Twin deficit hypothesis and reverse causality: a case study of China

This paper analyses the causal relationship between budget deficit and current account deficit for the Chinese economy using time series data over the period of 1985–2016. We initially analyzed the theoretical framework obtained from the Keynesian spending equation and empirically test the hypothesis using autoregressive distributed lag (ARDL) bounds testing and the Zivot and Andrew (ZA) structural break for testing the twin deficits hypothesis. The results of ARDL bound testing approach gives evidence in support of long-run relationship among the variables, validating the Keynesian hypothesis for the Chinese economy. The result of Granger causality test accepts the twin deficit hypothesis. Our results suggest that the negative shock to the budget deficit reduces current account balance and positive shock to the budget deficit increases current account balance. However, higher effect growth shocks and extensive fluctuation in interest rate and exchange rate lead to divergence of the deficits. The interest rate and inflation stability should, therefore, be the target variable for policy makers.