan (Annual data) Yamamoto View)
Causality Test
Yasmin (2015) 1990 – 2010 Co-integration Uni-directional
Pakistan (Annual data) Test, Impulse relationship from CAD
Response to BD (reverse
Function, Granger causality)

3
Current Account Deficit
4
Budget Deficit
5
Error Correction Model
6
Unrestricted Error Correction Model.
7
For Malaysia data ended at 1998: Q2 before pegging of its currency to US dollar.
8
Vector autoregressive
 1621
causality
Ravinthirakumaran et al. 1980-2012 Co-integration, Pakistan & Sri Lanka:
(2016) (Annual data) ECM, Granger BD → CAD
SAARC Countries Causality Nepal, India &
(Pakistan, Bangladesh, Bangladesh: CAD →
India, Sri Lanka and BD
Nepal)
Bhat and Sharma, (2018) 1970 – 2016 Non-linear ARDL9 Confirms association
India (Annual data) between CAD and BD
but instead of linear
association, study
confirms asymmetric
relationship between
CAD and BD.
Manzoor et al. (2019) 1973-2017 VAR Trade deficit directly
Pakistan (Annual data) IRF10 causes budget deficit,
Granger Causality whereas, budget
deficit causes trade
deficit though different
channels.
Shruti (2019) 1985 – 2016 ARDL and Toda Pakistan & Sri Lanka
South Asian Countries (Annual data) Yamamoto (CAD → BD)
(Pakistan, India, Causality Nepal (BD → CAD)
Bangladesh, Nepal, Sri (for time series India & Bangladesh
Lanka) analysis) (bi-directional
GM – FMOLS11 association between
GM – DOLS12 CAD and BD)
(for panel data
analysis)
Bucevska (2020) 2005:QI –2017:QIV VAR Long run relationship
Republic of North (Quarterly data) Granger Causality exists between CAD
Macedonia VECM and BD.
Note: → denotes one way causation

From reported work on subject matter we can safely conclude that literature
remains inconclusive. Thus it demands more research on subject matter. To best of our
knowledge there is no research that have utilized simultaneous model in context of
Pakistan. In order to bridge this gap in literature, this research is undertaken.

III. Rationale of Conventional View of Twin Deficit Hypothesis

In order to provide economic rationale of twin deficit hypothesis, we start from
national income identity which is stated as follows:

(a)

Where N.Y = National income, Cons = Consumption (private sector), Inv =

Investment (private sector), Govt = Government expenditures, (Exp-Imp) = Exports
minus imports13.

9
Auto –Regressive Distributed Lag Model
10
Impulse Response Function
11
Group Mean – Fully Modified Ordinary Least Square
12
Group Mean – Dynamic Ordinary Least square
13
Net exports
1622 Pakistan Journal of Social Sciences Vol. 40, No. 4

Now, we can define current account balance as:

(b)

Where, NITF is Net income and transfer flows.

For the sake of simplicity, we assume that NITF does not constitute status of
major item in CAB therefore equation (b) can be rewritten as follows:
( )
The above equation states that CAB mainly depends on net exports of a country.
If exports of goods and services are greater than in relation to imports then a country has
current account surplus or vice versa. In an open economy national savings can be stated
as:
(c)
Or we can rewrite above stated equation as;
(d)
Where,

Since we know that national savings can be bifurcated into two distinct
categories i.e. private and public savings therefore algebraically we can write it as:
(e)
Where, P.Sav (private savings) = Disposable income (Yd)14 minus Consumption
(Cons), G.Sav (government savings) = Revenue (TX)15 – Expenditures (G+TR)16. The
equation of national savings can also be expressed algebraically as:

Keeping in view equation (d) and (e’), we can state eq (f) as follows:
(f)

We can write above equation as follows in order to capture savings decisions

related to government in an open economy.
(g)

The above equation can be written for CAB as follows:

(h)

14
Y-TX (income minus taxes)
15
Taxes (direct + indirect)
16
Expenditures consist of government expenditures and transfer payments (e.g. old age allowances,
unemployment allowances etc.)
 1623
In order to show effect of fiscal deficit on current account balance, we can
rewrite above equation as:
( )

Or,
(h//)

The above final equation stipulates twin deficit conventional view that if (P.Sav
– Inv) is fixed or constant an increase in government expenditures (keeping tax
collections remain unchanged) positively affects current account deficit. This view is
advocated by Keynes and his proponents.

