DRAFT

Fiscal Stability, Trade Policy, and Implications for Economic Growth:

Does the Twin Deficit Hypothesis hold for Jamaica?

Llemar Nicholson1

Economic Information and Publications Department

Research and Economic Programming Division

Bank of Jamaica

October 2015

Abstract

Using the Toda and Yamamoto (1995) lag augmented (LA-VAR) method, this paper tested the

validity of the twin deficit hypothesis for Jamaica using quarterly data from Q2 2001 to Q1 2015.

The twin deficit hypothesis proposes that higher fiscal deficits lead to higher current account

deficits. A multivariate VAR model integrating the real effective exchange rate was used,

departing from the various bivariate analyses conducted in testing the twin deficit hypothesis.

The empirical results strongly suggest reverse causality, a unidirectional causal relationship

running from the current account to fiscal balances. This is consistent with studies done for open,

developing economies and puts forward the challenge that twin deficits are mainly a developed

country phenomenon.

Keywords: Granger non-causality, twin deficits, current account deficit, fiscal deficit

JEL classification: C32, H62, F32, F40

1 The views expressed in this paper are those of the author and do not necessarily reflect the opinion of the Bank of

Jamaica.

2

Table of Contents

I. Introduction 3

II. Theoretical Background 6

III. Empirical and Estimation Procedures 7

IV. Data 9

V. Unit Root and Granger Causality Tests 9

VI. Impulse Responses 12

VII. Conclusion 14

VIII. Appendix 15

IX. References 16

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I. Introduction

An expansionary fiscal policy having its genesis in the 1970s has coincided with Jamaica

recording persistent fiscal and current account (trade) deficits. Jamaica has financed these

deficits through internal and external loans. Increased imports partially owed to an

overdependence on expensive crude oil and growing propensity for foreign products

compounded by deteriorating terms of trade are some of the common explanations for the

negative current account balances. Jamaica’s export sector has remained underfunded due to the

massive debt burden the country faces. Instead, government expenditure has increasingly been

channelled towards debt servicing2. Together, current account and fiscal deficits have worked in

conjunction to mount a massive debt burden that has contributed to balance of payment

difficulties. In response to the maturing debt and a balance of payments crisis following the

2007/08 global financial crisis, the Jamaican government (GOJ) opted to negotiate a Stand-By

Loan Agreement with the International Monetary Fund (IMF)3. The GOJ also conceptualised the

Jamaica Debt Exchange (JDX)4 and two years later a National Debt Exchange (NDX) aimed at

restructuring the terms of interest payments on domestic debt.

A country experiencing both current account deficits and fiscal deficits is said to have ‘twin

deficits’. The term originated during the 1980s in the US during the Reagan administration when

tax cuts created a large fiscal deficit that coincided with current account deficits. The interest

generated by this occurrence gave birth to the ‘Twin Deficit hypothesis’ which proposed that

higher fiscal deficits lead to a deterioration of the current account. Jamaica has consistently

recorded both fiscal and current account deficits over the past four decades. However, whether

they are indeed to be classified as ‘twins’ depends on the existence and direction of causality

between the two. Figure 1 illustrates the trends in fiscal and current account balances for the

sample period.

2 Jamaica had a public debt to GDP ratio of 138.5% at the end of FY2014/15 according to estimates from the

Ministry of Finance, Jamaica. This ranked in the top five highest in the world as of 2015. 3 The IMF approved a US$1.25 billion stand-by loan to Jamaica in February 2010 provide support for balance of

payments and assist the country in dealing with the global financial crisis of 2007/08. 4 The JDX and NDX involved exchanging Jamaican dollar and US dollar denominated bonds with high interest rates

with new securities with lower interest rates and longer times to maturity.

4

Figure 1: Fiscal, Current Account Balances and the REER, Q2 2001 to Q1 2015

Earlier research such as that by Enders and Lee (1990), Dibooglu (1997), Hatemi-J and Shukur

(2000) testing the twin deficit hypothesis has been primarily done on advanced economies,

particularly the US. Some exceptions are Faizul Islam (1998) for Brazil, Anoruo and

Ramchander (1998) for selected Asian countries, Vamvoukas (1999) for Greece, Pattichis

(2004), and Marashdeh and Saleh (2006) for Lebanon, Kouassi et al (2004) for a group of

developed and developing countries, Kim and Kim (2006) for Korea, Sobrino (2013) and

Katircioglu et al (2009) for a group of small island states. Existing research has, in general,

pointed to support of the Twin Deficit hypothesis for advanced economies and reverse causality,

that is, causality running from the current account to the fiscal account for developing

economies. Reisen (1998), and Khalid and Teo (1999) also posit that reverse causality should

hold since developing countries have limited domestic resources and frequently require external

funds. Below is a summary of some related literature and the associated findings.

