This document analyzes the relationship between current account deficits and budget deficits in Malawi using annual time series data from 1970 to 2012. It aims to test three hypotheses: 1) the Keynesian twin deficits hypothesis of a positive relationship between the deficits, 2) the reverse causality hypothesis that current account deficits cause budget deficits, and 3) the Ricardian equivalence hypothesis that budget deficits do not impact private savings. The empirical analysis finds support for the twin deficits hypothesis but not for the other two hypotheses. It concludes that fiscal consolidation is needed to improve Malawi's external imbalance.

1. Twin Deficits
An empirical analysis of the
relationship between current account
deficits and budget deficits in Malawi
By
Tayamika Kamwanja

2. OUTLINE
1. Brief Background & Motivation of the study
2. Study Objectives
3. Methodology
4. Empirical Results
5. Policy Recommendations & Limitations of Study

3. Background & Motivation of the study
• Most developing countries including the Malawi Economy
are characterized by budget deficits and a deteriorating
trade balance which has led to current account deficits.
Many analysts suspect that these features are closely, and
perhaps even causally, related.
• Four possible causation linkages between the budget
deficit and the current account deficit have been
proposed.
• These stem from the national income accounting
identities which guarantee that budget deficits must
create either an excess of private saving over investment
or an excess of imports over exports (Pilbeam, 1998).

4. • Y = C + I + G + (X –M) (1)
• Y = C +S + T+ F (2)
• (X – M - F) = (S – I) + (T – G) (3)
The first linkage is the Keynesian (conventional)
proposition often associated with the Mundell-Fleming
model (Twin Deficits). It argues that there exists a
positive relationship between the two deficits and that
causality is from the budget deficit to the current
account deficit (Mundell, 1963; Fleming, 1962).
The second linkage is the Reverse causality proposition
which argues that the causality runs from the current
account balance to the budget deficit. (Marinheiro,
2007)

5. Bidirectional causality may exist between current
account and budget deficits (Zengin, 1999).
Lastly, proponents of the Ricardian equivalence
hypothesis (REH) suggest the absence of any
relationship between the current account deficit and
the budget deficit (Barro, 1989).

6. 2%
0%
-2%
-4%
-6%
-8%
-10%
-12%
1970 1976 1982 1988 1994 2000 2006 2012
Budget Balance (% of GDP)
Fiscal balance over the decades (1970:K-25.5m, 1980: K-78
million, 1990:K-156.6m, 2000: K-5,458.4m, 2010: K-22,940m &
2014: K-107,000m,(Reserve Bank of Malawi).

7. 5
0
-5
-10
-15
-20
-25
-30
1970 1976 1982 1988 1994 2000 2006 2012
Trade Balance Current Account Balance Linear (Trade Balance) Linear (Current Account Balance)
The Current Account balance over the decades (1970:K-30.5m,
1980: K-168.1m, 1990:K-411.7m, 2000 K-11,245.6m, 2012:
K119,367m & 2014: K123,244m.

8. • Fiscal and external deficits have been a common feature
of the Malawian economy, and a possible reinforcement
on each other.
• It is evident that export diversification and graduation
from primary commodities is needed to limit the effects
of external shocks on the country’s top export products
and curb the deterioration of the external balance.
• As for the internal balance, the strain of external debt on
the national budget cannot be overemphasized.

9. Study Objectives
The main objective of this study was to empirically
examine the existence of a causal relationship between
current account and budget deficits in Malawi.
Specifically,
• To explore the plausible long-run linkage between the
current account deficit and the budget deficit in Malawi.
• To explore the possibility of reverse causality from
current account deficits to budget deficits.
• To determine if the Ricardian equivalence holds in
Malawi, that the budget deficit has no impact on the
private savings.

10. Methodology
• This study used the Autoregressive Distributed Lag method
(ARDL) of co integration (Pesaran & Shin, 1999) to test the
three proposed hypotheses using annual time series data
of Malawi over the period 1970 to 2012.
• Test for Keynesian proposition:
CAB t CAB BB GDP RER
      
   
( )    ( )  ( )  ( ) 
( )
3
CAD BB GDP RER ut
• Test for REH:
q
i
t i
q
i
t i
q
i
t i
p
i
t t t t t
        







   
( ) ( ) ( ) ( )
0
9
2
0
8
1
1
7
1
6
0 1 2 1 3 1 4 1 5 1
   
CONS CONS DY BDEF DY GD CONS
        
( )   ( )  ( )  ( )  ( )  ( ) 
( )
0 1 2 1 3 1 4 1 5 1 6
3
DY BDEF GD ut
t i
q
i
t i
q
i
t i
q
i
t i
p
i
t t t t t
      








   
  

( ) ( ) ( )
0
9
2
0
8
1
1
7
1
  

11. • For the REH we focused on the reaction of private
consumption on government financing decisions, using
a reduced form consumption function proposed by
Perelman and Pestieau (1993).
C =α0 +α1 (Y -TX) t +α2 BDEFt +α3 Wt +α4GBt +εt (4)
• In this formulation, the sum (α1 + α2) gives the effect
on current consumption of a tax-for-deficit
substitution, holding public expenditure unaltered.
Hence, the Ricardian equivalence hypothesis is
interpreted as implying α1 + α2 = 0 and α4 = 0.