IV. Methods and Material

Using annual data this research aims to explore twin deficit hypothesis in
Pakistan for the period 1974-2018. Data is of secondary nature and variables are selected
in accordance to theory as detail is given in table 3.

A. Model Specification
Following structural equations are formulated to investigate twin deficit
interactions in Pakistan.

Current Account Deficit Equation

Fiscal Deficit Equation

List of Endogenous Variables

CAD/GDP17 = Current Account Deficit as Percent of GDP
ln (FD/GDP) = Log of Fiscal Deficit as Percent of GDP

List of Exogenous Variables

ln EXR = Log of Nominal Exchange rate
ln TOT = Log of Terms of Trade
ln PCY = Log of Per Capita Income
ln (ED/GDP) = External Debt as Percent of GDP
ln (M2/GDP) = Broad Money Supply as Percent of GDP

The current account deficit equation is first equation of simultaneous structural

model, whereas, fiscal deficit is second equation. Since number of equations and
dependent variables are identical therefore system is complete. The alphas (  ' s )

17
We cannot take log of current account deficit even after taking as percent of GDP because there exist three
values whose log is non negative.
1624 Pakistan Journal of Social Sciences Vol. 40, No. 4

represent coefficients of dependent variables whereas deltas (  ' s ) indicates coefficients

of exogenous or independent variables.

Table 3: Description and Data Sources of the Variables

Variables Description Source
CAD/GDP Current account deficit as percent of GDP
Fiscal deficit as percent of International Financial
FD/GDP
GDP Statistics database
EXR Nominal exchange rate
TOT Terms of trade (2000-01=100)
PCY Per capita income proxy for economic growth Pakistan Economic
ED/GDP Total external debt as percent of GDP Survey, various issues.
M2/GDP Broad money supply as percent of GDP

B. Research Methodology
Time series data often exhibit trending pattern therefore to avoid spurious
regression results we need to check stationarity and for this we have used Ng-Perron unit
root test (2001) which is the most powerful and recommended test among others because
it overcomes the issues related to poor size and power distortions of ADF test and PP test.

An application of OLS in case of simultaneous model provides inconsistent and

biased empirical estimates. Therefore an alternate approach i.e. 3SLS is adopted in this
research. This approach was proposed in 1962 by A.Zellner and Theil. It is a full
information method that gives estimates with lower variances and strongly considered
superior over 2SLS. The 3SLS estimation strategy consists of three stages.

 In first stage, fitted values of regressands are obtained by regressing each

stochastic dependent variable on all fixed independent variables.

 In second stage, we estimate all structural parameters with the aid of OLS
method. It is relevant to mention here that before estimation of structural
parameters, we have to replace values of actual regressands with respective
fitted values of regressands.

 In third stage, estimation of cross equation variances and co-variances is done

by using stochastic residuals of each equation. In this stage GLS (Generalized
least Square) method is utilized to obtain parameter estimates which in turn
called 3SLS estimates.

There are various pre-conditions of 3SLS approach including, simultaneity must

present in the structural model, there must be correct specification of the structural
model, each equation of the structural model should be over-identified and the residual
term of each structural equation must be serially uncorrelated. Hausman simultaneity test
is used to check endogeneity of the variables.

