Recently, I’ve been seeing a lot of people discussing about the twin deficit hypothesis. Twin deficit means a country is having both fiscal balance deficit and current account deficit at the same time.
So let me explain how fiscal balance works first. Fiscal balance is the government accounting balance between its tax revenue (T) and expenditure (E). Fiscal surplus happens when its tax revenue exceeds its expenditure (T > E). Fiscal deficit happens when its expenditure exceeds its tax revenue (E > T).
How we measure current account is similar to what I have written above. The current account is the accounting balance between a country’s exports (E) and imports (I). If a country exports more than they import (E > I), that means the country is running a current account surplus. If a country imports more than what they export, that means they are running a current account deficit.
You might ask, what is the relationship between these two? Who do both of these have to do with the twin deficit hypothesis?
Well lets look at the national accounting. When we are calculating growth from the expenditure side, we add up consumption (C) , investments (I) , government spending (G) and net exports (NX). If we write this one down into an equation, it looks something like this:
Y = C + I + G + NX ………. (1)
If we calculate this from the supply side, we add up consumption (C), savings (S), and tax revenue (T). In an equation term, it will look something like this:
Y = C + S + T ………. (2)
If we rearrange equation (2) in terms of savings, it will look something like this:
S = Y – C – T ………. (3)
Therefore, if I plug in equation (1) into equation (3), it will look like this:
S = (C + I + G + NX) – C – T
Cancel out consumption, you will get:
S = I + G + NX – T ………. (3)
Again, if I rearrange equation (3) in terms of net exports, we will get:
NX = (S – I) + (T – G) ………. (4)
NX is also known as current account balance (like I mentioned above, that current account measures the difference between exports and imports), and (T – G) is the fiscal balance (again, revenue minus government expenditure).
So, equation (4) perfectly sums up the twin deficit relationship. If the government spends more than what they are collecting (where G > T), then NX (current account) will decrease and eventually turn into a deficit, ceteris peribus.
Now, let’s focus on how do all of these have to do with the currency. Let’s start with the fiscal balance first. There are 2 situations here:
- If the fiscal balance is in surplus (T > G), that will be fine because the government still have extra cash to fund its operation.
- If the fiscal balance is in deficit (G > T), that means the government needs to finance its debt in order to operate. One of many ways the government can do this is to issue government bonds and sell them to either local investors or foreign investors.
- If the government decides to sell all of them to local investors, that will be fine since everyone will be using the same currency.
- If the government decides to sell 50% to local investors, and another 50% to foreign investors, that means when foreign investors need to convert their currency first before any transaction takes place.
- For example, let’s say ABC Corporation from the US decides to buy a government bond issued by the Government of Malaysia. When ABC Corporation shows up to the Government of Malaysia, they will come in with their own currency, which is the US Dollars. That means they have to change it to Malaysian Ringgit first. If there are 50 other companies are doing the same thing as what ABC Corporation is doing, that means there is a strong demand for Malaysian Ringgit. When demand exceeds supply, the currency will strengthen.
Same thing could happen to the current account. There are 2 scenarios here:
- In a current account surplus situation (E > I), that means exporters now have a huge surplus in foreign currencies such as the US Dollars, Singaporean Dollars, Euro, Japanese Yen, and the list goes on.
- Picture this, If I am an exporting company in Malaysia, that will also mean I want to convert most, if not all of my profit into Malaysian Ringgit. Now, if there are other 100 exporting companies in Malaysia is doing the same, that means there is a strong demand for Malaysian Ringgit, thus the currency appreciates.
- In a current account deficit situation however (I > E), this means we are importing too much, and we have to use more foreign currencies to pay for the items we are importing.
- For example, if I am an importing company and I want to import electrical products from the US, that means I have to exchange the Malaysian Ringgit I have for US Dollars. If 100 companies are doing the same thing what I am doing, selling the Malaysian Ringgit for the US Dollars, that means there is an oversupply of the Malaysian Ringgit in the market, and this will depreciate the currency.
These are the fundamentals of how current account and fiscal balance work. In Malaysia’s case, however, is quite unique, since Malaysia is one of many countries that runs a fiscal deficit, but runs a current account surplus.
Many emerging economies however run both fiscal deficit, and current account deficit. This is what in the economics textbooks call a ‘twin deficit hypothesis’ (the reason why it is called hypothesis, is because there is no definite conclusion on it yet).
Fiscal deficit will make the currency depreciate, and current account deficit will also make the currency depreciate. This is what happens to few the emerging economies. The most notable ones are, or course, Turkey, Argentina, Brazil, India, and our neighbor Indonesia.
Now the next question you would ask, is what kind of situation that will push Malaysia into a current account deficit.
I would say there are 3 different ways it can turn into a deficit.
- Huge contractions in shipments of major products including electrical and electronics, palm oil, petroleum and natural gas.
- Massive imports of big ticket items, especially the capital and intermediate goods.
- Travel service (the component within the services) shrinks.
To be frank, I don’t see any strong reason for Malaysia’s current account to turn into a deficit at least for the next 12 months. But few things could change, depending on a few points I mentioned above, especially regarding exports of goods.