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A RE-EXAMINATION OF THE TWIN DEFICIT PHENOMENON IN THE NIGERIAN ECONOMY

CHAPTER ONE

INTRODUCTION

1.1 . Background of the Study

The “Twin deficit” debate was a common policy issue during the 1980s and the early 1990s and the term was initially invented to describe the co-movement between the budget deficit and the current account deficit in the United States (Chang and Hsu, 2009). Subsequently, researchers began applying it to other countries. Ever since, it has become an area of interest for researchers to examine the causal link between the two deficits and the direction of causality. The simultaneous emergence of budget deficit and the current account deficits for most countries most especially in the United States (US) during the mid-1980s led to the characterization of this phenomenon as the “twin deficits” issue as both economic theory and empirical observation suggested a link between the two deficits (Chinn, 2005). Thus, the twin deficit hypothesis has come to be regarded as one of the important relationships among aggregate economic variables. Over the years, there has however been renewed interest in understanding the relationship between the budget and current account deficit.

According to Giancarlo et al (2006), the fiscal deterioration in the United States during the first George W. Bush administration coupled with persistent US trade deficits focused renewed attention on the twin deficits issue. Chang and Hsu (2009) also supported this by stating that the recurrence of huge fiscal and trade deficits in the US since the switch of the century have revived public interest in the relations between the twin deficits. Yanik (2006) equally pointed out that the relationship between current account deficits (CAD) and budget deficits (BD) are now at the centre of international macroeconomics literature. It is believed that the two deficits move together, at least in the long-run. Having a foundation in international macroeconomics, the twin deficit hypothesis posits that changes in the budget deficit of a country can translate to a change in the current account balance of the country or could be the other way round. This relationship, however, is said to take place through the channel of real interest rate, real income and real exchange rate.

According to Kim et al (2007), fiscal deficits tend to occur jointly with current account deficits. Giarcarlo et al (2006) also argued that fiscal shocks will cause a deterioration of the government’s budget and also worsen the country’s current account balance. Thus, the main thrust of the twin deficit hypothesis, however, is that current account deficits of most countries is caused by government’s budget deficits phenomenon and the most suitable way to solve this problem and stabilize internal and external deficits is reducing the government’s budget deficit (Zamanzadeh and Mehrara, 2011).

In empirical literature, there are two major theories that are used to explain the causal link between budget deficit and current account deficits. These are the Mundell-Fleming Model of Exchange Rate Regime and the Ricardian Equivalence Hypothesis (REH). The traditional Keynesians use the Mundell-Fleming model to explain the twin deficit relationship and they argued that when budget deficit increases, the current account balance will deteriorate as the increases in the budget deficits will drive up domestic interest rates, real exchange rate and rate of capital inflows. On the other hand, while acknowledging the detrimental effects of large fiscal deficits on the economy, the critics of the Mundell-Fleming model have disputed the sequence of causation implied by the model (Harshemzadeh and Wilson, 2006). These groups of researchers used the Ricardian Equivalence Hypothesis (REH) to argue that no relationship exists between the two deficits as budget deficits results mainly from tax cuts which tend to reduce public revenue and public savings. They opined that individuals will perceive these tax cuts as incurring future tax liabilities and thus will increase savings rather than consumption.

Despite the large number of studies that have been done on the dynamic relationship between the budget and current account deficits over the years, there has been no consensus as to the direction of causality. This is very vital for policy implications as identifying the direction of causality helps policy makers to know direction of policy. In theory, it can be found from the National Income Identity that there exists a causal relationship between the budget deficit and the current account deficits, but direction of causality is what the issue is. Egwaikhide (1997) and Onafowokan and Owoye (2006) attempted to capture the causal relationship and direction of causality between the budget deficits and the current account balance for Nigeria, in the case of Onafowokan and Owoye (2006), trade deficits. Egwaikhide (1997) examined the effects of budget deficits on the current account balance in Nigeria and concluded that quantitative evidence suggests that budget policy affects the current account balance for Nigeria.

On the other hand, Onafowokan and Owoye (2006)’s findings showed evidence of positive relationship between trade and budget deficits in both the short and long run but that causality is unidirectional running from trade deficits to budget deficits. Also, Egwaikhide et al(2002) in their paper on causality between budget deficit and current account balance for a number of African countries, found a unidirectional causality from the budget deficits to the current account deficits to exists for Benin, Burkina Faso, Ghana, Nigeria and South Africa. In light of the above, this study attempts to re-examine the direction of causality between the budget deficit and the current account deficit within the framework of the multivariate Granger causality method as against the bivariate framework commonly used in previous empirical studies.

1.2 . Statement of Research Problem.

