Twin deficits

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Information about Twin deficits

Published on November 20, 2016

Author: AhmedFaizan1


1. Mobeen Alam(13813) Twin Deficit Twin Deficit Submited To:Nabeel Latif

2. Mobeen Alam(13813) 1 Twin Deficits - Basics Twin deficit economy is one that has both fiscal and current account deficits. Even if one of these deficits remains persistent, it is seen as a serious problem for an economy. Hence, one can imagine the plight of an economy which faces both these deficits. Fiscal/Budget Deficit: Fiscal deficit means government expenditure is more than its revenues. The government has to borrow to meet its excessive expenditure leading to government absorbing higher portion of domestic savings and higher interest rates. This in turn leads to crowding out of private sector investment in the economy. Higher interest rates, in turn lowers the private sector investment and consumption levels. In many economic history cases, we have seen governments resorting to printing press to manage their deficits leading to hyperinflation as seen in cases of Germany, Hungary and Zimbabwe. Current Account Deficit: Current account deficit means imports are higher than exports and hence foreign funds are needed to manage the deficit. An economy manages its current account deficit by foreign savings/foreign capital inflows. Unlike fiscal deficit the impact of current account deficit is less clear. Ideally, it should lead to depreciation of the currency but the currency can actually appreciate if capital inflows are more than the current account deficit In case of twin deficits, an economy needs both domestic savings and foreign savings to manage its deficits. In normal times, both can be managed but in case of a shock, the deficits could lead to a severe crisis. The impact of twin

3. Mobeen Alam(13813) 2 deficits has to be taken more seriously now as we have multiple cases of twin deficit economies in crisis and this includes developed economies. Relation Ship between Fiscal Deficit & Current Account Deficit The relationship between budget deficit and current account deficit could be written as: CA = Spvt–I – (G – T) … … … … … (1) Where, CA stands for current account balance, Spvt for private saving; I for investment, G for government purchases; and T for direct taxes collected from household firms by the government. The government deficit is given by G–T. A rise in the government deficit will increase the current account deficit if the rise in government deficit decreases total national saving. If the current taxes are held constant and (Spvt–I) remains the same or stable, an increase in temporary purchase will raise the government deficit (G – T) which affects the current account positively. In this way a government deficit resulting from increased purchases reduces the nations' current account surplus or widens the nations’ current account deficit. The impact of increasing budget deficits in increasing a large trade deficit could be one aspect of the twin deficit phenomenon. Another aspect could be a positive effect of budget deficit on interest rates [Vamvoukas (1997)]. Higher interest rates attract investment from abroad, so that the demand for home currency rises and results in appreciation of its value, which implies cheaper import and moreexpensive exports, pushing the trade balance towards deficit.

4. Mobeen Alam(13813) 3 There are no two opinions that deficit due to government purchases will reduce both desired consumption and national saving and increases the current accounts deficit. But the Ricardians and Keynesians have differences over the effects of budget deficit caused by tax cut or tax increase. According to Ricardian advocates if the current and planned future government purchases remain unchanged, a current tax cut will not lead people to consume more. As a cut in current tax would be balanced by an increase in expected future taxes, and tax payers do not feel better off even though their current after tax incomes have increased. Thus, national savings, current account balance, consumption, interest rates and investment remain unaffected. On the other hand proponents of Keynes believe that consumers do respond to a current tax cut by consuming more because they may expect that a higher deficit now may more likely bring higher taxes in future. This will reduce national savings, increase current account deficit and will affect all macro linkages between them as well. This leads to twin deficits phenomenon. Furthermore, there is another link between budget deficit and current account deficit. As budget deficit increases, government will increase its borrowing, thereby rate of interest will increase leading to foreign capital inflow. This will appreciate the value of the local currency which, results in cheaper imports and expensive exports. Thus there would be merchandise trade deficit. Besides the above primary linkages there are other channels through which these two deficits are interlinked. In this regard Abell (1990) finds four important macro variables like economic growth, rate of inflation, exchange rate and money supply as directly affecting these deficits in U.S. Firstly, rapid economic growth accompanies large investments followed by higher interest rate attracting foreign capital. Also stronger growth of economy leads to increase in foreign imports, which could cause a worsening of trade deficit.

5. Mobeen Alam(13813) 4 Secondly, the rate of inflation affects the relative desirability of internationally traded goods and thus the trade balance. Thirdly, a prior changes in deficit causes changes in trade deficit not only through interest rate linkage but also through exchange rate linkage. And finally the influence of budget deficits on domestic monetary policy affects the trade deficit as changes in M1 are influenced by prior changes in the deficit and interest rates. These changes in M1 influence the trade deficit through the causality prior relationship with interest rates. Twin Deficit economies in 2007 crisis 1. United States: US economy has been having twin deficits since 1980s. The fiscal deficit did turn into surplus for a brief period during former President Bill Clinton’s second term (1998-2001). The surplus turned into deficit in 2002 and widened sharply during the crisis to touch 10.6% levels in 2010. Current Account Deficits widened from 1.5% levels in 1990s to touch 6% in 2006. CAD has narrowed since 2006 levels because of the crisis. The crisis led to depreciation of the dollar (though dollar did not depreciate much given the scale of the crisis) and decline in imports, and both led to lower CAD. However, IMF projects CAD to rise going forward.

