Empirical Evidence from Developing Countries

The Organisation for Economic Co-operation Development (OECD) (2002), using the cost benefit analysis, found that investing in public transport infrastructure causes the resources to be allocated and used efficiently in a country. Government expenditure increasing to invest in transport infrastructure improves the accessibility of economic activities leading to an increase in the market size for manufacturing, tourism and competitiveness. Investment in transport infrastructure does encourage economic development in underdeveloped regions by generating employment and improved environmental outcomes.

23 A study by Raju and Mukherje (2010) of fiscal deficit, crowding out and the sustainability of economic growth in India from 1980-2009 shows that there is no long run relationship between the variables. The study applied unit root tests and cointegration techniques that allow for endogenously determined structural breaks. It was found that there is either crowding in or crowding out of public spending and investment and the findings are in line with the ricardian equivalence theory that implies that it does not matter whether a government finances its spending with debt or tax increases. The convergence in fiscal deficit and debt has helped to accelerate the rate of investment in the economy in the medium run.

Bose, Harque and Osborn (2007) investigate the relationship between budget deficit and economic growth for 30 developing countries, from 1970 to 1990. By using panel data analyses, they found that the budget deficit helps the economy to grow provided that the deficits were due to productive expenditures such as education, health and capital expenditures. The same conclusion is derived based on the research done by Fischer. A huge budget deficit helps Morocco and Italy to grow since the excessive spending helps to increase the level of private consumption in the short-run. It was due to the deficits which were used to reduce the burden of taxation from the consumers’ perspective. In the long-run, huge budget deficits ruined the level of economic growth for these two countries since they have to struggle in paying back all the national debts.

Ramzan, Saleem and Butt (2013) explored the impact of budget deficit on economic growth in Pakistan. Time series data was used for the period 1980 to 2010 and the study used regression analysis. The Pearson Correlation test was also applied to check the relationship among independent variables. The analysis reveals that the model was a good fit. The results showed that there is moderate correlation between budget deficit and investment.

Odhiambo, Momanyi, Frederick and Othuon (2013) investigated the relationship between fiscal deficits and economic growth in Kenya. The study used both exploratory and causal research designs and employed time series secondary data for a period of 38 years (1970-2009) and was estimated using the OLS method as well as the Johansen Cointegration test.

The study also performed various econometric tests such as the Dickey Fuller (DF) and Augmented Dickey Fuller (ADF) unit root test as well as the error correction model.

Diagnostic tests, like multicollinearity, were also performed. The study found a positive relationship between budget deficits and economic growth, in line with the Keynesian

24 assumptions and hence recommends prudent financial management and enhanced revenue collection by revenue authorities so as not to crowd-out private sector investment by borrowing domestically.

Kukk (2004), in a working paper about the effect of fiscal policy on economic growth in both the short run and the long run, found that government revenue and government expenditure have a significant effect on GDP because public investments are positively related to growth.

With the government improving its expenditure when it is needed the best results in GDP growth can be achieved. By raising taxes and increasing investments the government could experience accelerated growth rates. Using the cost function modelling approach and augmented dickey fuller test for checking the unit roots it was found that underinvestment in transport infrastructure was largely responsible for low levels of growth rates in output.

Roy, Heuty and Letouze (2006) investigated the fiscal space for public investment in Singapore; they found that public investment has been declining since the 1980s especially in public investment in infrastructure due to fiscal conditions such as the country experiencing a fiscal deficit. A fiscal deficit is an important cause for the decline of public investments and slows down economic growth. Public investments such as infrastructure have an important role in kick starting economic growth, reducing the unemployment rate and, in turn, reducing poverty. They used time series data from the period 1970-2000 that was obtained from the International Monetary Fund.

Rahman (2012) explored the relationship between budget deficit and economic growth from Malaysia’s perspective. Four variables were used, namely: real GDP, government debt, productive expenditures and non-productive expenditures. The ARDL approach is used to analyse the long-run relationship between all series since it can cater for a small sample size.

By using quarterly data from 2000 to 2011, it was found that there is no long-run relationship between budget deficit and economic growth in Malaysia. However, productive expenditure has a positive long-run relationship with the economic growth.

