sustainability

Article
Fiscal Deficit and Its Less Inflationary Sources of
Borrowing with the Moderating Role of Political
Instability: Evidence from Malaysia
Hanana Khan 1,2 , Maran Marimuthu 1, * and Fong-Woon Lai 1
1 Department of Management and Humanities, Universiti Teknologi PETRONAS, Seri Iskandar 32610, Perak,
Malaysia; hanana_17005179@utp.edu.my or hananabangash@gmail.com (H.K.);
laifongwoon@utp.edu.my (F.-W.L.)
2 Department of Economics, Kohat University of Science and Technology, Kohat 26000, Pakistan
* Correspondence: maran.marimuthu@utp.edu.my




Received: 7 October 2019; Accepted: 18 December 2019; Published: 2 January 2020


Abstract: Theoretically, fiscal deficit may be inflationary, but its sources of financing can bring change
in significance and impact. Malaysia is facing a high tendency of fiscal deficit from the last decade.
To finance the fiscal deficit, which sources are less inflationary in the country? To answer this question,
the study aims to analyze the quarterly financial time-series data covering the period from 2000 Q1
to 2018 Q4 of Malaysia using recent econometric techniques. The analysis is carried out in three
stages. In the first stage, it is tested that the fiscal deficit is inflationary along with the money supply.
In the second stage, it is determined that political instability moderates the link between inflation and
the fiscal deficit and the external sources of borrowing in the short-run, while the domestic sources
of borrowing in the long run are found inflationary. In the third stage, the central bank borrowing
and Bank institutions borrowing from the domestic sources and the short-term borrowing from
the external sources are found less inflationary. The findings suggest that borrowing through the
central bank and bank institutions (domestic sources) is less inflationary in the long term; while for a
short-term policy, from external sources, only short-term borrowing is less inflationary; medium- and
long-term borrowing are much more sensitive to inflation.

Keywords: fiscal deficit; inflation; ADRL; FMOLS; DOLS; CCR; ECM; and cointegration

1. Introduction
Higher, more persistent, or more volatile inflation plays a significant role in fiscal sustainability [1].
Fiscal deficit can be the significant cause of inflation, is one of the views of macroeconomics [2].
Specifically, for developing countries, it is very challenging to control this single variable “inflation
rate”. This has been a serious macroeconomic problem of attaining a steady growth in the economy.
There are various factors that can cause inflation in the economy, and the fiscal deficit is one of
them. A large fiscal deficit occurs when the government spending is high relative to government
revenues. Fiscal deficit and inflation are both serious economic problems in developing countries,
and inflation has attracted much attention from economists. However, less attention is given to fiscal
deficit and its relationship with inflation. The transmission mechanism of fiscal deficit operates in
two ways [3]: (1) the government can reduce the fiscal deficit by raising tax, which leads to increased
cost of production, so producers will increase prices in market for consumers, the result is cost-push
inflation from the supply side; (2) the government can reduce fiscal deficit through printing of new
money, in that way money supply will be increased in market, which in turn raises aggregate demand
and prices, known as demand-pull inflation [4]. The demand-pull inflation is based on well-known

Sustainability 2020, 12, 366; doi:10.3390/su12010366 www.mdpi.com/journal/sustainability

Sustainability 2020, 12, 366 2 of 16

Fisher equation quantity theory of money, MV = Py, the direct relationship between money supply and
price level [5]. Fiscal deficit creates both sides of inflation (demand and supply).
Malaysia, as an emerging economy, has maintained a starring record of macroeconomic
management, for instance, [6]. The country needs a fiscal policy framework, which should be
carefully designed to confirm that expenditures are consistent with social objectives and available
for financing [7]. In 1981–1986 crises, Malaysia has experienced a severe current account deficit.
The budget deficit as a percentage of Gross National Product (GNP) was historically high, up to 18% in
1983. The public debt at Gross Domestic Product (GDP) percentage sharply increased from 44% in 1980
to 103.4% in 1987. In the late 1990s, Malaysia faced heavy selling pressure on ringgits because of the
Thai Baht depreciation in May 1997. In January 1998, Ringgit depreciated against the dollar by almost
50%. However, the low foreign debt experience of financial institutions made Malaysia policymakers
unable to manage the situation. In short, fiscal profligacy was the main reason of macroeconomic
imbalance in the first two crises, that is, 1981–1986 and 1997–1998. The first two crisis happened in
Malaysia somewhat based on fiscal grounds, and financing sources of fiscal deficits. Malaysia, affected
by the Asian crisis 1997 and the Global crisis 2007–2008 (see, Table 1, and Figure 1), is planning to
enrich the effectiveness of government expenditures through the application of zero-based budgeting,
in which all expenditures will be justified for each new period, as reported in the annual report 2018 by
Bank Negara [8]. The overall balance of the Federal Government budget is 3.7 percent of GDP, as per the
report of the Ministry of Finance [9]. Fiscal deficit can be financed through many sources, for instance,
printing of new money, domestic borrowing, and external borrowing. In Malaysia, domestic borrowing
includes the Bank institution borrowing (commercial banks) and central bank borrowing, and these
sources and more are highlighted by Bank Negara Annual reports. While in external borrowing,
the most important are medium- and long-term borrowing and short-term borrowing. In past trends,
Malaysia has faced a rising inflation of 5.44% and faced a fiscal deficit of 35,594 RM million (RM
denotes the Malaysian currency symbol) in 2008 Q1 as per World Bank Data [10]. As mentioned earlier,
there are sources of financing the fiscal deficit, but debt levels always exert extra pressures on the fiscal
sustainability of public finances [11].

Table 1. Impact of global financial crises on Malaysia’s economy.

