Testing the fiscal, current and financial account deficits nexus (triplet deficits hypothesis) for Kenya 1980-2014
Kariuki, Njoroge Samuel
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Macro-economic theory suggests that there exists a causal relationship that runs from the Budget Deficit to Current account deficit, a concept referred to as the Twin Deficits Hypothesis. Further analysis has pointed towards an extension of this relationship running up to the Financial Account through the Savings-Investment Imbalance, a concept known as the Triplet Deficits Hypothesis. Presence of the triplet deficits implies that all the accounts are in deficit making internal balance in the budget account and external balance in the BoP account major problems with undesirable effects on economic growth, domestic prices, interest rates, and balance of payment. This study contributes to this growing literature by testing validity of the Triplet Deficits Phenomena in Kenya from 1980 to 2014. The specific objectives are to establish if there is a relationship between the Fiscal Balance, the Current Balance, and Financial Balance; and to establish direction of causality between the three balances. Identifying the connection of the three deficits would help provide appropriate policy recommendations on the specific deficit to target in order to reduce the deficits. In addition, investigation on this issue is essential since fiscal policy is used as a tool for managing economic imbalances, and if the triplet deficits hypothesis exists, it can be used to influence the budget and trade account balance, along with the financial account balance, all which are major determinants of Economic Growth. The findings of this study will assist design policies that aim at addressing the budget and current accounts deficits, the burgeoning external debts and the reduction in international reserves. Kenya provides an ideal scenario for studying the relationship of the deficits not only because it is a developing nation but also because it has been running the deficits for several decades. To estimate if a relationship exists between the variables, the study estimated the cointergration properties by employing the Johansen & Juselius model. The study also applied the structural VAR model to estimate IRF and Variance Decomposition. Finally, the study investigated the causal relationship of the three deficits in the framework of Toda-Yamamoto MWALD test for causality. The overall finding using a VAR Model on three equations was that the Budget Balance increases both the Current Account Balance and Savings-Investment imbalance; the Current Account Balance on the other hand increases the Budget Balance, but decreases the Financial Account Balance. Lastly, the Financial Account Balance increases the Budget Balance but is negative on the Current Account Balance. The Toda-Yamamoto MWALD test for causality indicated that a Financial Account Balance causes a Budget Balance while Budget Balance and Current Account Balance cause Financial Account Balance. An analysis of these findings evidence validity of the Triplet Deficits Hypothesis for the Kenyan case. Therefore, the study recommends that the government should strive to keep the three balances in sustainable levels, but especially the budget balance for its causal effect on both the current account balance and financial account balance. This will in effect reduce the negative effects of Current Account deficits and Savings-Investment Imbalances on the economy by improving the terms of trade and reducing over-reliance on external funding. This can be achieved through having proper and efficient tax collection and administration systems, observing fiscal discipline in the budgeting process, encouraging a saving culture, restructuring banking sector about credit arrangement and sectorial credits, interest rates and exchange rates counter measures that are favorable to foreign investments, and encouraging external debts at concession rates.