Hadiwibowo (2010) finds significant relationships between fiscal policy variables such as government expenditure and government revenue and investments. In this study, the vector error correction model was employed to investigate fiscal policy, investments and economic growth in Indonesia. The study uses data obtained from Statistics Indonesia, Ministry of

25 Finance, world development indicators; it uses quarterly time series data from 1969-2008.

The Augmented Dickey Fuller test is applied as well as the Phillips Perron (PP) method to check for unit roots; the Schwarz Information Criterion to determine the lag length in the ADF tests and, lastly, the Newey West band width selection with Bartlett kernel in PP tests was also employed. The results indicated that government development in developing countries is more valuable because it provides higher returns, accelerates growth and the government should be aware of the negative effects that expenditure could bring; such as, the misallocation of resources in unproductive expenditure which would later imply budget deficits and higher taxes. Government expenditure and government revenue (budget deficit) have an adverse relationship with investment whereas a budget surplus has a relatively positive relationship with investments. Higher budget deficits affect investments negatively because of the crowding out effect and they generate higher interest rates which mean that the cost of capital will be high, thus discouraging local investments and encouraging investments from abroad (FDI).

Kuştepeli (2001), in Turkey, shows that a government deficit leads to inflation which later brings uncertainty, which negatively affects economic growth. The study used Augmented Dickey-Fuller tests to test for unit roots for the variables, the Engle Granger and Johansen Cointergration tests and causality tests are performed. It was assumed that a high and persistent deficit leads to increases in inflation and the monetary base; this affected the growth of the economy negatively.

Fatima, Ahmed and Rehman (2011) investigated the effects of a budget deficit on economic growth and looked at the indirect impact of fiscal deficit on GDP through investment as a share of real GDP per capita in Pakistan. It used the time series data obtained from International Financial Statistics, Pakistan Economic Surveys and the State Bank of Pakistan’s annual reports and considered the period 1980-2009 which covers up to 30 observations; the regression analyses were performed to check the impact of a budget deficit on economic growth. The ordinary least squares are employed in the study and it uses the model developed by Shojai, in 1999, in investigating the effects of a budget deficit on economic growth and the two-stage least squares method (2-SLS) is used to estimate simultaneous equations. The results were that a budget deficit has a negative impact on the country’s economic growth which will cause a major decline in real investments such as transport infrastructure investments. The country’s deficit reached its highest percentage in

26 2007-2008 by 7.3% but later decreased to 4.7% of GDP in 2008-2009. With a 1% increase in inflation it led to a decrease in investment by 84%; this indicated that there are adverse effects of inflation to economic growth. The fiscal deficit itself showed a negative and significant impact on investment. Lower investments will cause lower economic growth and it clearly showed that fiscal deficit not only affected the economic growth directly but also indirectly through investments. Moreover, the Durbin Watson statistics in the regressions showed that the models are free from autocorrelation problems.

Reungsri (2010) examined the impact of public infrastructure investment on economic growth in Thailand using the Dickey-Fuller and the Augmented Dickey-Fuller tests to justify the stationary status. In addition, the OLS method can be used in estimation and ECM as well as the ARDL. This study concentrated on quarterly time series data from 1993:Q1 to 2006:Q4 and was obtained from the Bank of Thailand, the National Economic and Social Development Board, the Ministry of Finance, the Revenue Department, the Excise Department, and the Customs Department. The results showed that a country experiencing a large deficit could have a negative impact in productivity and there will be a failure in promoting efficient and responsive goods and services, especially when the infrastructure is financed by the public sector. The empirical results discovered that, with the government having sufficient public capital, economic growth can be promoted through infrastructural investments.

Joshi (2009) explores whether the does fiscal deficit of India hurt economic growth; he states that the fiscal deficit was a budgeted 6.8 per cent of GDP in 2009-10. With a budget deficit this is where the problem starts; it can be financed through domestic borrowing or foreign borrowing which could, in turn, mean a cut back in spending on critical sectors such as infrastructure. Where excessive domestic borrowing can lead to a hardening of interest rates, too much foreign borrowing can lead to an external debt crisis. The domestic-borrowing programme of the government puts pressure on domestic government-bond yields; this complicates the implementation of a soft-interest rate policy by the central bank. Further, a high deficit is bound to crowd out private investment, inflation and exchange rate fluctuations.

27 Khan and Khattak (2008) investigated the analysis of short-term effects of budget deficits on macroeconomic variables such as private investment, public investment, economic growth and unemployment using the annual data for the period 1960-2005, taken from the International Financial Statistic (2003). ECM was used for estimation. The Augmented Dickey-Fuller (ADF) test has been used and the Akaike information criterion is used to select the optimum ADF lag. Stationarity of the variables was checked and the Johansen Cointegration test was used to ascertain the Cointegration in the regressions used for analysis.