6. Mobeen Alam(13813) 5 One of the deficits or both together could become a factor for a crisis or act in aggravating the impact of the crisis. In US and other cases discussed below, it was the latter. As the crisis struck US economy, government could not intervene aggressively as fiscal position had worsened over the years. Some economists criticized the fiscal stimulus as very small compared to the size of the US economy. Others criticized that the fiscal stimulus has made the situation of US public finances highly precarious and will affect growth over a long-term. The other effect of rising budget deficits i.e. rising interest rates, crowding out of private sector investment etc did not occur as Federal Reserve pumped in a lot of liquidity. Moreover, demand remained weak and therefore there was no need to raise investment levels. However as crisis situation eased, businesses havebecomeworried over the state of public finances in US. US’s huge CAD has been one side of the global imbalances debate with high savings of developing economies (in particular China) being the other. Before the crisis, leading economists like Martin Feldstein had raised concerns over the rising current account deficit as a source for a crisis in future. The crisis did happen but the trigger was not current account deficit. However, the global imbalances did lead to spill overs with sub-prime crisis becoming a global financial crisis. The decoupling theories which gained before the crisis were trashed as it was seen that prospects of US economy are highly interconnected with the world economy. United Kingdom: The trajectory of twin deficits in UK follows nearly the same path as US. Fiscal position was in a deficit for most of the time since 1980s except for two brief periods 1988-89 and 1999-01 (in US the surplus was between 1998-01). The

7. Mobeen Alam(13813) 6 fiscal deficit has widened substantially in the crisis period to touch 11% in 2009 and is expected to ease till 4% by 2015. Current account remains in deficit for the entire period and is expected to remain so till 2015. Comparing with US, fiscal deficits are more or less similar as a per cent of GDP but CAD in UK was much lower than US in the same period. UK’s persistent fiscal deficit puts the government in similar problems like US. The scale of the problem was worse for UK economy as UK depends more on financial sector compared to US economy which is larger and more diversified. Hence, the pressure on UK government was more as the financial firms suffered and tax revenues declined. The situation has normalized now but it raises the dilemma of how to control financial sector size and also ensure tax revenues don’t decline. In terms of CAD, GBP depreciated significantly in wake of the crisis. So, there was more currency adjustment in UK than US. In terms of global spillover, UK did not impact because of its CAD but because of its financial sector. London is

8. Mobeen Alam(13813) 7 an international financial centre and financial crisis in UK had a wide impact on the global banking sector. Many UK banks have subsidiaries/branches etc in other economies especially in Asia impacting economies in latter. UK has also been setting examples in terms of financial sector policy for other economies. It has suggested some far reaching changes like a levy on banks’ balance sheets, leverage ratio, banks developing their own wills etc. This could set examples for others to follow. EMU economies: Fiscal Deficit: The economies in European Monetary Union (EMU) have signed Growth and Stability pact under which fiscal deficits will be capped at 3%. However, this has been abused by most economies from time to time. Germany and France form the core of the union and should have led by example. But both had higher deficits in early 2000s and did little to change it. This led smaller economies in EMU to follow suit and ran deficits much higher than 3% limit. Prime example of this was Greece which just brought deficit closer to 3% in order to qualify for the union in 1999. It has missed the 3% cap in each year since 1999 and touched 7.5% in 2004. The deficits lowered to 3.5% levels in 2007 becauseof the global boom. In crisis years, deficits became much higher and acted as a trigger for the European crisis. The Government revised the deficit upwards from 7% to 13% in 2009 acting as a trigger for the European debt crisis. Spain and Ireland had fiscal surpluses before the crisis with Irish economic model hailed as a role model to be followed by other economies. Ireland was dubbed as a Celtic Tiger economy for its promising growth potential.

9. Mobeen Alam(13813) 8 The surpluses have turned into deficits in both these economies as the tax revenues declined sharply and expenditure rose. Portugal had minor deficits before the crisis and still has lower deficits than the other three economies. Post-crisis, EMU model was criticized severely for not having a political and fiscal union. The crisis economies could not get any finances from the better performing economies like Germany prolonging the crisis. The help came much later amidst stiff pressure from financial markets but was deemed as little as scale of the problem had grown manifold.

