SYMPOSIUM

Current Account and Fiscal Deficits:

Evidence from Five Developing Economies of
Asia
EMMANUEL ANORUO and SANJAY RAMCHANDER

The persistent and coinciding fiscal and external trade deficits have been in the economic
spotlight largely because of its important policy implications concerning the long-term via-
bility of economic progress. Most studies on the subject have focused attention on the rela-
tionship between the two deficits in developed countries such as the United States. The
present study, in contrast, uses multi-variate time series analysis to extend the "twin defi-
cits" debate to five developing Southeast Asian economies--namely, India, Indonesia,
Korea, Malaysia and the Philippines. The discussion is especially relevant given the back-
drop of the current economic crisis that is engulfing many Asian economies, and the plau-
sibility that there could be wide disparities in the macroeconomic dynamics governing
fiscal and current deficits between developing and developed economies. Specifically,
Granger causality test based on a vector autoregressive (VAR)model is utilized to underpin
the direction of causality between the two deficit series. Contrary to most findings in the lit-
erature, this study finds trade deficits to cause fiscal deficits and not vice versa. A case for
increased government spending in response to the domestic hardships caused by a worsen-
ing of trade balance is made. Furthermore, the study identifies several other macroeco-
nomic variables that jointly influence the twin deficits, thus highlighting some degree of
commonality in the twin deficit nexus. A number of policy implications are derived. [JEL:
E620, F400]

Emmannel Anorno • Department of Management Science & Economics, Coppin State College, Baltimore, MD 21216. Tel:(410)
383-5582. Emaih eanoruo@coppin.edu. Sanjay Ramchander • Department of Finance, Insurance and Real Estate, Minnesota State
University, Mankato, MN 56002. Tel: (507) 389-5345, Email: SANJAY.RAMCHANDER@MANKATO.MSUS.EDU
Journal of Asian Economics, Vol. 9, No. 3, 1998 pp. 487-501 Copyright © 1998 by JAI Press Inc.
ISSN: 1049-0078 All rights of reproduction in any form reserved.

487
488 JOURNAL OF ASIAN ECONOMICS 9(3), 1998

I. INTRODUCTION

The issues concerning federal deficits, public debt, and current account balance have
been in the economic spotlight during the last two decades. The dramatic increases of
both fiscal and trade deficits, popularly referred to as the 'twin deficits', have led
many experts to posit a causal linkage between the two variables (for example, see
Rosensweig & Tallman, 1991, 1993). This article seeks to investigate the twin deficit
relationship across five developing countries in Southeast Asia--India, Indonesia,
Korea, Malaysia and the Philippines. All of these countries have witnessed both large
and unprecedented trade deficits as well as massive federal budget deficits in recent
years. For instance, India's trade deficits rose from Rupees 44.8 billion ($5.6 billion)
in 1980 to Rupees 1006 billion ($38.4 billion) in 1992. During the same period, fed-
eral budget deficits soared from Rupees 88.6 billion ($11 billion) in 1980 to more
than Rupees 366 ($14 billion) in 1992. The experiences of other Southeast Asian
countries are very similar in nature, i.e., large fiscal deficits accompanied by widening
trade deficits.
The issues involving current account and fiscal deficits have important policy
implications concerning the long-term viability of economic progress of a developing
nation. 1 Persistent large trade deficits are troublesome due to the associated transfer
of wealth to foreigners and the burden that this imposes on future generations. Sup-
pose that the basic reason for rising trade deficits is indeed the escalating central gov-
ernment budget deficit, then the current account balance cannot be remedied unless
policies that address government deficits are put into place. However, if such a view
concerning the "causal" role of the budget deficit is incorrect, then reductions in the
federal budget deficits may not resolve the trade deficit dilemma and, moreover,
scarce economic resources will be diverted from more relevant and urgently needed
policy options (see Belongia & Stone, 1985).
Not surprisingly, because of its policy implications, the twin deficit relationship
has been extensively studied in the U.S. and other developed economies. The current
body of evidence does not yield a consensus on the relationship between government
and trade deficits. Some studies using a Mundell-Fleming framework indicate that the
twin deficit nexus of a causal relationship between budget and trade deficits is consis-
tent with the data. In contrast, other studies, finding no underlying relationship
between government and trade deficits, are consistent with the predictions of Ricard-
ian equivalence.
The purpose of this study is to empirically investigate the twin deficit hypothesis
for five Southeast Asian countries, that persistent fiscal deficits have been the prime
"cause" of the escalating trade deficits. The paper makes several important contribu-
tions to the existing literature on the twin deficit debate. First, the study employs the
Granger causality test based on a vector autoregressive model (VAR) to underpin the
causal ordering of the deficit variables. The estimation technique places minimal
restrictions on the explicit structure of the relationship. This is a definite methodolog-
ical improvement over similar studies that base their analyses on either direct com-
Current Account and Fiscal Deficits 489