The recent fiscal expansion due to the global financial crisis in 2008 has made it timely to revisit the twin deficit phenomenon for Nigeria and examine the direction of causality. The apparent similar movement in both the budget and current account deficits gave rise to the idea that there might be a relationship between the two deficits (Egwaikhide et al, 2002). It has also been established in economic theory and empirical observation that there exists a link between the two deficits. For Nigeria, there have been persistent and rising budget deficits most especially from the 1970s. The country has also been having current account deficits, even though there has been a surplus in the last 12years. So it is evident that the Nigerian economy has been experiencing the twin deficit phenomenon. In the same vein, Nigeria as an oil-exporting country where revenue from oil production contributes more than 95% of its foreign exchange, 40 percent of GDP and 80 percent of fiscal revenues makes the economy susceptible to fluctuations in government revenues as a result of volatility in oil revenue (Onafowokan and Owoye, 2006).

As it has been argued in empirical literature that large budget deficits can have negative implications for the stability of the current account, countries that run budget deficits are believed to most likely have a current account deficit. According to Harshemzadeh and Wilson (2006), growing budget deficits are reflected in growing current account deficits. This makes it important to know to what extent fiscal balances can be used to achieve adjustment in the current account balance. Despite the detrimental economic and social effects of large budget deficits on an economy, it is believed that running a budget deficit over a period of time is not necessarily bad for an economy, likewise a current account deficit, in as much as the deficit is used to finance developmental project for the country to bring about growth. According to Fleegler (2006), governments often incur fiscal deficits to grow their economies and provide certain services to the population. So at some points, an economy incurs deficit in its budget balance.

Thus, the issue is not whether the country is running a budget deficit or current account deficits in as much as the deficits is been incurred for developmental purposes, the problem lies in a country running the two deficits simultaneously known as having a twin deficits. This have important implications for the economy as it can affect the country’s external rating in the global economy and foreign direct investment into the country. The importance of the policy implication is that if the basic reason for rising current account deficits is the escalating budget deficits, then policy makers may have to focus on curtailing the budget deficits to resolve the current account deficits. On the other hand, if the reverse is the case, then the reductions in the budget deficits will not resolve the current account problem (Onafowokan and Owoye, 2006). This will also help make fiscal policy more prudent especially in the case when an unbalanced budget causes predicted changes in current account.

As it is believed in open economy macroeconomics that budget deficit leads to deterioration of the current account balance (Jayaraman et al, 2008), it therefore becomes imperative to find out if the resulting current account balance experienced by the Nigerian economy is as a result of the substantial increase in its budget deficit over the years as has been argued by the twin deficit hypothesis or it is the other way round. In other words, this study investigates the direction of causality between the two deficits. Also, as it has been advocated in empirical literature that domestic fiscal consolidation can be used as a necessary measure to correct current account deficits, it becomes important to ascertain the direction of causality as the causality may flow from current account deficit to budget deficit for an oil-based economy like Nigeria and so the fiscal consolidation may not be a useful tool.

1.3 Scope of Study.

This study re-examines the relationship and direction of causality between the budget balance and the current account balance for the Nigerian economy by applying theoretical considerations of the twin deficit hypothesis using annual data covering the period 1970 through to 2010, which is a period of 40years. The data for this study was sourced from the Central Bank of Nigeria (CBN) Statistical Bulletin (2010 edition) and the World Bank Development Indicators (WDI) Database for 2010.

1.4. Research Questions.

Is the twin deficit hypothesis still valid for Nigeria?

Is there a long run relationship between budget deficits and the current account deficits?

What are the major channels of transmission through which budget deficits affect current account deficits?

What is the direction of causality between the budget deficit and the current account deficit?

1.5. Research Objectives.

The main objective of this study is to re-examine the long run relationship between the budget and current account deficits for the Nigerian economy. Other specific objectives of the study include:

To investigate the direction of causality that exists between the budget deficits and the current account deficit in Nigeria.

To evaluate the major channels of transmission through which the budget deficit influence the current account balance of Nigeria.

1.6 Justification of Study.

This study attempts to re-examine the validity of the twin deficit hypothesis for Nigeria as data from the last ten years showed that the two deficits have not been moving together as argued by the two studies (Egwaikhide, 1997 and Onafowokan and Owoye, 2006) that were previously done for Nigeria. The most recent study to the best of my knowledge was carried out in 2006 and between then and now; there could have been some adjustment. So it becomes imperative to re-visit the twin deficit phenomenon for Nigeria. This study also provides an alternative methodology for testing the causality direction between twin deficits in Nigeria.

Also, most empirical studies on the twin deficit hypothesis are usually focused on developed nations, only recently have attention been shifting towards developing countries. According to Egwaikhide (2007), there are only a few empirical studies that have specifically examined the impact of budget deficits on the current account balance in developing countries such as Nigeria (Egwaikhide, 1997). Two major studies on the twin deficit testing for Nigeria is the work of Egwaikhide (1997) and Onafowokan and Owoye (2006).

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