Over identification of the model is confirmed through order and rank condition
of identification. The correct specification of the model is checked by Ramsay RESET
test. Serial correlation of residual terms is checked by Breusch-Pagan-Godfrey Serial
Correlation test.
 1625
V. Results and Discussions
A. Stationarity Results
After checking stationarity of the data, pre-conditions of the 3SLS method are
confirmed through appropriate statistical tests as mentioned in section IV.
Table 4: Ng-Perron Unit Root Test Results 1974-2018
MZα MZt MSB MPT
Deterministic Deterministic Deterministic Deterministic
Variables terms terms terms terms
c c,t c c,t c c,t c c,t
Ng-Perron in Levels
CAD/GDP -9.8** -10.4 -2.1** -2.2 0.22** 0.21 2.6** 8.7
ln (FD/GDP) -10.3** -11.7 -2.2** -2.3 0.21** 0.20 2.3** 7.9
ln EXR 0.03 -5.1 0.01 -1.5 0.54 0.30 21.4 17.5
ln TOT -5.1 -8.2 -1.2 -1.9 0.24^ 0.23 5.5 11.3
ln (ED/GDP) -5.7 -7.2 -1.6 -1.8 0.29 0.26 4.2^ 12.5
ln (M2/GDP) -5.1 -23.2** -1.3 -3.3** 0.26^ 0.14** 5.3 4.0*
Ng-Perron in First Differences
dCAD/GDP -17.4* -17.4** -2.9* -2.9^ 0.16* 0.16** 1.4* 5.2**
dln(FD/GDP) -15.4* -16.5^ -2.7* -2.8^ 0.18** 0.17^ 1.5* 5.7**
dlnEXR -17.2* -17.3^ -2.9* -2.9^ 0.17** 0.16** 1.4* 5.2^
dlnTOT -1.2 -15.0^ -0.7 -2.6 0.57 0.18 17.3 6.5^
dln(ED/GDP) -1.7 -16.8^ -0.9 -2.8^ 0.52 0.17^ 13.7 5.5^
dln(M2/GDP) -12.5** -20.8** -2.3** -3.2** 0.19** 0.15** 2.4** 4.4**
Critical Values
1% -13.8 -23.8 -2.58 -3.42 0.17 0.14 1.78 4.03
5% -8.10 -17.3 -1.98 -2.91 0.23 0.17 3.17 5.48
10% -5.70 -14.2 -1.62 -2.62 0.27 0.18 4.45 6.67
Note: * is used for significance at 1 %, ** at 5 % and ^ at 10 %, “c”→ constant, “c,t” → constant and trend,
MZα → Modified Philips-Peron test, MZt → Modified PP t-test = MZα * MSB, MSB → Modified Sargan-
Bhargava test, MPT → Modified Point Optimal test.

The econometric results pertaining to all pre-conditions of 3SLS approach are

not reported here given limitation of word length and to conserve space. However,
empirical estimates of 3SLS are reported in table 5.
B. Estimated Twin Deficit Model
Table 5 reports estimates of 3SLS approach along with respective probabilities
and it indicates that all variables are statistically significant except one i.e. terms of trade.
Furthermore, variables have expected signs and evidence of two-way association between
fiscal deficit and current account deficit in long run is also reported. The two way
association between variables during reference period is also consistent with empirical
work of Ahmad et al. (2007) in case of Pakistan.

In current account deficit equation three variables out of four are statistically
significant i.e. fiscal deficit as percent of GDP, nominal exchange rate and per capita
income. Fiscal deficit has significant positive impact on current account deficit with a
reported coefficient 5.85. The estimated coefficient can be precisely interpreted as 1
percent increase in fiscal deficit, on average, directly endorse or increases current account
deficit by 5.85 units in the long run, given other factors constant. This empirical finding
supports conventional view of twin deficit hypothesis that fiscal deficit causes current
account deficit by escalating trade deficit and it is also consistent with current experience
of Pakistan’s economy and with findings of Piersanti (2000), Cavallo (2005) and Iram et
al. (2011) on subject matter. The rising trend of Pakistan’s fiscal deficit has caused
1626 Pakistan Journal of Social Sciences Vol. 40, No. 4

serious impediments for current account balance as increased fiscal deficit forced
government to borrow externally as well as internally which has adversely impacted on
current account balance.