10. Mobeen Alam(13813) 9 Current Account Deficit: European Monetary Union (EMU) economies ran their own imbalances with countries like Greece, Ireland, Spain and Portugal running current account deficits and Germany running surpluses. The imbalances ran fine till the crisis as the four troubled economies grew on account of consumption and Germany grew because of its exports to these economies. However, the model turned upside down in the wake of the crisis. As it wasa monetary union, currency adjustments werenotpossible. So, the troubled four economies had to adjust internally via wages which was difficult given inflexible labour markets. People also could not migrate to more prosperous regions within the union like Germany given vast cultural differences and language issues. This compounded the problem leading to more pressures on the fiscal policy which was paralyzed for lack of a fiscal union. Here too, Greece ran huge current account deficits before the crisis touching 14% in 2007. Spain and Portugal too had high CADs leading to problems for their economies. As the European crisis deepened, foreign flows stopped coming to these economies making it difficult to finance the current account deficits. Ireland had lower current account deficits than the other three but faced a much bigger problem from the surge in fiscal deficits.

11. Mobeen Alam(13813) 10 Hence, overall we see different reasons for EMU economies coming under pressure. Unlike the US and UK, the twin deficits did act as a trigger for the crisis in especially in the case of Greece. PakistanCurrent Account to GDP Pakistan recorded a Current Account deficit of 2 per cent of the country's Gross Domestic Product in the fiscal year 2011-12. Current Account to GDP in Pakistan is reported by the State Bank of Pakistan. Pakistan Current Account to GDP averaged -2.32 Per cent from 1980 until 2012, reaching an all-time high of 4.90 Per cent in June of 2003 and a record low of -8.50 Per cent in June of 2008. The Current account balance as a per cent of GDP provides an indication on the level of international competitiveness of a country. Usually, countries recording a strong current account surplus have an economy heavily dependent on exports revenues, with high savings ratings but weak domestic demand. On the other hand, countries recording a current account deficit have

12. Mobeen Alam(13813) 11 strong imports, a low saving rates and high personal consumption rates as a percentage of disposable incomes.

13. Mobeen Alam(13813) 12 PakistanGovernment Budget Pakistan recorded a Government Budget deficit equal to 6.40 per cent of the country's Gross Domestic Product in 2012. Government Budget in Pakistan is reported by the Government of Pakistan. Pakistan Government Budget averaged 3.76 Per cent of GDP from 1990 until 2012, reaching an all-time high of 8.80 Per cent of GDP in December of 1990 and a record low of -6.40 Per cent of GDP in December of 2012. Government Budget is an itemized accounting of the payments received by government (taxes and other fees) and the payments made by government (purchases and transfer payments). A budget deficit occurs when a government spends more money than it takes in. The opposite of a budget deficit is a budget surplus.

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15. Mobeen Alam(13813) 14 Pakistan Government Spending Government Spending in Pakistan increased to 2475567 PKR Million in 2013 from 2102526 PKR Million in 2012. Government Spending in Pakistan is reported by the State Bank of Pakistan. Pakistan Government Spending averaged 568938.42 PKR Million from 1982 until 2013, reaching an all-time high of 2475567 PKR Million in June of 2013 and a record low of 33522 PKR Million in June of 1982

16. Mobeen Alam(13813) 15 PakistanBalance of Trade Pakistan recorded a trade deficit of 172754 PKRMillion in July of 2013. Balance of Trade in Pakistan is reported by the Pakistan Bureau of Statistics. Pakistan Balance of Trade averaged -19092.32 PKR Million from 1957 until 2013, reaching an all-time high of 6457 PKR Million in June of 2003 and a record low of -215020 PKR Million in December of 2011. Pakistan runs regular trade deficits primarily due to high imports of energy. Main imports are: fuel (40 per cent of total imports); machinery and transport equipment (18 per cent) and chemicals (16 per cent). Pakistan exports: cotton and knitwear (28 per cent of total exports); bed wear, carpets and rugs (8 per cent) and rice (8 per cent). Main trading partners are United Arab Emirates (10 per cent of total exports and 17 per cent of imports) and China (9 per cent of exports and 15 per cent imports).

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18. Mobeen Alam(13813) 17 CONCLUSION The main objective of this study was to investigate the pros and cons of the twin deficits issue in the context of Pakistan economy. The estimated empirical results confirmed the strong evidence in favour of long run relationship between the budget deficit and current account deficit for Pakistan. The Granger causality test points out to one way causation, that is, from current account deficit to the budget deficit. Again however, this result warrants caution. In the case of Pakistan, twin deficits are surely inter-linked. However, the underlying rationale is not the movements of the interest rates. Pakistan has to borrow most often directly from the donor agencies to finance its development and defence needs. Further, the country is in practice of inviting direct foreign investment to carry out heavy development projects in the public sector. All these factors, along with population pressure and consumption demand, have led to an ever increasing demand for imports. On the other hand, the exports of Pakistan are low and more or less stagnant because of structural problems rather than variations in the exchanges rates. In fact, the Pakistani currency is constantly depreciating since 1970’s in the international market but exports are not increasing due to several restrictions and non-access to the markets concerned. Naturally, the country is facing a persistent deficit on the current account of the balance of payments.

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