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Growth of GDP % 8.9 0.5 5.4 5.8 6.8 5.3 5.8 6.5 4.7 −1.7 5.0
Consumers Price Index (CPI) % 1.5 1.4 1.8 1.2 1.4 3.1 3.6 2.0 5.4 0.6 2.0
Fiscal Deficit (at GDP %) −6.6 −5.5 −5.8 −5.3 −4.1 −3.6 −3.3 −3.2 −4.8 −7.4 −5.6
Sustainability 2019, 11, x FOR PEER REVIEW
Total public Debt (TPD) at GDP % 36.6 41.3 45.6 44.9 45.7 43.8 42.2 41.6 41.5 48.5
3 47.8
of 16
Foreign Debt (at TPD %) 15 16.7 22 19.7 16 13.1 10.3 7.3 6.6 4.3 4.5
MoneyMoney Supply
Supply (M2)/GDP
(M2)/GDP 100100 103.4
103.4 100.9
100.9 102.5
102.5 113.4
113.4 118.9
118.9 126.7
126.7 124.1
124.1 121.9
121.9 145.6
145.6 148.6
148.6

Global Financial Crisis 2007-2008

Figure 1. Trend in Malaysian currency against US Dollar (Source: Bank Negara Malaysia).
Figure 1. Trend in Malaysian currency against US Dollar (Source: Bank Negara Malaysia).

In general, several studies argued about fiscal deficit and inflation [3,13,14]. These arguments
are based on theory, that is, Fiscal deficit causes an increase in money supply, inflation, which
increases the interest rate and finally, crowds out the investment in the private sector. According to
the Keynesian school of thought, budget deficit affects the interest rate, inflation through financing
Sustainability 2020, 12, 366 3 of 16

Consequently, to lessen this pressure and assuming fiscal sustainability as a constraint, it is

essential to choose those sources which are less inflationary. There are several factors from supply side
and demand side which can be responsible for inflation, like oil prices and food prices in the market.
Now, the question is whether the fiscal deficit is inflationary in Malaysia? If it is inflationary, then
which sources of financing the fiscal deficit are less inflationary? Ideally, at the time of fiscal deficit
in the economy, the government covers the deficit with less inflationary sources. Sources with high
inflation costs can make the economy in trouble. While discussing fiscal deficit and sources of financing
and inflation, it is considered important to also discuss political instability in this study. As mentioned,
political instability has been given less importance in studies, even though it causes many economic
problems, and one of the critical economic problems is the inflation rate [12]. Political instability
(PS) refers to fluctuations or variabilities in the political system which severely damage the economic
system of a country. In Malaysia, political stability has specific challenges, such as institutional reforms,
job-led growth, religious and racial issues, and national security challenges. In this study, political
instability (PS) is considered as a moderator between fiscal deficit and inflation. The index range of PS
is −2.5 (refers Not stable) to 2.5 (more Stable).
In general, several studies argued about fiscal deficit and inflation [3,13,14]. These arguments are
based on theory, that is, Fiscal deficit causes an increase in money supply, inflation, which increases the
interest rate and finally, crowds out the investment in the private sector. According to the Keynesian
school of thought, budget deficit affects the interest rate, inflation through financing methods. Besides,
the Monetarist school of thought argued that budget deficit affects money supply and inflation
through financing methods. A plethora of studies has been done on the relationships of fiscal deficit
and inflation [15–19].However, these studies have only analyzed the fiscal deficit and inflation as
theoretically described in the fiscal theory of price, but another side of the fence has been ignored,
which is the sources to finance the fiscal deficit and its inflation cost. It is essential to address the budget
balance because, in the short run, it becomes crucial for the government to control inflation in the
country [20]. Also, political instability has a significant relationship with rising inflation, as reported
by Barugahara [21], Aisen & Veiga [22], and Telatar et al. [23]. As discussed earlier, the political
instability means certain challenges in Malaysia, which is given less importance in the previous studies,
even though it causes a high inflation rate [20,21]. So, it is quite important to know the impacts of fiscal
deficit on inflation having political instability as a moderator. Further, from a technical perspective,
the Autoregressive Distributed Lag (ARDL) technique has been used in previous studies to find out
the long-run relationships, but its sensitivities are missing, for example [16,24]. Thus, this study
re-estimates the model by incorporating Fully Modified Ordinary Least Squares (FMOLS), Dynamic
Ordinary Least Squares (DOLS), and Canonical Cointegration Regression (CCR) techniques to find out
the robustness of the estimates.
This study aims to investigate the relationship between fiscal deficit and inflation in Malaysia’s
economy, along with long-run and short-run relationships. The second objective is to evaluate the
sources, including external and internal, to finance the deficit with less impact on inflation. Also, the
third objective of this study is to examine the political instability as a moderating variable between
inflation and fiscal deficit in Malaysia.
This paper is structured as follows. Section 2 describes the findings of previous related studies,
Section 3 explains the data sources and methodology, Section 4 presents the empirical findings, Section 5
discusses the empirical findings, and finally, Section 6 gives the concluding remarks.

2. Literature Review
Numerous studies have investigated the relationship between fiscal deficit and inflation with
both time-series and panel data. Nguyen [15] examined the impacts of fiscal deficit and money supply
(M2) on inflation in nine Asian countries and concluded that M2 and fiscal deficit have a positive and
significant impact on inflation. Lin and Chu [16] applied dynamic quantile regression model under
autoregressive distributive lag (ARDL) and investigated the fiscal deficit and inflation relationship in 91
Sustainability 2020, 12, 366 4 of 16