parison of data, or at best, correlation-based analyses to reach their conclusions

concerning the "causal" relationship between budget and trade deficits. Second, the
study includes mediating variables namely - short term interest rates, exchange rates,
real output, and inflation known to influence the twin deficits. The inclusion of medi-
ating variables mitigates the possibility of distorting the causality inferences due to
the omission of relevant variables. Moreover, research into the twin deficit's story
requires explicit examination of the entire set of variables that may relate meaning-
fully to fiscal and trade balance behavior. Finally and perhaps most important, apart
from its obvious policy implications, the discussion is particularly relevant since there
is little empirical attention devoted to the twin deficit relationship for developing
economies with nascent stock markets and potentially unique transmission mecha-
nisms mediating current account and fiscal policies. The experiences of a developing
country are arguably very different from that of large industrialized nations. For
instance, developing countries are generally plagued with an inefficient public enter-
prise, deficient infrastructure, tight trade controls, restrictive regulations in the finan-
cial sector and political uncertainty. Under these conditions, there could be wide
disparities in the macroeconomic dynamics governing fiscal and current deficits
between developing and developed economies.
The remainder of the article is organized as follows. The next section uses the
saving-investment identity to discuss the basic analytical views in relation to the
twin-deficit nexus. The third section reviews the empirical literature in this area,
as they predominantly apply to the United States. Section IV discusses the data
and methodology. The results of the study are presented in Section V. The final
section summarizes the major findings of the study and makes several policy
implications.

II. THE ANALYTIC F R A M E W O R K

Most open-economy macroeconomic models reflect the pioneering work of MundeU

(1962, 1963) and Fleming (1962), which essentially extend the Keynesian model by
introducing the external sector. In the Mundell-Fleming framework, the effect of fis-
cal policy depends on various factors - particularly the exchange rate regime. More
specifically, under fixed exchange rates, the fiscal stimulus generates higher real
income or prices, and this worsens the current account balance. Under the flexible
exchange rate regime, an increased government deficit (1) places incipient upward
pressure on real, or inflation-adjusted, interest rates, (2) the higher interest rates
induce foreign capital inflows thereby raising the foreign exchange value of the coun-
try's currency, and (3) the stronger currency in turn reduces net exports (i.e., exports
minus imports). Thus, the model implies that government deficit ultimately widens
the trade deficit under both fixed and flexible exchange rate regimes, although the
transmission mechanisms differ.
490 JOURNAL OF ASIAN ECONOMICS 9(3), 1998

The above hypothesized relationship between the two deficits can be formally
stated by using a variant of the saving/investment identity from the National Income
and Product Account:

Gross National Investment = Gross National Savings (I)

The identity can be disaggregated into a familiar form:

I = SH + SB + SG + S F (2)

where
I = net private domestic investment
Sn = household saving
SB = net business saving
SG = government saving (tax revenue minus spending)
SF = foreign saving (trade deficit with a negative sign)

