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Does fiscal deficit influence trade deficit?

Pakistan has been facing a major problem of high trade deficit for several years. This deficit is increasing rapidly. During the fiscal year 2008 this deficit was at highest level of Rs.1,304.15 billions, which is 108% of total exports (Rs.1,208.12 billion). On the other hand fiscal deficit has also deteriorated. Table below, shows the value of trade deficit and budget deficit, recorded since 1976 to 2008.
Pakistan trade and budget deficit 1976-2008

 (Rs in million)
S.No Years Trade Deficit Budget Deficit

1 1976 9,212 13,065
2 1977 11,718 13,261
3 1978 14,835 14,416
4 1979 19,463 18,250
5 1980 23,519 16,127
6 1981 24,264 16,637
7 1982 33,212 19,076
8 1983 33,709 27,940
9 1984 39,368 27,712
10 1985 51,799 39,416
11 1986 11,354 44,586
12 1987 29,076 48,529
13 1989 34,106 63,352
14 1989 45,658 62,068
15 1990 42,384 62,840
16 1991 32,832 89,193
17 1992 58,161 89,971
18 1993 81,615 107,525
19 1994 52,751 92,179
20 1995 69,719 105,352
21 1996 102,834 137,839
22 1997 139,688 156,588
23 1998 63,178 204,560
24 1999 75,622 179,177
25 2000 90,114 196,600
26 2001 87,930 164,900
27 2002 73,683 202,150
28 2003 62,078 177,400
29 2004 188,789 162,000
30 2005 368,991 216,967
31 2006 726,317 325,300
32 2007 822,494 502,011
33 2008 1,304,153 683,400

The Keynesian income-expenditure approach explains the mechanism behind this twin deficit relationship. It says that increase in the budget deficit will increase domestic absorption in the economy which consequently increases the domestic income level. This increase in the income level would induce imports and resultantly the deficit in the trade balance will be increased.

There is another linkage of the twin deficits, which can be explained through the Keynesian open economy model with high capital mobility. This model maintains that increase in. the budget deficit will increase aggregate demand and the domestic real interest rate. This increase in the interest rate will cause inflow of foreign capital and consequently the domestic currency would appreciate. This in turn will make exports expensive in international markets and adversely affect net exports, therefore trade balance would deteriorate.

This paper will attempt to find the causal relationship between the budget deficit and the trade deficit for the Pakistan economy. This study employs annual date for the period 1976 to 2008.

Literature review Rosenswieg and Tallman (1993) investigated two questions: in the US economy, do increased government deficits cause dollar appreciation, and do fiscal deficits lead to higher trade deficits. Using a five variable vector; VAR (Vector Auto Regression) model the study concludes that government deficit lead to trade deficit, therefore the deficits are twin.

Enders and Bong-Soo (1990) developed at two-country micro-theoretic model consistent with the Ricardian Equivalence Hypothesis that deficit are not twin. Therefore, an increase in tax used to retire government debt will not affect private spending or the current account balance. However, increases in government spending, regardless of the means of finance, can be expected to stimulate a current account deficit. However, the unconstrained VAR estimate shows that the Ricardian equivalence hypothesis did not hold and the authors concluded that deficits are twin in case of US economy.

VAR analyses can be converted into VMA (Vector Moving Average) analyses. Such type of analysis is useful to check the composition of explaining the variables given a shock in one variable. Cholesky decomposition is used to orthogonalize the shocks by placing enough restrictions to identify the system (the VAR is originally under identified). By using this VMA we can estimate impulse responses and undertake variance decompositions.

An impulse response function traces the effect of a one-time shock to one of the exogenous factor on current and future values of the endogenous variables. Annex-B shows the impulse response of both variables. It explains that a shock in the trade deficit would affect the budget deficit in the following period and then quickly come back to its normal position in the next term and remain constant. This implies that a shock in trade deficit would affect the budget deficit in the next period only.


Variance Decomposition states that in the first period the budget deficit is fully explained by itself, however from the next period it is 85% explained by itself and rest of the 15% variation is explained by the trade deficit and this phenomenon remains constant till the tenth period. This implies that the trade deficit have only 15% effect after one lag period.

The VAR analysis shows that twin deficit hypothesis does exist in the short run for Pakistan.


We investigated the twin deficit hypothesis in case of Pakistan for the period 1976-2008 using annual date. The VAR, Granger Causality and Johansen co-integration techniques were applied. The VAR ad Granger causality analysis confirmed one way direction causal relationship showing trade deficit positively effecting budget deficit. So, one of the four possibility of twin deficit hypothesis, that deterioration in current trade deficit leads to slower pace of economic growth and hence increase the budget deficit, is confirmed. Policies which effectively reduce the trade deficit would have a desired impact on the budget deficit.
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Author:Siddiqui, Aamir Hussain
Publication:Economic Review
Article Type:Statistical data
Geographic Code:9PAKI
Date:Jul 1, 2009
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