countries from 1960–2006, empirical results showed that fiscal deficit could be inflationary when there
is already inflation in the economy (high-inflation time) and can be less inflationary in low-inflation
time. Sergey Pekarski [17] examined shifts in moderate and hyperinflation occurring because of shifts
in monetary and fiscal policy by considering Laffer curve—represents the relationship between the tax
rate and the amount of tax collected by governments, which is used to illustrate the Laffer’s argument
that sometimes cutting tax rate can increase total revenue [25], and Olivera-Tanzi effect—an economic
situation involving a period of high inflation and a decline in tax revenues, which can divide the
budget deficit effect into two parts, one part, which is subject to negative inflation, and the second
part, which is inflation proof. Graeve and Heideken [18] discussed anticipated inflation, which is
strictly related to fiscal policy, and pointed out that warnings for fiscal inflation are always ignored in
policies. The results suggested that fiscal inflation had already induced a 1.6 percent points increase in
long-term inflation in 2001. Nandi [26] investigated the monetary policy and fiscal policy consistency
and found that under high interest rate, passive monetary policy is consistent with fiscal policy. The
study findings suggested the impact of fiscal policy on monetary policy; for instance, favorable fiscal
policy can make monetary policy expansionary. The study highlighted the issue that there is a need for
coordination between both policies. Ahmad and Aworinde [19] analyzed the relationship between
fiscal deficit and inflation in twelve African countries using quarterly data by using asymmetric
cointegration analysis, which is suitable for African countries with under-developed and imperfect
financial markets system. The study exposed that fiscal deficit is inflationary in Africa, and there
is a long-run relationship between fiscal deficits and inflation, indicating the importance of fiscal
consolidation. Montes and Limba [27] analyzed fiscal transparency and its effects on inflation, inflation
expectations, inflation volatility, and inflation expectations volatility in 82 developed and developing
countries. Their findings suggested that countries could have low inflation volatility and low inflation
expectations volatility as well as lower inflation and lower inflation expectations with a high level of
fiscal transparency; especially in developing countries, fiscal transparency has a substantial impact
on inflation. Hove et al. [28] studied the importance of institutional quality regarding the inflation
target regime in emerging market economies. The study found that monetary policy is more effective
in countries having good institutions. Canh [29] examined the effects of fiscal policy on economic
growth under the contributions of internal and external debt levels in emerging market economies.
The findings showed the fact that improvements in institutions can promote a huge crowd in the effects
of fiscal policy and reported nonlinear effects of external debt on economic growth. Jalil et al. [30] tested
the fiscal theory of price level in Pakistan covering the period from 1972 to 2012. The study exposed
the fact that fiscal deficit is a significant contributor to inflation, along with other factors like interest
rate, government sector borrowing, and private borrowing. Asterio [31] examined large fiscal deficits
and public debt (by considering fiscal and budgetary shocks) and developed a macroeconometric
model for the Greek economy. They have reported that the Greek government should try to reform
fiscal programs which can boost the Greek economy. A similar study [32] investigated the impact
of economic growth and external debt on fiscal deficit in Jordan, after using unit root and ARDL
bound test, the empirical results showed that external debt has a negative impact on the budget
deficit in Jordan. A related study reported the effects of a fiscal deficit on inflation in selected African
Countries [33]. It concluded that in Nigeria, inflation is affected positively by the fiscal deficit in the
short run and long run, while in South Africa and Kenya; there is a short run and adverse effects.
The review of studies shows that many studies have analyzed the relationship between fiscal
deficit and inflation. However, the literature is lacking in the subject domain and shows a clear gap to
fulfill. This study is considering domestic sources and external sources to finance the fiscal budget.
The domestic sources include central bank and bank institutes, while the external sources include
medium- and long-term loans and short-term loans. This study analyzes each of these sources of
financing for fiscal budget and their corresponding inflation cost so that the policymakers can target
the specific less inflationary sources to covers up the fiscal deficit.
written as:

𝐶𝑃𝐼 = 𝑓(𝐹𝐷) (1)

The above function states that fiscal deficit can be inflationary in nature. This study presents the
modified version
Sustainability 2020, 12,of
366this function by extending it to include the ways and means of financing5 the of 16
fiscal deficit in Malaysia. The government can finance the deficit by making changes in the money
supply (M2), borrowing from domestic sources (DB) and external sources (ES). In addition, political
3. Methodology
instability (PS) is included as a moderator between inflation and the sources of financing, so the next
equation can be denoted as:
3.1. Data Source and Functional Form of the Models
𝐶𝑃𝐼 = 𝑓(𝑃𝑆, 𝑀2, 𝐷𝐵, 𝐸𝑆, 𝐺𝐷𝑃) (2)
The main source of Data for this study is the Bank Negara Malaysia covering the period from
2000Domestic
Q1 to 2018 sources (DB)acan
Q4 with be categorized
sample size of 76, into
andtwo
the forms:
unit is (1)
RMCentral bank
million. borrowing
Local currency(CBB), (2)
has been
Bank
usedinstitutions borrowing
in recent studies (BIB),
in other and the such
economies, external
as insources
Hussaincanand
also be categorized
Haque [34]. This into
study two forms:a
is taking
(1) Medium-and
quantitative long-term
research borrowing
paradigm (MLT),
and using (2) Short-term
quarterly borrowing
data to identify (STL).inThus,
the changes the previous
the trends (Figure 2).
equation
Variablescan arebein written
log formas:(growth rate) and represented in small letters, except Consumers Price Index
(CPI), as it is already in percentages.
𝐶𝑃𝐼 = 𝑓(𝑃𝑆, 𝑀2, 𝐶𝐵𝐵, 𝐵𝐼𝐵, 𝑀𝐿𝑇, 𝑆𝑇𝐿, 𝐺𝐷𝑃) (3)

1st stage of
Fiscal Deficit
Estimation

Money Supply (M2)

2nd stage of
Estimation Domestic Sources of
External Sources of
Borrowing Borrowing

3rd stage of
Estimation
Medium and Short-term Central Bank Bank
Long-term Borrowing Borrowing Institutions