Table 5: 3SLS Estimates of Twin Deficit Model 1974-2018

Dependent Variables: CAD/GDP and ln(FD/GDP)
Current Account Deficit Fiscal Deficit
Variables Equation Equation
(CAD/GDP) ln(FD/GDP)
Dependent Variables
0.10*
(CAD/GDP)1t -----
Prob. (0.00)
5.85*
ln(FD/GDP)2t -----
Prob. (0.005)
Independent Variables
2.90*
lnEXR1t -----
Prob. (0.05)
-2.92
lnTOT2t -----
Prob. (0.22)
-6.86*
lnPCY3t -----
Prob. (0.02)
0.91*
ln(ED/GDP)4t -----
Prob. (0.03)
-1.55*
ln(M2/GDP)5t -----
Prob. (0.007)
53.32* 3.83*
Intercept
Prob. (0.02) Prob. (0.09)
Summary Measures
R2 0.50 0.35
S.E of Regression 1.97 0.28
Note: * shows significance of the variable and prob. values shows exact level of significance

With regard to current account deficit and exchange rate relationship we came
to know that nominal exchange rate has exerted positive impact on current account deficit
and it is significant in Pakistan. The estimated coefficients can be precisely interpreted as
1 percent increase in nominal exchange rate directly, on average, increases current
account deficit by 2.90 units in the long run. Since the establishment of Pakistan, it has
faced severe depreciation of exchange rate as 9.9 rupees per US $ in 1974 to 68.28 rupees
per US $ in 2008 to 84.56 rupees per US $ in 2010 and to 109 rupees per US $ in 2017.
Because of this massive depreciation Pakistan’s currency is becoming weaker and attracts
less foreign investment or foreign capital and causes current account deficit. With regard
to current account deficit and terms of trade nexus, we found negative insignificant
association between the variables. Due to insignificance of the variable no valid
conclusion can be drawn.

With regard to current account deficit and per capita income nexus, we found
significant and negative association between the variables. In this research we have used
per capita income as proxy for economic growth. Higher economic growth means lesser
current account deficit which is theoretically valid. The empirical estimate of the variable
(economic growth) indicates that 1 percent increase in economic growth, on average,
directly can lowers current account deficit by 6.86 units in the long run. This finding has
an important policy implication that Government should focus on channels of economic
 1627
growth and put efforts to achieve past growth momentum of 1960’s in order to curb
current account deficit and to achieve financial competitiveness.

In fiscal deficit equation all four variables are statistically significant and
carrying expected signs. We also find significant two-way relationship between fiscal
deficit and current account deficit. The increase in fiscal deficit positively affects current
account deficit or vice versa. The estimated coefficient of current account deficit is
interpreted as 1 unit increase in current account deficit directly, on average, increase
fiscal deficit by 0.10 percent in the long run. The rationale behind this empirical finding
is that because mostly Pakistan’s current account deficit was financed by borrowings
(internal or external) which caused huge government debt. Due to accumulated debt,
interest payments have drastically increased over the years and Pakistan has trapped into
larger persistent fiscal deficits. Furthermore, composition and structure of foreign
assistance has changed from grants to hard term loans which are detrimental to economic
growth and current account balance.

With regard to fiscal deficit-external debt nexus we found highly significant

positive impact of debt on fiscal deficit with the reported coefficient 0.91 which means 1
percent increase in foreign indebtedness directly increases fiscal deficit, on average, 0.91
percent in the long run. Due to escalated debt build up, real drain on resources is debt
servicing which obstructs economic growth and increase fiscal deficit in Pakistan. With
respect to relationship between fiscal deficit and money supply, we found signs of
negative relationship and it is statistically significant with the reported coefficient 1.55
which means 1 percent increase in monetary expansion directly curbs fiscal deficit by
1.55 percent in the long run. Deficit financing remained in practice in context of Pakistan
but it should be undertaken with care because it has severe implications for inflation.

