The Nexus between Fiscal Deficits and Economic Growth in ASEAN.

• Author: Lau, Wee-Yeap
• Position: Association of Southeast Asian Nations - Report

This study provides new evidence on the nexus between fiscal deficits and economic growth among ASEAN countries in the pre- and post-Global Financial Crisis (GFC) periods. Using annual data from 2001 to 2015, three results stand out. First, fiscal deficits are found to be growth-deteriorating in the pre-Crisis period and growth-enhancing in the post-Crisis period. Second, the impact of fiscal deficits on growth in pre- and post-GFC are robust to different measures of economic growth. Third, among control variables, inflation is important in influencing economic growth in the pre-Crisis period while exchange rate and inflow of foreign direct investment have a positive impact on growth in the post-Crisis period.

Keywords: ASEAN, fiscal deficit, economic growth, Global Financial Crisis, capital accumulation.

1. Introduction

   The 2008-09 Global Financial Crisis (GFC) dealt a severe blow to some of the ASEAN member countries, especially to their main engine of growth--the export sector. Lower exports led to slower or negative growth in their respective economies. Income and living standards fell overall, but the impact of the Crisis varied from one member state to another.

   As observed in Table 1, Brunei led the pack of negative growth countries with -1.78 per cent, followed by Malaysia (-1.53 per cent), Thailand (-0.69 per cent) and Singapore (-0.61 per cent) in 2009. Likewise, Cambodia and the Philippines also experienced a low growth phase in 2009. In contrast, Myanmar, Lao PDR, Vietnam and Indonesia were able to maintain decent growth rates, partly due to capital inflows from foreign direct investment (FDI).

   Moreover, for all ASEAN members, the policy responses show a similar pattern--pursuing a fiscal stimulus to revitalize the economy in the aftermath of the GFC. Table 1 also presents the data on the fiscal deficits for all ASEAN countries. As observed, Malaysia generated a rather large fiscal deficit, close to 6.7 per cent of gross domestic product (GDP) in 2009. Obviously, the large fiscal deficit enabled the Malaysian economy to recover from economic stagnation in 2009, as evidenced by the annual GDP growth of 7.16 per cent in 2010. Likewise, for Thailand, a fiscal deficit of 4.2 per cent of GDP in 2009 translated into annual GDP growth of 7.24 per cent in 2010.

   However, one may argue that the recovery of ASEAN's economic growth was also due to other factors such as an increase in FDI. To determine the validity of this argument, this study aims to investigate the relationship between fiscal deficit and economic growth among ASEAN countries in pre- and post-GFC periods.

   Apart from revealing the relationship between fiscal deficits and economic growth during the two phases, this study also analyses macroeconomic variables such as inflation rate, exchange rate, and the inflow of FDI to identify the exact factors that contributed to ASEAN's economic growth in the post-GFC period. With this approach, the study provides a clear direction to policymakers to achieve higher economic growth among ASEAN countries.

   The rest of this paper is organized as follows. The following section reviews the existing literature on the linkages between fiscal deficits and economic growth. The third section describes the empirical model and presents the hypotheses for the study. The subsequent section focuses on data and methodology employed. The fifth section discusses the findings and the last section concludes.

2. Literature Review

   There are two major schools of thought on the impact of fiscal deficits on economic growth. On one hand, neoclassical economists state that fiscal deficits will negatively affect economic growth (Bernheim 1989). This is because the deficit will raise an individual's total lifetime consumption by shifting taxes to subsequent generations. If economic resources are fully employed, the increase in consumption implies a decrease in savings. Therefore, the interest rate must rise to bring capital markets into equilibrium. This means that a persistent deficit will eventually "crowd out" private capital accumulation and subsequently deteriorate the overall economic growth.

   Conversely, the Keynesian school posits that there is a positive relationship between fiscal deficit and growth (Keynes 1936). This school of thought argues that a significant fraction of the population faces liquidity constraints. Such individuals have very high propensity to consume out of current disposable income. Hence, a temporary tax reduction will have an immethate and quantitatively significant impact on aggregate demand. Furthermore, if the economy's resources are initially underemployed, the rise in consumption will lead to an increase in national income, thereby generating a second-round effect through the well-known Keynesian multiplier. Therefore, fiscal deficit will stimulate consumption and economic growth.

   Various empirical stuthes have been undertaken to clarify these conflicting claims. The study of the relationship between economic growth and fiscal deficits can be traced back to the work of Martin and Fardmanesh (1990). Using cross-section data from seventy-six developed and developing countries from 1972 to 1981, the authors investigate the impact of different fiscal variables on economic growth. These variables include: government fiscal deficit; expenditure; revenue; non-tax revenue; gross capital formation; and population growth. Results from the cross-sectional linear regression show that deficit and tax revenue have a negative impact on economic growth, while government expenditure is found to have a positive impact. Furthermore, by dividing countries into low, middle and high-income categories, the study finds that there is a negative relationship between fiscal deficit and economic growth only in middle-income countries. In contrast, Nelson and Singh (1994) examine the deficit-growth nexus for seventy developing countries and find no significant relationship between fiscal deficits and economic growth.

   Through a panel data approach, Adam and Bevan (2005) investigate the same relationship for forty-five countries from 1970 to 1999. Results indicate that there is a threshold effect in the deficit-growth relation. If the fiscal deficit is less than or equal to 1.5 per cent of GDP, then deficits are found to be growth-enhancing, whereas deficits above the threshold level are found to be growth-deteriorating. Moreover, a robustness check by replacing government expenditure with fiscal deficit shows that productive expenditure has a positive impact on economic growth, while residual expenditure is found to have a negative relationship with growth.

   By focusing on an individual country, Tan (2006) examines the dynamic linkages between fiscal deficits, inflation and economic growth in Malaysia from 1966 to 2003. The study finds unidirectional causality from fiscal deficit to money supply, and from money supply to prices. The paper concludes that a fiscal deficit could have an inflationary impact on the economy via monetization of the deficit.

   Subsequently, Taylor et al. (2012) examine the relationship between fiscal deficits, government debt and economic growth for the U.S. economy. Using quarterly data from 1961 to 2011, their results from the vector error correction (VEC) model show that fiscal deficits had a significant positive effect on economic growth. Also, the paper strongly argues that higher fiscal deficit tends to stimulate the economy during periods of recession.

   Van and Sudhipongpracha (2015) study the relationship between government budget deficit and economic growth from 1989 to 2011 for the Vietnamese economy. Their results demonstrate that government deficits have no effect on the country's economic growth. Instead, they find that FDI is important in influencing Vietnam's economic productivity over the same period while the real interest rate adversely...