Figure 2. Fiscal deficit (FD) and sources of financing, that is, the printing of new money (Money
Figure 2. Fiscal
Supply), deficit
external (FD) and
borrowing, andsources of borrowing.
domestic financing, that is, the printing of new money (Money
Supply), external borrowing, and domestic borrowing.
CPI is the most commonly used indicator to gauge the level of prices. Here, CPI is used as a
measure of inflation. Inflation (CPI) is defined as a function of fiscal deficit (FD) [2,24] and can be
written as:
CPI = f (FD) (1)

The above function states that fiscal deficit can be inflationary in nature. This study presents the
modified version of this function by extending it to include the ways and means of financing the fiscal
deficit in Malaysia. The government can finance the deficit by making changes in the money supply
(M2), borrowing from domestic sources (DB) and external sources (ES). In addition, political instability
(PS) is included as a moderator between inflation and the sources of financing, so the next equation
can be denoted as:
CPI = f (PS, M2, DB, ES, GDP) (2)

Domestic sources (DB) can be categorized into two forms: (1) Central bank borrowing (CBB), (2)
Bank institutions borrowing (BIB), and the external sources can also be categorized into two forms:
(1) Medium-and long-term borrowing (MLT), (2) Short-term borrowing (STL). Thus, the previous
equation can be written as:

CPI = f (PS, M2, CBB, BIB, MLT, STL, GDP) (3)

Sustainability 2020, 12, 366 6 of 16

Variables Definitions
• Gross Domestic Product (GDP): GDP at current prices is the sum of gross value added by all
resident producers in the economy plus any product taxes and minus any subsidies not included
in the value of the products. It is calculated without making deductions for depreciation of
fabricated assets or depletion and degradation of natural resources. The data are available in the
local currency.
• Inflation: Consumer Price index (CPI) is used as an indicator of inflation. In the empirical analysis,
CPI is the most frequently used variable for the price level in the economy [35].
• Fiscal deficit: Fiscal deficit is the difference between total revenue and expenditure during the
fiscal year.
• Money supply (M2): M2 is defined as the sum of currency in circulation, other deposits with
the central bank of Malaysia (Bank Negara), including resident foreign currency deposits with
scheduled banks.
• Political instability (PS): Political instability estimates perceptions of the likelihood of political
stability or politically motivated violence. This estimate gives the country’s score on the aggregate
indicator, in units of standard normal distribution (i.e., ranging from −2.5 to 2.5).
• Central bank borrowing for budgetary support (CBB): It is the government source of borrowing
from central bank of Malaysia (BNM) directly for fiscal deficit financing through printing of new
money in economy or borrowing through ways and means advances.
• Bank institution borrowing (BIB): Bank borrowing for budgetary support is the borrowing of a
government from banking sector within the economy during the fiscal year.
• Domestic borrowing (DB): Domestic borrowing includes the central bank and other bank
institutions. In the study, domestic borrowing is categorized in two parts, central bank borrowing
and bank institutions borrowing.
• External borrowing (EB): External borrowing for fiscal deficit financing includes two main
categories: medium and long-term borrowing (MLT) and short-term borrowing (STL).

3.2. First Model

In the first model, inflation is used as a function of fiscal deficit [2]. The Gross Domestic Product
(GDP) is considered as a control variable, and the money supply (M2) is used as an endogenous
variable. The relationship between inflation and fiscal deficit is symbolically denoted as follows:

CPIt = α0 + β1 FDt + β2 GDPt + β3 M2t + εt (4)

The model domestic and external sources of financing are not included in the first model. This
model is reflecting the direct effect of fiscal deficit on inflation.

3.3. Second Model

In the second model, the previous model is modified by substituting the FD with its sources of
financing, that is, domestic borrowing (DB) and external borrowing (EB). Both sources are assumed as
endogenous for comparison purposes. In addition, political instability (PS) is acting as a moderator
between inflation and the external sources. Previously, studies reported that fiscal deficit leads to
inflation if political instability (PS) is moderating this relationship, especially in developing and
emerging economies [36,37]. Further, in most of the developing countries, the dominance of political
instability ultimately contributes to large fiscal deficit [38]. In this study, political instability (PS)
is incorporated as a moderator between inflation and sources of financing to check specifically the
significance of the PS as a moderator. The second model can be written as:

CPIt = α0 + β1 DBt + β2 EBt + β3 PSt + β4 M2t + β5 GDPt + εt (5)

Sustainability 2020, 12, 366 7 of 16

3.4. Third Model

In the third model, the subcategories of domestic sources, central bank borrowing (CBB), and Bank
institutions borrowing (BIB), and subcategories of external sources, medium- and long-term borrowing
(MLT) and short-term borrowing (STL), are included as a replacement for DB and EB. The third model
is defined as follows:

CPIt = α0 + β1 CBBt + β2 BIBt + β4 M2t + β5 GDPt + β6 PSt + β7 MLTt + β8 STLt + εt (6)

3.5. Econometric Techniques

3.5.1. Unit Root Test

This study used time-series data. Usually, time-series data illustrate trending behavior or the
problem of nonstationarity. Consequently, it is necessary to remove such a stochastic behavior to
get valid results. So, it is important or a pre-condition to test time-series properties to identify the
stationarity at levels or at first difference and second difference. These analysis steps help to select a
suitable model for data analysis. This study performs Augmented Dickey Fuller (ADF)—a well-known
test for estimation of the integration order of variables [39].

