An Empirical Investigation of the Twin Deficits Hypothesis in Sub Saharan Africa (A Dynamic Panel Approach)

Ekpenyong Udom Imoh^*, Ogbuagu Matthew Ikechukwu

Department of Economics and Development Studies, Federal University Oye-Ekiti, Ekiti State, Nigeria

Abstract

Among the challenges confronting sub Saharan Africa (SSA) are maintaining favorable fiscal and trade balances. Based on historical data from these countries, both balances have simultaneously trended in the negative region. This suggests the presence of the twin deficits in SSA. To provide an empirical explanation for this relationship, we adopted a dynamic panel model. The model was estimated using the Generalised Method of Moments (GMM) estimation technique. This technique is suitable because it takes care of the serial correlation problem that may exist as a result of including the lagged value of the dependent variable as a regressor in the model. The result shows a positive and significant impact of the budget balance on the trade balance, confirming the presence of the twin deficits in SSA. Also, the long run impact of the budget balance on trade balance was discovered to be 0.6 or 60%.Based on the empirical findings, the study recommends that a necessary condition in reversing the negative trend in the trade balance in SSA is maintaining a favourable fiscal balance. That is, to reverse the downward trend in the trade balance in SSA, measures should be put in place first to reverse the fiscal deficits. Also, it was recommended that if SSA countries are to reap positive gains from trade agreements like the European Partnership Agreement (EPA), they should make efforts to add value to products they send to the international market.

Keywords

Budget Deficits, Trade Deficits, Dynamic Panel, Generalised Method of Moments

Received: March 30, 2015
Accepted: May 2, 2015
Published online: May 27, 2015

@ 2015 The Authors. Published by American Institute of Science. This Open Access article is under the CC BY-NC license. http://creativecommons.org/licenses/by-nc/4.0/

1. Introduction

Sub Saharan African countries are plagued with several economic challenges among which are maintaining a stable internal and external balances. The internal balance can be aptly captured by the fiscal balance while the external balance can be captured by the trade balance. Over the years, both balances have generally trended in the deficit region in SSA. This suggests the presence of the twin deficit phenomenon in SSA. Going by historical data, both balances (as percentages of GDP) have, on average, been in the negative in SSA as a whole (-2.53 and -7.19 on average respectively). In fact, the correlation coefficient between both variables is about 13% in SSA using data from 1970-2013.

The simultaneous occurrence of these events (fiscal deficits and trade deficit)  has given rise to a controversy on the causal link between the budget deficit and the trade deficit or the "twin deficits" hypothesis that neither theoretical nor empirical analysis had been able to resolve (Nickel and Vansteenkiste, 2008). The controversy has reflected two main opposite views. One is based on the traditional Keynesian view that budget deficit has an important effect on the economy (Salvatore, 2006). The other is based on the Ricardian view that budget deficit has no effect at all on economic variables (Enders and Lee 1990).

An understanding of the causal link between fiscal balance and trade balance in SSA is required for proper policy coordination. A fundamental assumption of the theory is that fiscal deficits precedes trade deficit. Therefore, if it is established that there is a relationship between both, the attention of policy makers may be shifted to maintaining a stable fiscal balance as it is the cause of the deficit in the trade balance. In spite of the relevance of understanding the linkage between both deficits in SSA, the available literature is still scarce with studies that focused on SSA as a whole (Ekpenyong and Ogbuagu, 2014). Studies on the relationship between fiscal deficit and trade deficit in SSA have generally been country-specific (e.g. Egwaikhide (1997) and Korsu (2007).

Hence, the research problem this study seeks to find answers to is the nature of the relationship between fiscal balance and trade balance in SSA. Also, we would be interested in affirming the direction of causality between both balances.

The remainder of this paper is divided into five different sections. The second section covers the background to the study. Here, the dynamics of fiscal balance and trade balance in each sub region of SSA are discussed. Section 3 and section 4 present a brief review of related literature and methodology of the study respectively. Section 5 discuses the empirical findings of the study. Finally, section 6 provides conclusion and recommendations of the study.

2. Background to the Study

As stated above, the average values of both the fiscal and trade balances have generally been in the negative region and they tend to move in the same direction (as reflected on the correlation coefficient). Behind this general overview are very large sub regional differences. As shown in figures below, only West Africa and Central Africa sub regions posted surpluses in trade balance in the review period.

Figure 1. Trend in the Trade Balance and Budget Balance across Region in sub Saharan Africa.

