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Twin Deficits in Developing Economies

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Abstract

This paper provides new evidence of the existence and magnitude of the “twin deficits” in developing economies. It finds that 1 % of GDP unanticipated increase in the government budget balance improves, on average, the current account balance by 0.8 percentage point of GDP. This effect is substantially larger than that obtained using standard measures of fiscal impulse, such as the cyclically-adjusted budget balance. The results point to some heterogeneity across countries and over time. There is suggestive evidence that the effect tends to be larger: (i) during recessions; (ii) in countries that are more open to trade; (iii) that have less flexible exchange rate regimes; and (iv) with lower initial public debt-to-GDP ratios.

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Notes

  1. 1.

    Carrière-Swallow et al. (2018) extend previous studies using the narrative approach to identify fiscal shocks for 14 countries in Latin America and the Caribbean.

  2. 2.

    Ilzetzki et al. (2013) assembled quarterly data on government spending for 24 emerging market economies. In contrast, the methodology chosen in the paper allows us to cover an unbalanced sample of 114 EMDEs.

  3. 3.

    See, for instance, Forni and Gambetti (2010), Leeper et al. (2012), Leeper et al. (2013), and Zeev and Pappa (2015). Agents receiving news about changes in government spending in advance may alter their consumption and investment decisions well before the changes occur. An econometrician who uses the information contained in the change in actual spending would be relying on a different information set than that used by economic agents, and this may lead to biased estimates. By using forecast errors, the econometrician’s information is aligned to that of economic agents.

  4. 4.

    The classification of countries in EMDEs and advanced economies (AEs) throughout the paper follows the one adopted by the IMF WEO.

  5. 5.

    See, for instance, Abbas and others (2011) that find a magnitude of the twin deficit of about 0.1–0.2.

  6. 6.

    Consistent with Auerbach and Gorodnichenko (2013b) and the previous literature on fiscal multipliers, our government spending series is the sum of real public consumption expenditure and real government gross capital formation—that is, excluding transfers.

  7. 7.

    In the next section, we show that the results are robust to using the forecasts of government expenditures made in April of the same year.

  8. 8.

    All fiscal and junctural information up to October of a given year is incorporated in the forecasts made in October.

  9. 9.

    In practice, we adopt a two-stage approach. First, we regress government spending forecast errors on GDP growth forecast errors and then use the residuals from this regression as our measure of government spending shocks.

  10. 10.

    The source of the data for these variables are IMF WEO and Leaven and Valencia (2012), respectively.

  11. 11.

    The results of the first-stage estimates suggest that a 100% unanticipated increase in government spending reduces, on average, the budget balance by about 2.5% of GDP. This effect is precisely estimated, with a F-statistic of 19.15.

  12. 12.

    Ideally one would like to consider a measure of output gap. Unfortunately, measures of potential output are not available for many countries, and there are a number of issues (structural breaks, optimal smoothness parameters varying across countries) when applying filtering techniques to GDP series in many developing economies. Measurement issues are also, and perhaps, even more relevant concerning other measures of utilization such as unemployment. Following Auerbach and Gorodnichenko (2013b), we set \( G\left({z}_{it}\right)=\frac{\exp \left(-\upgamma {z}_{it}\right)}{1+\exp \left(-\upgamma {z}_{it}\right)},\kern1.25em \upgamma =1.5 \) The results are robust to different values of γ (see for example Figure 12 in Appendix), as well as considering lagged GDP growth instead of current one.

  13. 13.

    Similar results are obtained using the median instead of the average as a threshold.

  14. 14.

    The exchange rate regimes are identified using the coarse classification of Ilzetzki et al. (2017). In particular, we classify fixed exchange rate regimes those with a score of 1 (No separate legal tender, Pre announced peg or currency board arrangement, De facto peg) and 2 (De facto crawling band that is narrower than or equal to ± 2%).

  15. 15.

    Bluedorn and Leigh (2011) find the twin deficits hypothesis still holds in the euro zone countries, but the impact is lower than before the euro adoption.

  16. 16.

    Similar results are obtained using the median instead of the average as a threshold.

  17. 17.

    The selection of these thresholds is based on Furceri and Zdzienicka (2012), who find that an increase in debt lowers output when the debt-to-GDP ratio exceeds 75%. Similarly, results are obtained estimating equation (3) using the debt-to-GDP ratio as interacting variable z.

  18. 18.

    Fiscal rules are also an important factor affecting the relationship between fiscal policy and the current account. For example, Afonso et al. (2018) find that the existence of fiscal rules strongly reduces the effect of budget balance on the current account balance.

References

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  2. Afonso A, Huart F, Jalles JT, Stanek PL (2018) “Twin Deficits Revisited: A Role for Fiscal Institutions?” REM Working Paper 031–2018

  3. An Z, Jalles JT, Loungani P, Sousa R (2018) “Do IMF Fiscal Forecasts add Value?” J Forecast, forthcoming

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  5. Auerbach AJ, Gorodnichenko Y (2013b) Fiscal multipliers in recession and expansion. In: Alesina A, Giavazzi F (eds) Fiscal policy after the financial crisis, National Bureau of Economic Research Conference Report. University of Chicago Press, Chicago, pp 63–98

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  10. Carrière-Swallow Y, David A, Leigh D (n.d.2018) “The Effects of Fiscal Consolidations in Developing Economies: Evidence from Latin America,” IMF Working Paper

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Acknowledgments

We are grateful to the editor George S. Tavlas, two anonymous referees and participants of various IMF seminars for comments and suggestions. This working paper is part of a research project on macroeconomic policy in low-income countries supported by U.K.’s Department for International Development. We are also grateful to Tiffany Wrong for excellent research assistance, and Karina Chavez for excellent editorial assistance. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF, IMF policy, or of DFID.

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Correspondence to Davide Furceri.

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Appendix

Appendix

Fig. 10
figure10

Distribution of Government Expenditure Shocks in EMDEs. Source: IMF World Economic Outlook and authors calculations

Fig. 11
figure11

Impact of Fiscal Shocks on the Nominal Exchange Rate (percentage). Note: X-axis indicate years after the shock at t = 0. Blue lines denote the response of the nominal exchange rate to 1 percentage point of GDP exogenous increase in the fiscal balance. Dotted lines 90% confidence bands. Estimates based on Eq. (2).

Fig. 12
figure12

Impact of Fiscal Shocks on the Current Account Balance: recessions vs. expansions—alternative gamma (3.5) (percentage point of GDP). Note: X-axis indicate years after the shock at t = 0. Blue lines denote the response of current account to 1 percentage point of GDP exogenous increase in the fiscal balance in the low- (Panel A) versus high-growth (Panel B) regime. Estimates based on Eq. (6). Dotted lines 90% confidence bands. Red lines indicate the baseline response in Fig. 1.

Table 2 Government Expenditure Shocks in EMDEs
Table 3 Mean square error of government spending growth rate forecasts

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Furceri, D., Zdzienicka, A. Twin Deficits in Developing Economies. Open Econ Rev (2020) doi:10.1007/s11079-019-09575-1

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Keywords

  • Fiscal policy
  • Current account
  • Twin deficits
  • Developing economies

JEL Classification Numbers

  • F42
  • H5