3.5.2. Auto-Regressive Distributive Lag (ARDL) Model Bound Test for Cointegration
This study used the ARDL model to test the relationship between inflation and fiscal deficit [40].
The ARDL model provides two bounds of critical values, one for I(0) and the second for I(1), where I(0)
refers to integrated at level zero, and the I(1) refers to integrated at level one. Therefore, the ARDL
model avoids the deficiencies arising due to the classification of variables according to their integration
order whether I(0) or I(1). In simple words, the ARDL model is possible to apply whether the
variable in purely I(0) or I(1) or a mixture of both. The ARDL model has advantages against the
traditional cointegration tests, such as the ARDL model is applicable even with the endogeneity issue
of independent variables [41]. In addition, the ARDL models can be helpful to explore short-run
dynamics and long-run relationships [42]. The unrestricted error correction representation of ARDL
general model is presented as follows:
p
X p
X
∆yt = α0 + β0 yt−1 + β1 xt−1 + δ1i ∆xt−i + δ2i ∆yt−i + εt (7)
i=0 i=0

where ∆ is the difference operator, p is the lag length, εt is the random error term. Yt represents the
dependent variable, xt represents the independent variables. All variables can be tested for the null
hypothesis of “No cointegration” by imposing restrictions on the joint significance. The null hypothesis
can be tested through computing F-statistics and comparing it against the lower and upper bounds
critical values [40]. If F-statistics is greater than the upper bound critical value at 5% level, then H0 is
rejected, it implies that there is a long-run relationship between the selected variables.

3.5.3. Fully Modified Ordinary Least Square (FMOLS)

Before concluding the findings, it is necessary to test the sensitivity of long-run parameters
obtained from ARDL. This analysis re-estimates the model by applying FMOLS to find out the
robustness of estimates [43]. FMOLS adopts the semiparametric approach in estimating the long-run
parameters [44]. This technique provides consistent parameters even in the small sample size and
overcomes the problem of endogeneity, serial correlation, and omitted variable bias. FMOLS adopts the
semiparametric approach in estimating the long-run parameters and estimates a single cointegrating
relationship, which is having a combination of I(1) variables [45].
Sustainability 2020, 12, 366 8 of 16

3.5.4. Dynamic Ordinary Least Square (DOLS)

DOLS adopts a parametric approach in the estimation of a long-run relationship [46]. DOLS results
are unbiased and efficient, controlling the endogeneity problem and adjusting the autocorrelation and
residual non-normality. Mathematically it can be expressed as:

i=k
X
yt = α + cxt + ∅∆Xt+i + t (8)
i=−k

where c represents the long-run elasticity, the term ∅ is the coefficient of leads and lags differences of
I(1) regressors. These coefficients are called Nuisance parameters, they adjust to avoid endogeneity,
autocorrelation, and non-normal residuals [47,48].

3.5.5. The Canonical Cointegration Regression (CCR)

Park [49] introduced canonical cointegration regression (CCR). This method can be used for
testing cointegrating vectors in a model with an integrated process of I(1). This model is quite like
FMOLS, though the difference is that CCR focusses on data transformation, while FMOLS is focusing
on the transformation and parameters as well [50]. CCR is a single-equation regression that can be
applied to multivariate regression without losing efficiency.

4. Empirical Results

4.1. Augmented Dickey Fuller Test

Variables from the first, second and third models have been tested for unit root by using Augmented
Dickey Fuller test. The results show that first- and second-stage variables are stationary at I(1). Unit
root results are mentioned with an intercept at levels while making it stationary at 1st difference.
With intercept and trend it moves the value on the left side of normal distribution. Intercept with time
trend is given below.
Yt = α + δt + ∅Yt−1 + εt (9)

The above equation includes a constant and deterministic time trend to capture the deterministic
trend under the alternative. The inclusion of intercept and trend in the test regression shifts the
distribution of t∅=1 and T (∅∗ − 1) to the left [51]. For a sample size 76, the 5% left-tail critical values
for t∅=1 and T (∅∗ − 1) are now 1.34 and −3.31 (for variable M2). In FD, t-statistic value with a constant
is negative while adding trend at first difference, the test regression further shifts the distribution to the
left. Similar, trend is observed for variables DB, BIB, and STL. In the third stage, one variable, which is
political instability (PS), is stationary at a level I(0) (see in Table 2).

4.2. First Stage Estimation

The first model (Equation (4)) has inflation as a dependent variable and fiscal deficit, GDP, and M
(money supply) as independent variables. ARDL bound test for cointegration has been performed to
analyze the long-run relationship between inflation and fiscal deficit. The model selection method
is based on the Akaike information criterion (AIC). The results are listed in Table 3. ARDL included
automatic lag selection (four lags). The null of no cointegration may not be accepted at 1% level of
significance, as F-statistics (5.40) lie outside the upper bound 4.66. Therefore, the long-run relationship
is satisfied.
Sustainability 2020, 12, 366 9 of 16

Table 2. Results of augmented Dickey Fuller (ADF) test.

Variables At Level At First Difference Conclusion

Dependent
CPI −0.089 (0.6376) −6.4413 (0.0000) *** I(1)
Variable
Stage 1 (Model in M2 1.3441 (0.9977) −3.3192 (0.0302) ** I(1)
Equation (4)) GDP 2.1967 (0.9997) −4.9957 (0.0011) *** I(1)
FD −1.6344 (0.4444) −2.6253 (0.0121) ** I(1)
Stage 2 (Model in DB −0.5024 (0.8694) −5.3468 (0.0006) *** I(1)
Equation (5)) EB 0.136477 (0.9595) −3.9580 (0.0087) *** I(1)
CBB 0.3183 (0.9719) −7.0602 (0.0000) *** I(1)
BIB −0.7007 (0.8224) −5.3723 (0.0005) *** I(1)
Stage 3 (Model in
MLT 0.2715 (0.9695) −3.3799 (0.0269) ** I(1)
Equation (6))
STL −0.1669 (0.9269) −4.3220 (0.0042) *** I(1)
PS −3.5060 (0.0203) - I(0)
Note: all variables are integrated at level 1. Value in parenthesis shows p-values. ***, ** representing stationary at
level 1% and level 5%, respectively. Rest values are t-statistic values. DB, EB, CBB, BIB, MLT, STL, PS (All variables
defined in Section 3.1.).