Sources: World Economic Outlook online database and World Development Indicators online database

The trade balance in the Central Africa sub region has largely been in the surplus due to positive contributions of crude oil exports. A large percentage of SSA’s crude oil deposits can be found in the sub region (Gabon, Central Africa Republic Cameroon and Angola are among the region’s largest oil exporters). For West Africa, the trade balance had largely been determined by Nigeria’s crude oil exports and Cote d’Ivoire’s export of cotton and cocoa. However, the sub region’s poor trade performance had been largely due to negative contributions from Benin, Gambia, Guinea Bissau, Niger, Mali and Senegal; with average trade balances of -14.30, -19.33, -8.18, -6.16, -10.95 and -12.68 respectively.

The Eastern and Southern sub regions posted consistent trade deficits from 1985 to 2010. The poor trade performance of Eastern Africa can be explained by observing that most countries in the sub region are heavy importers of consumer and producer goods. Hence developments in the international community (for instance, a rise in crude oil price) are easily transmitted in the form of deteriorating trade balance in these countries.

One common feature of the diagrams above is that the fiscal balance displays a common pattern in all the sub regions. Each sub region recorded improvements in fiscal balance starting from 2003. This development can be explained if we consider that most countries in the region were heavy beneficiaries of debt relief programs like the Heavily Indebted Poor Countries (HIPC) Initiative and Official Development Assistance (ODAs). In addition, this period witnessed increases in commodity prices, which translated into additional foreign exchange earnings in most countries in the region.

3. Literature Review

A considerable level of understanding on the issues surrounding the relationship between budget deficit and the trade balance requires a review of previous studies that had been undertaking on it. There are generally three macroeconomic theories that have been adopted in deriving the relationship between budget deficit and current account balance. They are: the Keynesian national income identity, the Mundell-Fleming model and variants of the intertemporal model.

Studies that have adopted the Keynesian model started with the basic assumption that the current account balance is the difference between national savings and national investment. This relationship is derived from the basic national income accounting identity:

                            (1)

From the equation above, represents national or total income of the economy, is domestic consumption, is investment,is government expenditure and net export.

From the identity above, it can be shown that

                     (2)

Equation reveals an important identity in open-economy macroeconomics; that is the trade balance is the sum of net private savings and net public savings. It also shows that any reduction in net public savings (budget deficit) holding net private savings constant will reduce the current account balance (current account deficit).

From equation two, the implication of the Ricardian theorem can be seen. If private savings  increase to offset the decline in net public savings, the trade balance might not be affected. One key feature of the equivalence theorem is that economic agents behave rationally; that is they are able to anticipate future increase in tax obligation perfectly well.  Some studies that have adopted this framework include: Holmes (2011), Palhavani and Saleh (2009), Nickel and Vansteenkiste (2008), Marinheiro (2007), Zakaria and Ahmed (2007), Bartolini and Lahiri (2006), Corseti and Muller (2006), Hashemzadeh and Wilson (2006), Onofowora and Owoye (2006), Papadogonas and Stournaras (2006), Salvatore (2006), Alkswani (2001), Egwaikhide (1997) and Bernheim (1987).

The Mundell and Fleming model captures the effects of interest rates and exchange rate.  Under a flexible exchange rate regime, a fiscal expansion will lead to a rise in both domestic interest rate and domestic output. Depending on the sensitivity of domestic investment to interest rates, domestic investment may actually fall. Portfolio investors will find increase in interest rate as an incentive to invest in domestic assets; resulting in an increase in demand for domestic currency which eventually results in exchange rate appreciation. The appreciation of the domestic currency, coupled with the increase in income, will tend to increase demand for import and reduce export. The overall effect is a deterioration of the trade balance. Studies that have adopted this framework include: Kalou and Paleologou (2012), Endegnenew (2012), Kim and Roubini (2007), Chen (2006), Baharumshah et al (2006), Salvatore (2006), Basu and Datta (2005), Anoruo and Ramchander (1998) and Vinals (1986)

Empirical results on the twin deficits had shown mixed results. These results can be divided into three broad categories: those that confirm the twin deficits hypothesis (e.g. Chihi and Normandin, 2012.,Holmes, 2011., Egwaikhide, 1997., etc), those that confirm the Ricardian theorem (e.g., Kim and Roubini, 2008., etc) and those that established reversed causation between both deficits (e.g. Onafowora and Owoye, 2006., Marinheiro, 2008., etc).