12. Empirical Results
Augmented Dickey Fuller and Phillips-Perron test results:
ADF PPERRON
Variable Levels 1st Difference Levels
*, ** and *** indicate the rejection of the null hypothesis of non-stationary at 1%, 5% and 10% significant
level, respectively.
1st
Difference
Integration
order
CAB 3.621* 8.6127* 3.5731** 13.3237* I(0)
BB 2.9566** 11.1886* 5.0147* 27.0898* I(0)
GDP 3.1988 7.6969* 3.2010 7.8118* I(1)
RER 3.4312*** 5.164* 4.2685*** 5.164* I(1)
CONS 4.7457* 5.9869* 4.7893* 22.987* I(0)
DY 2.774 7.5169* 2.7618 7.8443* I(1)
BDEF 5.8779* 11.5827* 5.9171* 25.4248* I(0)
GD 0.8358 5.4135* 0.7663 5.4279* I(1)

13. 
5% critical values 10% critical values
Null Hypothesis F statistic CVL CVU CVL CVU
β1 =β2=β3=β 4=0 7.9874 3.23 4.35 2.72 3.77
123 
4Table 2: Co integration test results on CAD model
Note: CVL and CVU are the lower bound and upper bound critical values provided by
Pesaran et al. (2001).
Table 3: Normalized long run effects on CAD model
Effect Value Null Hypothesis Probability
Budget balance: - β2 / β1 0.7907 - β2/β1 =0 (0.0003)
GDP: - β3 / β1 6.369 - β3/β1 =0 (0.0172)
REER: - β4 / β1 -0.0397 - β4/β1 =0 (0.0001)
Note: The normalized effects are calculated by dividing the long-run coefficients over the
dependent variables coefficient

14. 
10% critical values 5% critical values
Null Hypothesis F statistic CVL CVU CVL CVU
β1=β2=β3=β4=0 3.8867 2.72 3.77 3.23 4.35
12 3 
4 Table 4: Co integration test results on reverse causality model
Note: CVL and CVU are the lower bound and upper bound critical values provided by Pesaran
et al. (2001).
Table 5: Normalized long run effects on reverse causality model
Effect Value Null Hypothesis Probability
CAD: -β2/β1 0.213 -β2/β1 =0 (0.6131)
GDP: - β3/β1 -9.5326 -β3/β1 =0 (0.0067)
REER: - β4/β1 0.0256 - β4/β1 =0 (0.0041)
Note: The normalized effects are calculated by dividing the long-run coefficients over the
dependent variables coefficient.

15. 
5% critical values 10% critical values
Null Hypothesis F statistic CVL CVU CVL CVU
β1=β2=β3=β4=0 7.6748 4.01 5.07 3.47 4.45
12 3 
4 Table 6: Co integration test results on REH model
Note: CVL and CVU are the lower bound and upper bound critical values provided by Pesaran
et al. (2001).
Table 7: Perelman & Pestieau restriction results on REH model
.
Restriction Null Hypothesis F statistic (p) P value
Pure Ricardian
Equivalence BDEF=-DY, GD=0 1.2893 0.3011
Mild Ricardian
Equivalence -BDEF=DY 2.5241 0.1305
Note: BDEF, DY and GD are budget balance, disposable income and government debt
respectively

16. Interpretation and Conclusion
• This study found that in the period under study the current
account deficit in Malawi in the long run is partly caused by the
general government fiscal deficit (The Twin Deficits holds in
Malawi.
• There is no causal relationship flowing from the current account
to the fiscal deficit (No reverse causality).
• Private consumption in the country is not affected by the fiscal
deficits but responds to the external debt incurred by
government (REH does not hold in Malawi).
• Both GDP growth and real exchange rate have positive, long-run
impacts on the current account in Malawi. However, the current
account balance is more responsive to changes in GDP than to
changes in the real exchange rate.

17. Policy recommendations
• In order to improve the external imbalance, the
Government should begin with correcting the internal
imbalance. Contractionary fiscal policy channeled through
lower government spending and/or improvements in tax
collection systems (not tax rate adjustments as the tax base
is low).
• Policies should be put in place to ensure that government
debt consumption is spent on investments rather than
consumables, so that the money to repay this debt may be
realized in the future. Essentially, track what we are using
the borrowed funds for: Implementation bottlenecks &
corruption.

18. • Policies should be put in place to encourage export
production in the country, and curb imports by
encouraging buying Malawian products (branding
campaign & quality control), so that productivity may
boost the export industry.
• The current exchange rate policy should be maintained,
leaving the Kwacha to remain floating, so as to allow the
factors of demand and supply to determine its value. This
will allow the country’s exports to trade at a value that is
reflective of their quality and competitiveness on the
international market.

19. Limitations of study
• The main limitation of the study was the availability and
consistency of data
• We could possibly have different results if all the data
used in this study were compiled under one organization
as there would not be any variations in the calculations
and weights used.
• Another aspect is that this sort of study requires data that
is investigated compiled at shorter intervals such as
quarterly or bi-annually. Since the data here is recorded
annually, this might also have affected the results.

20. Thank you very much for
your attention!