The nexus between internal and external macroeconomic imbalances: evidence from Egypt

Abstract

This paper examines the nexus between internal and external imbalances of the Egyptian economy. In fact, both the twin-deficit hypothesis (TDH) and the Feldstein–Horioka (FH) paradox are examined. Using quarterly data (between 2002 and 2014) in order to capture the short-term dynamics that might affect the Egyptian economy, a Granger causality test and an error-correction model are run in order to determine both the short-term adjustment and the long-run relationship between internal and external imbalances. Our main findings show that the TDH is rejected and a reversed causality running from the current account to the budget deficit exits. Moreover, the FH puzzle is partially rejected since Egypt, while not being perfectly integrated in the world capital market, has a high degree of capital mobility.

Keywords:

• Egypt
• twin deficits
• budget deficit
• current account deficit
• Feldstein–Horioka puzzle
• capital mobility

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1. However, the resulting external deficit may be eased if fiscal deficits also raise the interest rate, which results in a simultaneous fall in domestic investment (Abbas et al., 2010; Corsetti & Muller, 2006; Nazier & Essam, 2012).

2. Appendix 1 includes the definition and the source of each variable.

3. Clearly, even if the financial crisis in 2008 and the Egyptian revolution in 2011 represent important evolutions at the economic level, we cannot run a separate regression for each sub-period given the limited number of observations. This is why we opted for introducing dummies that capture the effect of both the financial crisis and the revolution.

4. We run OLS regressions for the first-differenced variables where the current account deficit is the dependent variable and the budget deficit is the independent one (Table A1 in Appendix 2). We found an insignificant coefficient showing that the budget deficit does not have an impact on the current account. Hence, the twin deficit hypothesis is rejected for Egypt during the period 2002–2014. It is worthy to note that neither the financial crisis nor the revolution dummies are significant.

5. We also run a generalized impulse response function with deseasonalized data and found similar results (see Figure A1).

6. The results of the VAR model are in Table A3 in Appendix 2.

7. The model proposed by Fidrmuc (2003) has the advantage of providing in the same regression, a test for the twin deficit hypothesis together with an estimate for the degree of capital mobility (or financial integration).

8. Running a simple OLS model (Table A4 in Appendix 2), we found an insignificant coefficient of the budget deficit. Moreover, the effect of investment on the current account deficit seems to be insignificant even when we control for the impact of the financial crisis in 2008/2009 and the impact of the Egyptian revolution in 2011/2012.

9. The results of the VAR model are in Table A6 in Appendix 2.

10. We also run a generalized impulse response function with deseasonalized data and found similar results (see Figure A2).

11. As a robustness check, we run an OLS with first differences and a VEC model with annual data and found also an insignificant impact of budget deficit on current account balance (see Table A7 in Appendix 4).

12. Since July 2013, the Egyptian pound stabilized within a 2% band against the US dollar. This trend continued through April 2014 (IMF, 2015).

13. The Chinn–Ito index (KAOPEN) is an index measuring a country's degree of capital account openness. The index was initially introduced in Chinn and Ito (2006). KAOPEN is based on the binary dummy variables that codify the tabulation of restrictions on cross-border financial transactions reported in the IMF's Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER). This index measures capital account liberalization using four variables: the presence of multiple exchange rates, restrictions on current account transactions, restrictions on capital account transactions and the degree of commercial openness. The higher the index, the weaker the restrictions on capital movements.

Additional information

Funding

This work was supported by Egyptian Center for Economic Studies.