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Table 1: Summary of Literature on Twin Deficits

AUTHOR(S) COUNTRIES RESULTS

Markin and Narayan (2012) Australia FB causes CAB

Sulikova et al (2014) Estonia, Latvia and Lithuania FB causes CAB for Estonia and

Lithuania

Pattichis (2004) Lebanon FB causes CAB

Holmes (2010) US FB causes CAB

Tang (2013) US FB causes CAB

Enders and Lee (1990) US FB causes CAB

Hatemi -J and Shukur (2000) US FB causes CAB (1975 to 1989)

and CAB causes FB (1990 to 1998)

Dibooglu (1997) US FB causes CAB

Kouassi et al (2002) 10 developing and 10

developed countries

Mixed for developing countries,

inconclusive for developed

Kim and Kim (2006) Korea CAB causes FB

Marashdeh and Saleh (2006) Lebanon CAB causes FB

Fethi, Fethi and Katiricioglu

(2009)

Panel of 24 small island state

economies CAB causes FB

Sobrino (2013) Peru CAB causes FB

Notes: 1) BD – budget deficit, CAD, CD – current account deficit

2) BB – budget balance, CAB –current account balance

An explanation presented for results inconsistent with the twin deficit hypothesis has been that

imbalances in trade competitiveness create trade imbalances that are supported by increased

government spending. This imbalance invariably leads to an accumulation of debt and

perpetuates a cycle of reduced exporting capacity, current account deficits, increased debt

service, and increased fiscal deficits. There is also an apparent correlation between reverse

causality in fiscal and current account balances, trade openness, and small developing

economies. These countries also tend to be those with weaker terms of trade and as such are

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prone to incurring trade deficits. Jamaica fits squarely into these classifications and this paper

tests whether the fiscal and current accounts are twins or if reverse causality holds true.

The remainder of this paper is organised as follows: Section II presents the theoretical

background, Section III explains the empirical model and estimation procedures used in this

study and Section IV provides a brief synopsis of the data used. The empirical results are

presented in Section V, impulse responses in Section VI, and Section VII concludes.

II. Theoretical Background

The theoretical motivation for this paper stems from the Keynesian theory that higher fiscal

deficits lead to higher current account deficits. Consider the following equation:

From the national income identity:

Y = C + I + G + X - M (1)

If we define the current account balance as the difference between exports (X) and imports (M),

government savings ( SG ) as the difference between taxes (T) and government spending (G) and

domestic savings ( SP ) as the remainder of income after consumption and taxes are subtracted

and rearrange then

SP = (G - T) + (I + CA) (2)

So,

CA = (SP - I) + (T - G) (3)

If we consider an economy where Y is fixed then if the fiscal deficit (G - T) increases then either

investment (I) or the current account (CA) balance must deteriorate. Two formal theories

supporting the twin deficit hypothesis are the Keynesian absorption theory and the Mundell-

Fleming approach. Keynesian absorption theory suggests that an increase in the fiscal deficit

would induce domestic absorption and lead to import expansion, which will also deteriorate the

7

current account balance (Hatemi-J and Shukur, 2002). The reasoning behind the Mundell-

Fleming approach is that increases in the fiscal deficit of an open economy creates upward

pressure on the domestic interest rate. This induces a capital inflow which appreciates the

domestic currency. At the appreciated exchange rate, exports are more expensive to foreigners

and imports are cheaper to domestic residents which have the effect of driving the current

account into deficit. Proponents of the Ricardian-Equivalence Hypothesis (REH) dispute the twin

deficit hypothesis by arguing that private sector consumption decisions do not depend on how

government finances its spending since bonds are not net wealth and merely represent future tax

liabilities (Dibooglu, 1997).

III. Empirical Model and Estimation Procedure

To the best of my knowledge, there have been no published empirical studies done on the twin

deficit hypothesis for Jamaica. This study extends beyond the bivariate approach used in many

studies by accounting for possible omitted variable bias. In this respect, two additional variables

are incorporated based on the methodology employed by Ibrahim and Kumah (1996) who found

that the exchange rate plays an important role in the channel through which the fiscal balance

influences the current account balance; and inflation is added because of the theoretical

substitution effects of increased (or decreased) price levels towards greater (or lesser) imports.