It is important to note that while the saving-investment framework does not indi-
cate any behavioral or temporal relationships, it does predict that a policy-induced
increase in the fiscal deficit causes S G to fall exogenously. If one considers the saving-
investment identity as an equilibrium condition, then such a decrease in S G will
induce either an increase in S n + S B + S f or a decrease in I.
Under the Mundell-Fleming model, a fall in S G (an increase in fiscal deficit) is
associated with a fall in I (crowding out private investment spending), a rise in S F
(increasing trade deficit), or both. People are assumed to implicitly perceive that gov-
ernment bonds issued to finance deficit expenditure as increasing their net wealth.
Thus, they do not see a need for an offsetting increase in their private savings (SH+SB)
to cover future tax liabilities arising from the deficit financing. It is, however, impor-
tant to note that the response of I and S F to a larger fiscal deficit hinge on the degree
of capital mobility. If capital is highly mobile, then the domestic interest rates are rel-
atively inelastic to a fiscal stimulus - thus not crowding out domestic investment -
since foreign funds quickly offset the drain on domestic saving that the larger fiscal
deficit generates. These capital inflows put upward pressure on the real exchange rate,
through either a rising nominal exchange rate (under flexible rates) or a rising domes-
tic price level (under fixed rates). Thus, a positive relationship emerges between gov-
ernment deficits and trade deficits.2

IlL LITERATURE REVIEW

The connection between the twin deficits in the United States and other developed
countries has been made by a number of researchers such as Volcker (1984), Hakkio
and Higgins (1985), Kvansicka (1985), Laney (1986), Cheng (1987), Dan'at (1988),
Current Account and Fiscal Deficits 491

Miller and Russek (1989), and Rosensweig and TaUman (1991). While each of the
above papers provides considerable insights into the topic, a consensus has yet to
emerge. Moreover, as important as this issue is, there has been at best very little
empirical attention devoted to the application of this debate to the "newly industrial-
ized countries" in Southeast Asia. Consequently, much of the review in this section
focuses on the evidence reported on U.S. trade and fiscal deficits.
Questions pertaining to the impact of fiscal deficits on trade deficits have been
empirically addressed in two ways. First, researchers have provided indirect and sup-
plemental evidence about the twin deficit relationship by attempting to establish the
impact of fiscal deficits on interest rates, exchange rates, and other proximate deter-
minants of the trade deficit. For instance, in two related papers, Evans (1985, 1986)
finds no reliable relationship between budget deficits on the one hand and either inter-
est rates or exchange rates on the other for the United States. Batten and Belongia
(1984) provide somewhat less ambiguous evidence on the hypothesized relationship
between the value of a country's currency and the amount of its net exports. They sug-
gest that trade deficits in the U.S. are to some extent inversely related to the exchange
value of the dollar, though the response is both small and sluggish. In sum, lack of
empirical validity between the federal deficit-interest rate, and federal deficit-
exchange rate linkages casts some doubt on the conventional view that higher budget
deficits have necessarily caused higher trade deficits.
Second, researchers have examined the relationship by providing direct empirical
evidence based on regression analysis. Milne (1977), for instance, in her study of 38
countries using annual data from 1960 to 1975, finds a positive and statistically sig-
nificant relationship between the trade deficit and the fiscal deficit. More recent evi-
dence suggests that a $1 increase in fiscal deficit leads to a corresponding trade deficit
increase of anywhere between 25 cents and $1.00 (see Summers, 1986; Miller &
Russek, 1989). Additional evidence by Rosensweig and Tallman (1991), Enders and
Lee (1990), and Abell (1990) suggest that movements in the government deficit have
a causal impact on trade deficit after controlling for real interest and exchange rates.
In contrast, Evans (1989) provides empirical evidence corroborating the Ricardian
equivalence, in that there is no clear relationship between the two deficits, using data
from Canada, France, West Germany, Italy, Japan, the United Kingdom, and the
United States.

IV. DATA AND M E T H O D O L O G Y

Data

The study uses observations of fiscal deficit (FD) and trade deficit (TD) for five
Southeast Asian countries--namely India, Indonesia, Korea, Malaysia and the Philip-
pines. These countries, like others in Asia, have in the recent past initiated several
market-oriented policies such as liberalizing the industrial, trade and exchange-rate
492 JOURNAL OF ASIAN ECONOMICS9(3), 1998