Table 3. Results of bound test of cointegration.

Test Statistics Value K

F-statistics 5.40 3
Critical Value Bounds
Significance I0 I1
10% 2.37 3.2
5% 2.79 3.67
1% 3.65 4.66

4.2.1. The Error Correction Mechanism (ECM) of ARDL

The ECM of the ARDL model shows short-run fluctuations along with error correction. The results
of ECM are given in Table 4. According to the short-run analysis, fiscal deficit plays a significant role
in determining inflation as it is statistically significant at 6%. The money supply is insignificant and
negatively related to the inflation rate in short run. Money supply control is not required to reduce
inflation in the short run. Previous studies have reported negative relationships between money supply
and inflation [52–54]. GDP is highly contributing to inflation by 43.43 units if there is 1 unit increase in
GDP. Correction in the error is 22 percent in every quarter of the year. However, based on the analysis,
we can say that the fiscal deficit is inflationary. In the next step, after testing the long-run relationship
and short-run error correction between variables through a bound test and ECM, respectively, it is
important to know the elasticities of long-run variables by cointegration regression.

Table 4. Results of error-correction mechanism.

Variable Coefficient Std. Error t-Statistics Prob.

∆fd 5.58 2.96 1.88 0.06 *
∆m2 −11.22 7.70 −1.45 0.15
∆gdp 43.43 7.93 5.47 0.00 ***
ECT (−1) −0.22 0.04 −5.29 0.00 ***
R2 0.56 S.E of regression 0.06
Note: ***, **, * representing level of significance at 1%, 5%, and 10% respectively. ‘Prob.’ denotes probability, and it
refers to the p-values. S.E (refers standard error), ECT (error correction term).
Sustainability 2020, 12, 366 10 of 16

4.2.2. Cointegration Regression Analysis

Cointegration regression analyses re-estimate the model by employing FMOLS, CCR, and DOLS
to find the robustness of the estimates. This study has considered the robustness of long-run parameters
by estimating the coefficients through FMOLS, DOLS, and CCR. The long-run elasticities are almost as
same as the ARDL in signs and significance (see in Table 5). The fiscal deficit is significant in ARDL,
FMOLS, DOLS, and CCR. But it can be observed that the R2 value from FMOLS and CCR is quite a lot
less, while DOLS and ARDL R2 values are good. It can be because of the semiparametric approach of
FMOLS. The FMOLS and CCR almost give the same results with the long-run variance 0.04. DOLS
model is a good fit for the model in Equation (4), having low long-run variance value. The ARDL
fd, GDP and m are statistically significant. GDP and inflation are having an inverse relationship,
as mentioned in [55]. Inflation reduces the level of investment, which adversely affects the economic
growth of a country [56–58]. The money supply is positively related to inflation.

Table 5. Results of cointegration regression analysis (long-run coefficients).

Variable ARDL FMOLS DOLS CCR

C 4.07 (3.56) 10.53 (10.20) 6.88 (8.91) 10.03 (10.07)
Gdp −26.32 * (15.90) −1.53 (1.44) −1.004 (1.24) −1.44 (1.41)
Fd 5.75 ** (2.90) 1.09 *** (0.33) 1.01 *** (0.28) 1.04 *** (0.31)
m2 25.04 * (13.46) 2.14 * (1.26) 1.66 (1.09) 2.03 * (1.21)
Long-run variance 0.04 0.01 0.04
R2 0.85 0.21 0.76 0.21
Note: ***, **, * representing level of significance at 1%, 5%, and 10%, respectively. The values in the parentheses
are standard errors. Autoregressive Distributed Lag (ARDL), Fully Modified Ordinary Least Squares (FMOLS),
Dynamic Ordinary Least Squares (DOLS), and Canonical Cointegration Regression (CCR).

4.3. Second Stage of Estimation

In the second stage of estimation, fiscal deficit is replaced by external and domestic sources of
financing. Most importantly, political stability has been used as a moderator between inflation and its
source of financing. It can be observed specifically which source of financing is contributing more to
the inflation and political instability (PS) effect on inflation. In the second model (Equation (5)), four
variables are used as dependent variables, that is, external sources of financing and domestic sources
of financing, money supply, and Gross domestic product.
The results of the ADRL bound test are shown in Table 6. The null of no cointegration may not be
accepted at a 1% level of significance, as F-statistics (10.38) lies outside the upper bound 4.37. Therefore,
the long-run relationship is confirmed.

Table 6. Results of bound test of cointegration.

Test Statistics Value K

F-statistics 10.38 4
Critical value
Bounds
Significance I0 I1
10% 2.2 3.09
5% 2.56 3.49
1% 3.29 4.37

4.3.1. The Error-Correction Mechanism (ECM) of ARDL

The domestic borrowing is highly insignificant, as the corresponding obtained coefficient value is
0.03, as shown in Table 7. The external source of borrowing is significant and impactful as its coefficient
value is 1.31. Political instability is statistically significant and negatively related to inflation in the
Sustainability 2020, 12, 366 11 of 16

short run. ECT term representing the short-run adjustments in equilibrium as 11% convergence is
possible to the equilibrium quarterly.

Table 7. Results of error-correction mechanism of ADRL.

Variable Coefficient Std.Error t-Statistics Prob.

∆eb 1.31 0.31 4.13 0.00 ***
∆db 0.03 0.35 0.10 0.91
∆ gdp 15.85 1.67 9.46 0.00 ***
∆PS −0.44 0.22 −2.002 0.04 **
ECT(-1) −0.11 0.01 −8.20 0.00 ***
R2 0.61 S.E of regression 0.06
Note: ***, **, * representing level of significance at 1%, 5%, and 10%, respectively. “Prob.” denotes probability, and it
refers to the p-values.

