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Re-examining the twin deficit hypothesis for major South Asian economies: Some insights into the transmission mechanism

Shruti Shastri (Department of Economics, Banasthali Vidyapith, Jaipur, India)

Indian Growth and Development Review

ISSN: 1753-8254

Article publication date: 14 June 2019

Issue publication date: 11 November 2019

312

Abstract

Purpose

The purpose of this study is to revisit the twin deficit hypothesis (TDH) and provide insights into the transmission mechanism connecting budget deficits and current account deficits for five major South Asian countries, namely, India, Bangladesh, Pakistan Sri Lanka and Nepal for the period 1985-2016.

Design/methodology/approach

This study uses a multivariate framework including real interest rate, real exchange rate and real gross domestic product to avoid the possibility of incorrect inferences caused by omission of relevant mediating variables. The long-run relationship and causality are investigated through the autoregressive distributed lag bounds testing approach and Toda Yamamoto approach, respectively, for each individual country. The robustness of the results is assessed with the help of Westerlund’s cointegration test and group mean fully modified ordinary least squares (GM-FMOLS), group mean dynamic ordinary least square (GM-DOLS) and common correlated effect mean group (CCEMG) estimators in the panel framework.

Findings

Both time series and panel evidences indicate long-run relationship between budget balance (BB) and current account balance (CAB) together with the mediating variables. The results indicate bi-directional causation between the two balances for India and Bangladesh, TDH for Pakistan and Sri Lanka and the reverse causation from CAB to BB for Nepal. Regarding the transmission mechanism, the results indicate the absence of the causal chain postulated by Mundell–Fleming, which predicts that BB causes CAB via interest rate and exchange rate. A CCEMG estimate of the import demand function reveals a positive government spending elasticity of imports suggesting that BB affects CAB by direct impact through demand.

Originality/value

This study augments the twin deficit literature on South Asian countries by providing insights into the transmission mechanism connecting the BB and CAB. Moreover, the study provides robust evidences on the TDH by using both time series and panel data techniques.

Keywords

Citation

Shastri, S. (2019), "Re-examining the twin deficit hypothesis for major South Asian economies: Some insights into the transmission mechanism", Indian Growth and Development Review, Vol. 12 No. 3, pp. 265-287. https://doi.org/10.1108/IGDR-11-2018-0124

Publisher

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Emerald Publishing Limited

Copyright © 2019, Emerald Publishing Limited

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