regime; pursuing aggressive export promotion policies; and achieving rapid eco-
nomic growth. Therefore, the choice of the above countries in the investigation is not
without merit. The sample period chosen for the study varies for each country
depending on the availability of data - India and Philippines: 1957 to 1993; Malaysia:
1960 to 1993; Korea: 1967 to 1993; and Indonesia: 1970 to 1993. The data are
obtained from the database of the International Monetary Fund.
In order to eliminate the upward bias in the deficits that can be brought about by
increases in the price level and economic growth, the nominal deficit series are scaled
by the nation's gross domestic product. Although the main focus of this paper is on
the twin deficit relationship, a multi-variate rather than a bi-variate framework is
employed in order to avoid distorting the causality inferences due to the omission of
relevant variables. These additional variables include the short-term government
interest rates (R), the trade-weighted exchange rate of the local currency (E), gross
domestic product (Y), and inflation (INF). Various theoretical considerations suggest
the importance of these mediating variables in the budget/trade deficit process (see
Belongia & Stone, 1985; Bradley & Potter, 1986). Thus, in addition to testing for the
causal relationship between the two deficits, the study will also shed light on the
causal effect of these other macroeconomic variables on trade and budget deficits.

Methodology

The study employs the VAR model to underpin the direction of causality (in a
Granger-sense) between fiscal and trade deficits. The model provides a convenient
estimation procedure to investigate data relationships while imposing little structure.
This feature is particularly appealing since the analytical framework discussed earlier
do not imply a specific dynamic structure. The VAR specification allows each vari-
able (fiscal and trade deficit in the present case) to be affected by its own history and
those of the other variables in the system. Causal ordering among the variables can
thus be established without a priori restrictions of exogeneity.
The deficit series are fitted to the following VAR system:

n r/ m

(FD/Y)t = ~, °~iLi(FD/Y)t + ~, ~i Li(rD/Y)t + ~, ~i t i x t + Et (3)

i=1 i=1 i=0

Y/ n m

(TD/Y)t = ~, t~iLi(TD/Y)t + ~, ~i Li(FD/Y)t + ~ ~[iLiXt + Et (4)

i=1 i=1 i=0

FD/Yis the ratio of fiscal deficit to GDP; TD/Yis the trade deficit scaled by GDP;
L i is the lag operator associated with each I; and X is a vector of control variables that
includes interest rates, exchange rates, output, and inflation. Akaike's (1973) mini-
Current Account and Fiscal Deficits 493

mum Final Prediction Error (FPE) criterion is employed in the selection of the opti-
mal distributed lag structure. The F-statistic is used to indicate the significance of the
causality.
Prior to reporting the empirical results from the VAR model, a few methodologi-
cal notes are in order. First, VAR estimation is strictly appropriate only when all the
variables in the model are stationary (see Charemza & Deadman, 1992, p. 194). If
stochastic trends exist, detrended values of the time-series with appropriate differenc-
ing should be used to make the regression analysis meaningful. The test statistic sug-
gested by the augmented Dickey-Fuller (ADF) estimation is used to detect stochastic
trends in the time-series. 3 Second, to overcome the problem of contemporaneous
covariance (see Theil, 1971, p. 298), the system is estimated using full information
maximum likelihood, thus generating estimates that are asymptotically more efficient
than equation-by-equation OLS. Finally, it may be posited that the twin deficit nexus

TABLE 1. ADF Unit Root Test Statistics

Country/
time pe~od Series Level First Difference
India TD/Y -2.06 -4.08 ~
1957-1993 BD/Y - 1.27 -3.87"*
Y 0.33 -3.58**
E -1.37 -3.82**
R -3.92 -6.81"*
INF -4.71"*
Indonesia TD/Y -3.31"*
1970-1993 BD/Y - 1.92 -6.28**
Y 0.42 -3.07**
E 0.14 -3.62**
R - 1.51 -3.42**
INF - 1.88 -4.00**
Korea TD/Y - 1.74 -3.29"*
1967-1993 BD/Y -2.19 -5.13"*
Y -0.23 -3.65**
E -0.99 -4.74**
R - 1.84 -4.07**
INF - 1.85 -4.41"*
Malaysia TD/Y -3.42**
1960-1993 BD/Y -2.24 -4.86**
Y 0.31 -4.01"*
E - |.34 -3.54**
R - 1.64 -5.15**
INF -2.39 -4.10"*
Philippines TD/Y -0.52 -3.43**
1957-1993 BD/Y -2.26 -8.31"*
Y 0.33 -5.12"*
E 1.03 -5.30**
R - 1.87 -4.59**
INF -2.92 -5.16**
494 JOURNAL OF ASIAN ECONOMICS 9(3), 1998

is a long run behavioral relationship whose analysis requires methodologies for esti-
mating a long run equilibria. Wu et al. (1996), for instance, apply unit root and coin-
tegration tests to examine the sustalnability of the current account deficits in the U.S.
and Canada. The statistical methodology used in this study, on the other hand, limits
us to an estimation of only the short- run dynamics between the two variables and
hence, do not permit the estimation of long-run equilibrium states.