4.3.2. Cointegration Regression Analysis

The ARDL, FMOLS, DOLS, and CCR show the significance of domestic borrowing and have a
negative relationship with inflation, as shown in the long-run analysis in Table 8. External borrowing
is insignificant in all techniques and has a negative relationship with inflation. The external borrowing
may be positive if utilized for productive purposes (investment), it can put negative effects on the
economy if utilized for private or public consumption [59]. So external borrowing can be more
inflationary if utilization is not productive. In the long-run analysis, political instability is not
statistically significant. The DOLS and ARDL R2 values are 75% and 90%, respectively.

Table 8. Results of Cointegration Regression Analysis (Long-run Coefficients).

Variable ARDL FMOLS DOLS CCR

c −61.68 * (31.90) −21.18 *** (5.82) −10.03 (15.19) −7.45 (15.06)
gdp 7.96 * (4.57) 2.43 *** (0.66) 0.55 (2.13) 0.40 (2.17)
PS −0.47 (0.71) 0.27 (0.34) 0.57 (0.38) 0.30 (0.28)
m2 −1.79 (4.57) 1.88 (1.90) 2.46 (1.77) 2.03 * (1.21)
eb −0.69 (0.58) −0.39 (0.29) −0.52 (0.33) −0.3 (0.27)
db −3.73 *** (1.39) −1.32 ** (0.55) −1.76 *** (0.51) −1.31 ** (0.53)
Long-run variance 0.04 0.01 0.04
R2 0.90 0.30 0.75 0.30
Note: ***, **, * representing level of significance at 1%, 5%, and 10%, respectively. The values in the parentheses are
standard errors. Variables defined in Section 3.1.

4.4. Third Stage of Estimation

In the third stage of estimation, domestic borrowing and external borrowing are further divided
into two categories to get the specific results. The domestic borrowing includes bank institution
borrowing and central bank borrowing; while the external borrowing includes medium- and long-term
borrowing and short-run borrowing. The results for ARDL bound test for long-run relationships are
given in Table 9. The null of no cointegration is rejected at a 1% level of significance, as F-statistics
(5.18) lies outside the upper bound 3.9. Therefore, the long-run relationship is satisfied.
Sustainability 2020, 12, 366 12 of 16

Table 9. Results of bound test of cointegration.

Test Statistics Value K

F-Statistics 5.18 7
Critical value Bounds
Significance I0 I1
10% 1.92 2.89
5% 2.17 3.21
1% 2.73 3.9

4.4.1. The Error Correction Mechanism (ECM) of ARDL

The variables bib and cbb are significant but have less impact on inflation as 0.004 and 0.003,
respectively, as shown in the short-run results in Table 10. The relationships of cbb and bib with
inflation are positive. From external sources, the variables mlt and stl are both significant and have a
large impact on inflation. In addition, PS is highly insignificant in this model (refers to Equation (6)).
ECT term shows a 17% error correction in the model per quarter.

Table 10. Results of error-correction mechanism.

Variable Coefficient Std.Error t-Statistics Prob.

∆bib 0.004 0.002 2.03 0.04 **
∆cbb 0.003 0.001 3 0.00 ***
∆gdp 35.38 8.31 4.25 0.00 ***
∆PS 0.85 1.01 0.84 0.40
∆m2 10.74 7.86 1.36 0.17
∆ mlt 9.09 3.76 2.41 0.01 **
∆ stl 4.83 2.37 2.03 0.04 **
ECT(-1) −0.17 0.02 −7.30 0.00 ***
R2 0.60 S.E of regression 0.31
Note: ***, **, * representing level of significance at 1%, 5%, and 10%, respectively.

4.4.2. Cointegration Regression Analysis

As mentioned earlier, this study considered to estimate long-run elasticities using FMOLS, DOLS,
and CCR. The variable bib (bank institution borrowing) is significant in all methods, having less
impact on inflation, and the variable mlt (medium- and long-term borrowing) has a significant and
negative impact on inflation, see in Table 11. The variables bib and cbb are less-inflationary; while
the subcategories of external sources, stl and mlt are inflationary. A negative relationship between
external borrowing and inflation was reported in previous studies, like [60] and [59], showing that
external debt and inflation could have negative effects. External borrowing causes a rise in government
expenditures and in that case, the inflation rate may get increased. However, the negative sign is
reflecting the weak moderate inflation, (i.e., moderate inflation used as a proxy of macroeconomic
stability in [19]). Such situations occur when governments consume a large portion of external debt
on unproductive activities, which is diminishing the moderate inflation or macroeconomic stability
and putting inflationary pressures. Referring to the results reported in Tables 8 and 11, the domestic
borrowing (db), medium- and long-term borrowing (mlt) reflect that a significant portion of borrowing
is consumed by the government on unproductive activities, producing a significant rise in inflation.
In the long run, external sources are more sensitive to inflation. In this model (refers to Equation (6)),
the DOLS (parametric) R2 value is higher than the FMOLS and the CCR values; while the R2 value
obtained for ARDL is 89%.
Sustainability 2020, 12, 366 13 of 16

Table 11. Results of cointegration regression analysis (long-run coefficients).

Variable ARDL FMOLS DOLS CCR

c 760.44 (464.47) −128.22 * (71.26) 136.40 (103.44) −117.007 (71.98)
bib 0.001 ** (0.0007) 0.007 *** (0.002) 0.001 *** (0.0002) 0.007 *** (0.002)
Cbb 0.001 (0.0009) 0.0017 (0.0019) 0.004 (0.003) 0.002 (0.001)
PS 1.10 (3.20) 2.29 (1.42) 0.6 (1.72) 2.15 * (1.16)
m2 72.97 * (40.14) −5.15 (8.79) 46.48 *** (15.89) −3.38 (9.13)
gdp −102.56 * (60.12) 14.77 (10.03) -36.06 (16.50) 12.85 (10.44)
mlt −3.57 (9.47) −5.67 * (3.07) 13.05 * (6.50) −5.32 * (3.03)
stl 9.18(9.31) 3.83 (2.63) 9.43 * (5.22) 3.68 (2.45)
Long-run variance 0.8 0.3 0.08
R2 0.89 0.47 0.83 0.45
Note: ***, **, * representing level of significance at 1%, 5%, and 10%, respectively. Values mentioned in parenthesis
are standard errors.