The traditional F-test for Granger non-causality is invalid when the variables are integrated or

cointegrated and the test statistic does not follow its own distribution. In this case, Error

Correction Models (ECM) may be used instead (Granger, 1988). However, as noted by Kim and

Kim (2006), if the variables are integrated of different orders or are not cointegrated at all, an

ECM cannot be applied. In addition, ECMs may be biased especially for finite samples. A

multivariate framework is employed in order to avoid the distortion of the causality

interpretations that might result from omitted variables. Toda and Yamamoto’s (1995) Granger

non-causality method is adopted utilising a LA-VAR framework.

8

In this paper, the MWALD test is used in addition to the ECM. The MWALD test is simpler to

compute than the traditional F-test for Granger non-causality, the test overcomes the problems

associated with the ECM, and it is applicable whether or not the variables are cointegrated.

In light of these considerations, the following three-equation VAR system is estimated:

1 1 10 1 1 1

1 1 1

FBi i i

n n n

t t t t

i i i

FB A FB CAB REER

(1)

0 2 1 2 1 2 1

1 1 1

CABi i

n n n

t t t i t

i i i

CAB B CAB FB REER

(2)

0 3 1 3 1 3 1

1 1 1

REERi i

n n n

t t t i t

i i i

REER C REER FB CAB

(3)

where FB and CAB represent the fiscal and current account balances, respectively. The real

effective exchange rate is represented by REER, and the serially uncorrelated random error terms

are the ε’s.

The modified WALD test may be summarised as follows:

i. Determine the maximum order of integration (dmax) and the lag length (n) of the VAR

model.

ii. Estimate the VAR (n + dmax) model.

iii. Test restrictions on the first n coefficient matrices, ignoring the last dmax lagged vectors in

the model. The MWALD test statistic asymptotically follows a Chi-Square (χ2)

distribution having the usual degrees of freedom.

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IV. Data

The data used in this paper are quarterly spanning the period Q2 2001 to Q1 2015.

Fiscal balances (FB) and current account balances (CAB) are scaled by GDP. FB and CAB data

in Jamaican dollars (J$) are obtained from the Bank of Jamaica’s database. Multiplying by the

nominal exchange rate between the United States (US) and Jamaica in order to convert to US

dollars and dividing by Jamaican GDP in US dollars derives the fiscal and current account

balances as shares of GDP in US dollars. Quarterly real effective exchange rate (REER) with

base year 2010 for the sample period is also sourced from the existing database.

To account for the presence of seasonality, the data are seasonally adjusted using the Census X12

method.

V. Unit Root and Granger Causality Test Results

The maximum orders of integration of each of the series used in this paper are determined using

standard unit root tests. The Augmented Dickey-Fuller (ADF), Kwiatkowski et al. (KPSS), and

Phillips and Perron (PP) test are conducted for the series FB, CAB, and REER before seasonal

adjustment. A combination of the Akaike Information Criterion (AIC), Schwartz Bayesian

Criterion (SIC), the likelihood ratio (LR) test, the VAR lag order exclusion test and diagnostic

testing are used to select the optimal lags necessary in each instance. The results of the unit root

tests are presented in Table 2.

Table 2: Unit Root Test Results

Original

Variable Form Transformation New Variable ADF PP KPSS

FB level differencing DFB I(1) *** I(1) *** I(1)

CAB level differencing DCAB I(1) *** I(1) *** I(0)*

REER level none n/a I(0) ** I(0) *** I(0)

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Notes: 1) The null hypothesis for the ADF and PP tests are that there is a unit root. The null hypothesis for the

KPSS is stationarity.

2) *, ** and *** denote rejection of the null hypothesis at the 10%, 5% and 1% levels respectively.

The MWALD test requires that we know the maximum order of integration among the variables

used in the VAR model. From the unit root results above, although varying depending on the

test, the maximum order of integration is determined to be one, I(1). However, the variables

included in this study could possibly have undergone structural changes during the global

financial crisis beginning in 2007/085. In order to incorporate structural breaks into the analysis

of unit roots, the unit root test developed by Zivot and Andrews (1992) which endogenously

determines breakpoints is used for the variables in this paper:

Table 3: Zivot-Andrews Unit Root Test Results

Variable Break point Type of Break Test Statistic

FB none none none

CAB Q2 2012 Intercept and Trend -6.68**

REER none none none

Notes: 1) The null hypothesis for the Zivot-Andrews unit root test is that there is a unit root.

2) The critical values for the Zivot-Andrews unit root test for a break in intercept are -4.93 and -5.34 at the 5% and

1% levels respectively.