V. RESULTS

Table 1 documents the ADF tests for stationarity of the deficit variables and the addi-
tional control variables employed in the VAR estimation. The null hypothesis that the
time series have unit roots (are nonstationary) is tested against the alternative of no
unit roots. It can be observed that, with the exception of the trade deficit variable (for
Indonesia and Malaysia) and inflation (for India), unit roots are present in all the vari-
ables. On the other hand there is strong statistical evidence to support the hypothesis
the remaining variables are integrated of order I (1). In other words, the ADF statistics
generally reject the presence of unit roots in first differences in these variables.
In the VAR analysis for causality tests, the variables are detrended to make them
stationary by taking the first differences. The individual country and pooled estima-
tion results are reported in Panels A and B of Table 2. Based on Panel A, the hypoth-
esis that fiscal deficits do not cause (in the Granger-sense) trade deficit is not rejected
for all countries with the exception of Malaysia. But, one can immediately note from
Panel B that there is very little evidence to support the reverse hypothesis that trade
deficits do not Granger-cause fiscal deficit for the countries investigated. These
results, taken together, indicate that fiscal deficits are not causally prior to trade defi-
cits, while on the other hand, trade deficits are causally prior to fiscal deficits. A some-
what weak bi-directional causality between the twin deficits is noted in the case of
Malaysia. Furthermore, the pooled estimation results are consistent with those of the
individual country results, in that there is a prima facie causal relationship flowing
from trade deficit to fiscal deficit. 4
Such evidence of uni-directional causality from current account to budget deficit
is contrary to what is documented for the U.S. and other developed economies. A
direct comparison of our results with earlier evidence is not possible because of dif-
ferences in the empirical techniques, data measures, and samples employed. None-
theless, the seemingly anomalous evidence may be attributed to the fact that the
central governments of some developing countries step-up their own spending in an
attempt to lessen the deleterious economic and financial consequences of trade imbal-
ance. For instance, if large trade deficits are found to harm the domestic manufactur-
ing industries leading to unemployment and losses in foreign market share, the
government may opt to consciously expand its aid to these industries. Under this sce-
nario not only has government spending been increased, but government revenues
have also declined due to depressed business activities in the export sector, and due to
 TABLE 2. Multivariate Granger Causality Tests: F Statistics
India Indonesia Korea M a l a y s i a Philippines Pooled
(n=37) (n=24) (n=27) (n=34) (n=37) (n =159)
Panel A: TD/Y Equation:
FD does not Cause TD 0.14 0.22 2.70 4.23** 1.73 0.22
Y does not Cause TD 4.58** 0.66 0.19 3.59** 1.66 0.10
R does not Cause TD 3.25* 0.43 1.37 0.74 1.50 4.93***
E does not Cause TD 1.67 1.00 1.12 1.48 0.84 0.15
INF does not Cause TD 3.81"* 0.84 3.00* 2.56* 1.11 0.62
Panel B: FD/Y Equation:
TD does not Cause FD 6.62*** 6.19"** 4.42** 6.03*** 3.74** 3.39**
Y does not Cause FD 8.36*** 5.94** 2.99 2.66* 10.17"** 1.78
R does not Cause FD 3.83** 4.94** 0.36 2.60* 3.28** 2.88**
E does not Cause FD 3.06** 4.54** 3.66** 1.40 11.42"** 34.06***
INF does not Cause FD 0.48 2.09 6.58** 1.59 13.58"** 3.42"**
Note: *,**,*** in Tables 1 and 2 indicate statistical significance at the 10%, 5% and 1% level respectively