5. Discussion
Numerous studies have reported the relationship between inflation and fiscal deficit and concluded
different findings [16,19,29,30]. Theoretically, the fiscal deficit is inflationary, but the impact and
significance of its source of financing on inflation are varied. The analysis of this study is carried out
in three stages of estimation. In the first-stage estimation, the model in Equation (4) is used; in the
second-stage estimation, the model in Equation (5) is used; and in the final third-stage estimation,
the model in Equation (6) is tested. In the first model, which can be called in general a model, inflation is
depending on the overall fiscal deficit, money supply, and the GDP. Through the ARDL bound test, it is
confirmed that there is a long-run relationship between inflation and fiscal deficit. While analyzing the
short-run estimation, there is also a short-run relationship between inflation and fiscal deficit, but it is
significant at 6%. In this study, after finding the short-run and the long-run relationship, the sensitivity
of parameters is also estimated by using ARDL, FMOLS, DOLS, and CCR techniques. The coefficient
of fiscal deficit is 5.75 in ARDL, 1.09 in FMOLS, 1.01 in DOLS, and 1.04 in CCR findings. All coefficients
are positive, as expected, and significant at 1% and 5%. Increasing fiscal deficit implies an increase
in inflation. Malaysia’s economy is facing a fiscal deficit, and then obviously, the government must
face its inflation cost as well. In the same model, the money supply has shown a significant impact on
inflation. Due to the fiscal deficit, a country may print new money, which can create inflation. As Lin
and Chu [16] discussed, if inflation is already high, then the fiscal deficit may produce more inflation,
but on the other hand, the fiscal deficit can be less inflationary in a steady inflation period.
In the second stage of estimation, the fiscal deficit is replaced by two main sources of financing, that
is, the external source of borrowing and domestic source of borrowing, along with political instability
as a moderator. The political instability is not included in the first stage of estimation because in the
first stage, the aim is to find out the overall impact of fiscal deficit on inflation, GDP, and Money supply.
In the second stage, it can be explicitly observed how the political instability moderates the relationship
between the sources of financing and inflation, see Table 7. Hence, according to the findings, there
is a long-run relationship between the sources of financing and inflation. In the short-run analysis,
the external sources of borrowing have also shown a short-run relationship with inflation, when the
government borrows money from the external sources to cover up the fiscal deficit, affecting the
money supply in the country’s economy and causing inflation in the short run. On the other hand,
domestic borrowing has a long-run relationship, if the government takes domestic borrowing, which
may not be in a large amount and may not be affecting in the short run, but in the long-run, it is
significantly inflationary, see Table 8. Political instability is also one of the critical factors which can
affect inflation. Recently, the Malaysian government has changed through their democratic process,
resulting in changes in the revenue structure and the regulations, which affected the price level in
the market.
Sustainability 2020, 12, 366 14 of 16

In the third stage of estimation, the external sources, including short-, medium-, and long-term
borrowing, are having a short-run relationship with inflation. The short-term borrowing can be helpful
for the government to support the fiscal deficit because the short-term borrowing is less-inflationary
relative to medium- and long-term borrowing. In the long-term analysis, it is very clear from the
findings that the central bank borrowing and the Bank institution borrowing have a less and significant
impact on inflation. Utilization of these funds must be productive when the government funds fail to
achieve development policy over the long term, and it can seriously damage the fiscal stability [61].
On the other hand, the government is relying on medium- and long-term borrowing and short-term
borrowing to achieve the gap in the fiscal deficit, which is inflationary. In specific analysis (after
dividing the external and domestic sources), political instability is not significantly affecting the market
price levels.

6. Conclusions
The primary aim of this study is to explore the less inflationary sources to finance the fiscal deficit
and to analyze the long-run and short-run relationships between sources of financing fiscal deficit
and inflation. Further, political instability is used as a moderator between sources of financing and
inflation to check its significance. The findings from the first-stage analysis conclude that the fiscal
deficit is inflationary in the country. From the second stage of estimation, this study concludes that
political instability moderates the link between sources of financing and inflation. The external source
of financing may be inflationary in the short run. Similarly, from the third stage of estimation, the
study concludes that central bank borrowing and bank institution borrowing (domestic sources) have
less impact on inflation, medium- and long-term borrowing are more sensitive relative to the short-run
borrowing. In the short run, the government can rely on external sources for short-term borrowing
(as they are less inflationary in the short run), and for a long-term policy, domestic sources for central
bank borrowing and bank borrowing can be used, as these sources are found less inflationary.
The findings of this study recommend that Malaysia’s Government should rely on domestic
borrowing for long-term bases and external borrowing (short-term loans) for short-term periods as
they are found to be less inflationary. Besides, the study highly recommends the fiscal consolidation
for the Malaysian’s economy.

Author Contributions: Conceptualization and methodology, H.K. and M.M.; formal analysis, H.K.; M.M.; and
F.-W.L.; investigation, H.K.; and M.M.; validation, H.K., M.M.; and F.-W.L.; writing—original draft preparation,
H.K.; writing—review and editing, M.M.; and F.-W.L.; supervision, M.M.; and F.-W.L. All authors have read and
agreed to the published version of the manuscript.
Funding: This research received no external funding.
Acknowledgments: This study is supported by Universiti Teknologi PETRONAS, Malaysia.
Conflicts of Interest: The authors declare no conflict of interest.

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