3) For a break in trend, the critical values are -4.42 and -4.80 at the 5% and 1% levels respectively.

4) *, ** and *** denote rejection of the null hypothesis at the 10%, 5% and 1% level of significance respectively. If

the test statistic is significant at the 5% level, we reject the null hypothesis of a unit root.

5) The numbers in parentheses represent the optimal lags.

5 The global financial crisis led to changing economic conditions as Jamaica’s export sector came under increasing

pressure. However, since we are only interested in the direction of causality, including data points under crisis does

not affect the underlying structurally driven interactions between both balances.

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The Zivot-Andrews (ZA) unit root tests confirm that the maximum order of integration is one in

the fiscal balance from the prior unit root tests. Incorporating structural breaks the series is

revealed to be trend-break stationary. A dummy is included to account for the structural break in

the CAB series at Q2 2012. Optimal lags for the ZA unit root test are selected by starting with a

lag of five and testing until the last lag was significant at the 10% level. To ensure the MWALD

test yields valid test statistics, it is necessary to select the lag lengths of the VAR model. Hence,

the VAR lag order selection criteria are estimated and reviewed. Based on the all the selection

criterion (see Table 4), the optimal lag length for the VAR model is one (n = 1). This implies that

a VAR (2) model should be estimated in order for the MWALD test to be applicable since the

true lag length must exceed the order of integration. Therefore, an optimal lag of n = 2 is chosen.

The stability condition is satisfied for the VAR (2) model with diagnostic tests and lag exclusion

tests confirming that the model is well specified. The MWALD test results are presented in Table

3.

Table 4: Granger Causality Test Results

H0 MWALD Test

(χ2)

FB does not Granger cause CAB 0.65

CAB does not Granger cause FB 5.38**

REER does not Granger cause CAB 0.00

REER does not Granger cause FB 1.05

FB does not Granger cause REER 0.81

CAB does not Granger cause REER 8.65***

Notes: 1) *, ** and *** denote rejection of the null hypothesis at the 10%, 5% and 1% level of significance

respectively. The MWALD test is the Modified Wald test.

From Table 3, there is strong evidence of causality running from the current account to the fiscal

balance indicating reverse causality from the current account to the fiscal balance. These results

are similar to those found by Anoruo and Ramchander (1998), Kouassi et al (2004) and Kim and

Kim (2006). Reverse causality or current account targeting as referred to by Summers (1988) has

12

two straightforward explanations in this context. One is that fiscal policy may have been used to

compensate for a deteriorating current account by providing stimulus for the domestic economy

and the export sector. Another is that current account deficits help to create debt which then has

to be serviced by government expenditure. Therefore, higher current account deficits can lead to

increased government expenditure and in the absence of higher tax revenue, higher fiscal deficits

because of the need to negate against increased unemployment as export revenues remain below

desired levels.

Also, there is also evidence found of causality from current account balances to the real effective

exchange rate. This implies that, in all likelihood, current account deficits have forced foreign

borrowing which is demand for foreign currency. The effect of this is to put depreciationary

pressure on the Jamaica’s currency. Whether the depreciation and subsequent increase in

competitiveness leads to an improvement in the trade balance is dependent on a myriad of factors

such as external demand, the elasticity of demand for exports and imports, productivity, and the

extent to which imports are used as inputs into eventual exports.

VI. Impulse Responses

The dynamic adjustment of the fiscal and current account balances to shocks are then considered.

Impulse responses for the fiscal balance and current account balance are illustrated in Figure 3.

Figure 2-4: Generalised Impulse Responses of Fiscal Account, Current Account and the

REER (seasonally adjusted) to one standard deviation shocks in FB, CAB, and the REER

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The impulse response of the current account balance to a positive fiscal shock is negative and

persistent over 20 periods (quarters) reaching its peak after two quarters. This suggests a trade-

off after an improvement in the fiscal balance which can be due to reduced governmental support

to programmes having a contractionary effect on exports. Likewise, the effect of a shock to the

real effective exchange rate is also initially negative but exhibits elements of a J-curve effect6.

This provides support for the Marshall-Lerner condition7, at least over the sample period. It is to

be noted, however, that some of this effect is down to price declines in crude oil on which

Jamaica is so dependent. Therefore, the effect that mimics a satisfaction of the Marshall-Lerner

condition is largely a product of lower import values caused by exogenous factors and not an

expansion in exports.