',O
496 JOURNAL OF ASIAN ECONOMICS 9(3), 1998

the automatic stabilizing aspect of fiscal policy. In addition, the evidence found may
be representative of some of the structural differences that exist between developed
and emerging economies. 5
The Granger-causality test results reported in Table 2 are also useful for examin-
ing the causal influence of a number of other macro variables on the fiscal and trade
deficit process. An examination of the pooled estimation results in Panels A and B
reveal that movements in the interest rate variable have a direct stimulating effect on
both the current account balance and budget deficit. Additionally, the coefficients for
both trade-weighted exchange rate and inflation are found to be statistically signifi-
cant in the fiscal deficit equation. Thus, there is some evidence on the degree of com-
monality in the deficit generating process. Policy attempts to reduce the twin deficits
would therefore fall short of its objectives, unless it includes measures to influence
interest rates, exchange rates and the price level.

,q

-2
10
Fcriods

FIGURE 1A. Pooled Data: Response of Budget Deficit to Shocks in Trade Deficit

-1

-2

Periods

FIGURE lB. India: Response of Budget Deficit to Shocks in Trade Deficit

Current Account and Fiscal Deficits 497

06

0.4

0.2

0.0

-0.2

-0.4

-0.6

Periods

FIGURE 1C. Indonesia: Response of Budget Deficit to Shocks in Trade Deficit

0.6

.j 0.4

0.2

I 0.0

-0.2

-0.4
2 3" i "5" 0 "/ S ..... to
]~ods

FIGURE 1D. Korea: Response of Budget Deficit to Shocks in Trade Deficit

1.5

1.0
8
0.5

0.0

-0.5

-1.0
~ ~ .....~ '~ ~ 8 ..... 9 .....io
Periods
FIGURE 1E. Malaysia: Response of Budget Deficit to Shocks in Trade Deficit
498 J O U R N A L OF A S I A N E C O N O M I C S 9(3), 1998

1,2

0.8

0.4

g
0.0

..0.4

-0.8
10
Periods
FIGURE IF. Philippines: Response of Budget Deficit to Shocks in Trade Deficit

To obtain additional insight into the transmission mechanism of the twin deficit
process, impulse response functions are computed. The pattern of dynamic response
of the fiscal deficit to innovations in the trade deficit is traced by using the simulated
response of the estimated VAR system. The normalized impulse response of the budget
deficit to a typical shock, i.e. positive shocks of one standard deviation in the trade def-
icit, is provided in Figure 1A-1E Looking at the impulse response function pooled
from the pooled estimation (Figure 1A), it is observed that the budget deficit accom-
modates most of the innovation in the trade deficit within four periods. The individual
country response of fiscal deficits to shocks in trade deficit seems to be relatively quick
in the case of Indonesia, Korea and the Philippines. On the other hand, the response of
Indian and Malaysian fiscal deficits, seems to be relatively sluggish since there is a
delayed response in the budget deficit (specifically in periods 6 through 8) to the shocks
in the trade deficit. Nonetheless, the results from the impulse response functions gen-
erally support the prominence of the trade deficit variable in the twin deficit process.

VI. CONCLUSIONS AND POLICY IMPLICATIONS

The persistent and coinciding fiscal and external trade deficits have been in the eco-
nomic spotlight during the last decade, largely because of its important policy impli-
cations concerning the long-term viability of economic progress of developing
nations. This paper tests the twin deficit hypothesis that persistent fiscal deficits lead
to widenings of trade deficits, for five developing Southeast Asian economies--
namely India, Indonesia, Korea, Malaysia and the Philippines. The discussion is espe-
cially relevant given the backdrop of the current economic crisis that is engulfing
many Asian economies, and the plausibility that there could be wide disparities in the
macroeconomic dynamics governing fiscal and current deficits between developing
Current Account and Fiscal Deficits 499