4. Theoretical Framework and Methodology

This paper adopts the Keynesian theory of the twin deficits. Hence, our model will have the trade balance () as the dependent variable and the fiscal balance () as one of the explanatory variables. In addition, we assume that past values of the fiscal balance have effect on the current value of the trade balance (Salvatore, 2006). Hence, our model will be of the form:

                                  (3)

Equation (3) above is an example of an infinite distributed lag model. To aid estimation, we adopt the technique proposed by Koyck (1954). Koyck proposed a geometric distributed lag where each successive coefficients of  decays by. Note that the value of λ lies between 0 and 1. Therefore, we can rewrite our equation as

                          (4)

Where  is assumed to be well-behaved. That is, it follows the normality assumption of ~

Multiplying each term in (4) by λ and lag it by one period

                  (5)

Subtract (5) from (4) result in

The above equation can simply be rewritten as:

Introducing other variables into the model results in

                        (6)

are as previously defined. , ,,and  stand for term of trade, degree of openness, OECD countries growth rate and growth rate of SSA countries.captures individual fixed heterogeneity.

The task at hand will be to estimate the dynamic panel model specified above. The model will be estimated using the Generalised Method of Moment (GMM) technique of estimating dynamic panel models developed by Arellano and Bond (1991). This approach is suitable because it takes care of the serial correlation problem that may arise as a result of the correlation between  and . To resolve this correlation problem, we select two instruments that are highly correlated with , but not correlated with the error term . The choice instruments in this case are  and .

Data for this study will be sourced from the World Bank Development Indicator (WDI) database and the International Financial Statistics (IFS) CD-ROM. Where applicable, data will also be sourced from individual countries statistical bulletins.

5. Data Analysis and Discussions

This section presents the result of the estimated model specified above and discusses same.

Table 1. Generalised Method of Moments Estimation Result.

* implies significant at 1% level

The table above presents the result of estimated model using Generalised Method of Moments. The coefficient of the lagged value of trade balance is positive and significant. This implies that past values of budget balance have a positive impact on the current value of the trade balance. The coefficient of the trade balance is also positive and significant. This coefficient is the impact propensity of the budget balance on the trade balance. A 100% increase in the value of the budget balance in the current period will result in a 26.9% increase in the trade balance.  The long run impact of the budget balance on trade balance therefore is 0.6 or alternatively, a 100% increase in the value in the current period will have a 60% positive impact on the trade balance in the long run. This result also suggests the presence of the twin deficits in SSA.

The coefficients of growth rates of OECD countries and terms of trade are positive. However, the former is not significant at the standard 10% level. The coefficient of term of trade, on the other hand is significant. This implies that SSA enjoys a favourble terms of trade. An increase in the terms of trade will on the average, increase the trade balances of SSA.

The coefficients of the degree of openness and GDP growth rates are negative and significant. The more open SSA is to international trade, the more its trade balance worsens. This might be due to the way production and exports are structured in most countries in SSA. Most of these countries are engaged in the production and exportation of primary products. It has been shown that countries that still specialize in the production and exportation of primary products do not reap the full benefits associated with international trade. The negative coefficient of the growth rate of GDP suggests that as the economies of SSA countries are expanding, their trade balances deteriorate on average. A 100% increase in growth will lead to a decline in the trade balance by 51.8%. This also suggests the presence of the Absorption theory in SSA.

6. Conclusion and Recommendations

This study examines the presence of the twin deficits hypothesis in SSA. Data from 1970 to 2013 were used in testing this hypothesis. The Generalised Method of Moments (GMM) estimation technique was used to estimate a dynamic a dynamic panel model with lagged trade balance. The result showed the presence of the twin deficits in SSA. The coefficients of other important macroeconomic variables were also included in the model.

Based on our findings, we recommend that a necessary condition for reversing the downward trend in the trade balance in SSA is a favourable fiscal balance. That is, SSA countries should make effort in reducing their expanding fiscal deficits. This is important because decisions on the fiscal balance today, have significant implication on the trade balance in the future. Also, if SSA countries are to reap positive gains from trade agreements like the European Partnership Agreement (EPA), they should make efforts to add value to products they send to the international market.

Finally, since an increase in the growth rate of GDP deteriorates the trade balance, policy makers in SSA should try to pursue policies that lay more emphasis on savings over consumption. Alternatively, domestic production of imported goods should be encouraged. Each of these policies or a mixture of both will significantly reduce the over reliance of SSA countries on importation of goods from abroad. This has the effect of increasing the trade balance.

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