Similarly, the impact of a positive permanent shock to the current account on fiscal balances is

initially negative. This strongly suggests an initial expansionary fiscal policy after improved

current account performance. The effect is a temporary deterioration in the fiscal balance that is

reversed by six periods. In the medium term fiscal balances improve likely due to lower build-up

of debt releasing upward pressure on government expenditure. There is a positive initial response

in fiscal balances to a decline in competiveness after which fiscal balances decline exponentially.

Fiscal expenditure likely increases after a decline in competitiveness as the current account

deteriorates. A positive shock to the current account improves competitiveness, peaking between

6 The theory behind the J-curve effect is that currency depreciation will initially worsen the current account after

which the effect gradually is to improve the current account, mimicking a J-shaped response. 7 The Marshall-Lerner condition posits that a currency depreciation will only lead to an improvement in the current

account balance if the sum of demand elasticity for imports and exports is greater than one.

14

two to four quarters. Such an improvement in the current account suggests an improvement in

terms of trade which is analogous to an improvement in the real effective exchange rate. Finally,

competitiveness suffers after a positive shock to fiscal balances. The effect is only moderate but

persists up to 20 quarters at least.

VII. Conclusion

This study applies the Granger non-causality method developed by Toda and Yamamoto (1995)

in testing the validity of the twin deficit hypothesis for Jamaica. A multivariate approach using

quarterly data is employed, incorporating the real effective exchange. Reverse causality, that is,

causality running from the current account to the fiscal balance is found. Evidence gleaned from

the Toda and Yamamoto (1995) augmented lag procedure are consistent with results found by

Anoruo and Ramchander (1998), Kim and Kim (2006), Sobrino (2013), and Kouassi et al.

(2004). Persistent current account deficits have contributed to Jamaica experiencing balance of

payment problems. Subsequent IMF loan arrangements have also had the effect of compounding

an already substantial debt burden. The increased debt burden has also meant an increased

amount allocated to debt servicing and a corresponding increase in government expenditure. In

addition to this, tax compliance has suffered in a struggling economy. For this time period it

appears policy would dictate that a strategy aimed at ultimately improving the country’s current

account balance be pursued. This would need to be reinforced by prudent fiscal management to

both achieve the macroeconomic stability required under the current IMF programme and to

create the necessary environment for investment geared towards expanding export capacity.

A study decomposing the current and fiscal accounts could be invaluable as it could provide

further insight on the interplay and possible causality between components such as exports,

imports, government spending, and tax revenue. Furthermore, accessing data with increased

periodicity for at least 100 observations would further increase the power of the Granger

Causality tests and allow for even more definitive analysis.

15

Appendix

Table 5: VAR Lag Order Selection Criterion

Notes: * and bolded line indicates lag order selected by the criterion after autocorrelation is eliminated

LR: sequential modified LR test statistic (each test at 5% level)

FPE: Final prediction error

AIC: Akaike (An) information criterion

SIC: Schwarz information criterion

HQ: Hannan-Quinn information criterion

Table 6: VAR Lag Exclusion Tests

Lag 1 9.24 5.17 49.47 12.61 92.20

[ 0.06] [ 0.27] [ 4.66e-10] [ 0.01] [ 9.83e-13]

Lag 2 3.02 5.49 2.05 2.02 18.87

[ 0.55] [ 0.24] [ 0.73] [ 0.73] [ 0.28]

Lag 3 6.94 3.18 5.43 6.80 44.89

[ 0.14] [ 0.53] [ 0.25] [ 0.15] [ 0.0001]

Lag 4 16.73 5.60 6.83 5.05 42.20

[ 0.002] [ 0.23] [ 0.14] [ 0.28] [ 0.0004]

Lag 5 8.66 5.67 13.90 20.87 39.99

[ 0.07] [ 0.23] [ 0.008] [ 0.0003] [ 0.0008]

Lag 6 7.90 8.97 5.72 6.57 32.91

[ 0.1] [ 0.06] [ 0.22] [ 0.16] [ 0.008]

df 4 4 4 4 16

Lag LogL LR FPE AIC SC HQ

0 -409.987 N/A 2998.510 16.520 16.634 16.563

1 -338.998 130.619 251.472 14.040 14.499 14.215

2 -318.666 34.972* 160.541* 13.587* 14.390* 13.892*

3 -316.171 3.992 210.522 13.847 14.994 14.284

4 -312.508 5.4214 265.953 14.060 15.552 14.628

5 -304.283 11.185 283.602 14.091 15.927 14.790

6 -299.912 5.4201 358.958 14.277 16.456 15.107

16

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