and developed economies. Specifically, the Granger causality test based on a VAR
model is utilized to underpin the direction of causality between the two deficit series.
In testing for the causal relationship between the twin deficits, other mediating vari-
ables that are known to influence the deficits are also included in the model.
Contrary to most findings in the literature, this study finds trade deficit to cause
fiscal deficit and not vice versa for all the sample countries investigated, except
Malaysia where bi-directional relationship is documented. The study makes a case for
increased government spending in response to the domestic hardships caused by a
worsening of trade balance. Of course, the evidence may also be reflective of some of
the macroeconomic structural differences that exist between developing and devel-
oped nations. In addition to the major finding that trade deficits cause budget deficits,
the study identifies several other macroeconomic variables that jointly influence both
fiscal and trade deficits, thus highlighting some degree of commonality in the twin
deficit nexus. Specifically, results from the pooled estimation procedure indicate that
movements in the interest rate variable jointly cause the twin deficits.
The results from the study derive a number of policy implications. First, since
both deficits are found to be simultaneously caused by other macroeconomic mediat-
ing variables, a manipulation of these policy variables could be potentially employed
to bring the twin deficits under control. Second, the results imply that a reduction in
the budget deficit cannot be achieved unless trade policies that pursue aggressive
export promotion are put into place. Moreover, the entire economy would likely ben-
efit due to the dynamic positive spillover effect from the export sectors' growth.
Recent empirical evidence tends to support this notion that those economies which
actively pursue export-promotion policy have been more successful than those that
have pursued import-substitution policies (see, for example, Krneger, 1990; Baha-
mni-Oskooee et al., 1991; Anoruo & Ramchander, 1998). Finally, since only a portion
of the fiscal budget is controlled, policy makers should pay attention to the budgetary
implications of exogenous changes in trade balance. For instance, it is possible that a
deteriorating trade balance might aggravate the contractionary effects of a budget def-
icit reduction package. The above discussion suggests that ultimately a real solution
to the twin deficit problem lies in a simultaneous attack on multiple fronts.
Several avenues for future research are available. First, it would be interesting to
investigate the temporal stability of the results found in this study as the market-
sweeping reforms initiated by many of the 'newly industrialized countries' gradually
begin to take hold and have an impact on their economy. Second, it will be informa-
tive to test issues concerning the sustainability and persistence of current account and
fiscal deficits. Clearly, persistent deficits will impose an excessive burden on future
generations as the accumulation of larger debt will imply increasing interest pay-
ments and a lower standard of living. Finally, an inquiry into the possible channels by
which trade deficit could impact budget deficit is also worthy of examination.

Acknowledgments: The authors are grateful to two anonymous referees for their insightful comments
and helpful suggestions that helped improve the paper. We would also like to thank Mr. Suma Sama-
500 J O U R N A L OF A S I A N E C O N O M I C S 9(3), 1998

ranayake, a graduate student at Mankato State University, for excellent research assistance. The usual
disclaimer applies.

NOTES

1. The recent Asian crisis serves as a valid reminder of the importance of the twin deficit prob-
lem. Many of these emerging countries were successful in attracting significant foreign direct invest-
ment (FDI). Besides, as long as their currencies were pegged to the U.S. dollar, they were viewed as
even more attractive for FDI and portfolio investment in its securities markets. So it was no surprise that
these countries ran a large negative balance of payment on net investment income. But the presence of
large trade deficits worsened by the fiscal excesses of the government proved to be a lethal combination
for these countries. The governments of these countries finally succumbed to the economic and finan-
cial pressures and were forced to abandon their currencies peg to the U.S. dollar.
2. 2. An alternative theory proposed by Barro (1974), referred to as the Ricardian equivalence
suggests no anticipation of a twin deficit linkage under the savings-investment framework. Instead bud-
get deficits simply reflect the inter-temporal shifting of taxes and do not affect national savings and the
current account balance. Changes in private savings are expected to fully offset changes in government
spending. Thus neither a crowding-out effect of domestic investment nor a trade deficit necessarily
emerge from a budget deficit.
3. 3. For each of the series, x t, the following ADF regression is run:
m
Axt=ao+alXt_l+bj Y~ Axt_ j +vt
j=l
where AXt is the first difference operator and vt is a stationary random error. The null hypothesis of
nonstationarity is rejected when a 1 is significantly negative.
4. The conclusions remained essentially the same when the model was estimated after filtering-
out data outliers.
5. These findings, however, do not contradict the Ricardian equivalence proposition (of no clear
relationship between the two deficits) because the VAR specification does not allow for a direct test of
the Ricardian hypothesis.

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Received April, 1997; Revised May, 1998