C. Total and Direct Estimated Effect of Exogenous Variables on Current

Account Deficit and Fiscal Deficit
In order to draw concrete economic inferences from estimated structural
stochastic model, one should be well aware of total, direct and indirect impact of
independent variables on regressand. The total impact is gauged through reduced form
parameter, whereas, direct impact is gauged through structural parameter. Table 6 reports
estimated total and direct effect on subject matter.

Table 6: Total and Direct Effect of Exogenous

Variables on Dependent Variables 1974-2018
Current Account Deficit Fiscal Deficit Equation
Exogenous
Equation (CAD/GDP) (LnFD/GDP)
Variables
Direct Effect Total Effect Direct Effect Total Effect
LnEXR1t 2.90* 6.35* ----- -0.60*
LnTOT2t -2.92* 2.67 ----- -0.27
LnPCY3t -6.86* -6.89* ----- 0.47
LnED/GDP4t ----- -19.47* 0.91* 2.08*
Ln(M2/GDP)5t ----- -3.68 -1.55* 0.36
Intercept 53.32* 93.75* 3.83* -7.09
Note: * indicates significance of the variable

With respect to current account deficit equation, the direct and total impact of
nominal exchange rate on current account deficit is showing same sign although size of
the respective effect is quite different. The positive sign implying that more nominal
1628 Pakistan Journal of Social Sciences Vol. 40, No. 4

exchange rate in turn causes more current account deficit or lower nominal exchange rate
in turn results in lower current account deficit. We can easily compute magnitude of
indirect effect as 6.35 (total effect) minus 2.90 (direct effect) is equal to 3.45 (indirect
effect) which reveals that indirect impacts of exchange rate on current account deficit
outstrip its direct effects on current account deficit. Similarly, direct and indirect effects
of per capita income on current account deficit are also negative indicating economic
growth dampens current account deficit through both direct and indirect channels.

With respect to fiscal deficit equation, the direct impact of external debt as
percent of GDP on fiscal deficit is less than total impact as direct effect accounts for 0.91
percent increase in fiscal deficit whereas total impact accounts for 2.08 percent increase
in fiscal deficit given that 1 percent increase in external debt to GDP ratio. Therefore we
conclude indirect impact of debt through debt servicing channel is more important than
actual debt stock as percent of GDP. The adverse effects of debt servicing can be
visualized as it absorbs country’s own resources or revenues. The indirect impact of
money supply on fiscal deficit is not statistically significant therefore valid conclusions
cannot be drawn with precision.

VI. Conclusion
This study empirically explores simultaneous relationship between current
account deficit and budget deficit in Pakistan using annual observations from 1974-2018.
This research is of great significance given rising trend of twin deficit in Pakistan. After
ensuring stationary properties of the data, 3SLS method is utilized to estimate the
structural model on subject matter. Total and direct effects are also reported. The 3SLS
empirical results confirmed statistical significance of most of the variables used in the
analysis of twin deficit hypothesis. Secondly, empirical results are aligned with
theoretical expectations and also consistent with existing situation of the economy. The
core empirical finding of the study is that it strongly supports two-way relationship
between budget deficit and current account deficit during the investigated period. To
overcome ill effects of rising twin deficit following suggestions are made in the light of
estimated model.

First, coordinated fiscal and monetary policy is required to maintain macro-

economic balances and to gear growth of the country. Second, proper management of
escalated external debt is required in order to overcome its bad effects on rising fiscal
deficit. Third, expansionary monetary policy need to be pursued with special care.
Fourth, instability of domestic currency needs to be addressed on urgent basis.

Lastly, it is relevant to state that no research is inclusive of all possible aspects.

The present research is also limited as it only examine linear bi-variate relationship
between fiscal deficit and current account deficit. Although twin deficit hypothesis is
examined using simultaneous model rather than using single equation model but non-
linear association between fiscal deficit and current deficit is not examined in this study.
Therefore, potential researchers may contribute in literature on subject matter by
investigating non-linear relationship between variables in Pakistan.
 1629
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