The results show that short run changes in government consumption, private investment and public investment have a positive impact on the short-run changes in growth. If the government gives priority to long-term private public investment policies, it can gain better results in economic growth, poverty alleviation and unemployment retardation. The parallel and effective running of monetary, fiscal and exchange rate policies is needed to reduce the balance of payment deficit.

According to Al-Khedar (1996), interest rates increases in the short run due to a budget deficit but, in long run, there is not impact explored. The study employed the VAR model by selecting the data of G-7 countries for the period 1964-1993. The outcome shows that the deficit negatively affects the trade balance. However, the budget deficit has a positive and significant impact on the economic growth of the country. Hence, the money borrowed from abroad or domestically to finance the important sectors in the economy, such as transport infrastructure, generates some returns that would make a positive impact on the growth rate.

The researcher made use of Barro’s empirical work which explores a positive and significant impact of budget deficit on growth. This impact is due to the positive relationship between the budget deficit and the inflation and the fact that budget deficits have a way of crowding in investments, especially the constructive ones.

Ghali and Al-shamsi (1997) utilized Cointegration and Grangers causality to investigate the effects of fiscal policy on economic growth for the small oil producing economy of the United Arab Emirates, over the period 1973-1995. This study provides evidence that government investment has a positive effect on economic growth, whereas the effect of government consumption is insignificant. It concluded that an increase in investment leads to an increase in the economic growth of the country.

28 Gulcan and Bilman (2005) used the cointegration method and causality test and applied ADF, Phillips Perron and KPSS unit root tests to investigate the stationarity of the individual time series. The data used from Turkey was for the period 1960 to 2003 and proved that there is a strong impact of budget deficit on the real exchange rate. The study shows that the role of the budget deficit in maintaining the real exchange rate is crucial. It was suggested that the government must focus to stabilizing the budget because the trade balance is significantly affected by the real exchange rate.

Joharji and Starr (2010) analysed the impact of fiscal policy on economic growth using time-series methods and data for 1969-2005. The VAR, VECM and the Johansen Cointegration tests found that an increase in government spending has a positive and significant long-run effect on the rate of growth. Government investment in infrastructure and productive capacity has been less growth-enhancing in Saudi Arabia than programs to improve the administration and operation of government entities and support purchasing power. They concluded that investment in transportation and communication has a positive and strong effect on growth.

Abayomi (2011) explored the effects of government expenditure on economic development in Nigeria, using the econometrics model with Ordinary Least Square (OLS) technique. The paper tested for presence of stationarity between the variables using the Durbin Watson unit root test. The results showed an absence of serial correlation and that all variables incorporated into the model were non-stationary at their levels. The findings show that there is a positive relationship between real GDP as against recurrent and capital expenditure. The budget deficit that leads to excessive debt has a negative effect on economic growth since there will be reduced investments or they will be put on hold while the government searches for other sources of financing the deficit.

Mwakalikamo (2011) analysed the public budget deficit in Tanzania and its impact on macroeconomic variables such as inflation, trade deficit and the exchange rate. The results indicate that an increase in budget deficit will cause a similar increase in the current account deficit; government budget deficit has a positive impact on the real exchange rate through the price level and government deficit impacts the inflation rate in terms of how the deficit is financed. This means that if the government decides to increase deficit spending then Central Bank will be obliged to increase the money supply and such monetization will easily lead to inflation, at least in a long run. The data showed that when budget deficit increases, domestic

29 absorption - namely consumption and investment – increases; hence, importation will expand and cause the current trade deficit. The study used descriptive and secondary data which was collected from public documents, field notes, downloaded documents from the internet, reports and the library.

Easterly and Hebbel (1992) investigated the public sector deficits and macroeconomic performance varying sample of member countries of the OECD and developing countries.

The government deficit was blamed for the large part that encouraged all the downfalls that developing countries experienced such as over indebtedness, led to a debt crisis, higher inflation, poor investment and growth performance. The consequences of budget deficits depend on how they are financed because: if the deficit is financed by printing more money then it could lead to inflation; domestic borrowing leads to a credit squeeze through higher interest rates or when interest rates are fixed through credit allocation; the external borrowing leads to a current account deficit and real exchange rate appreciation, or an external debt.

Anayochukwu (2012), in Nigeria, explored the effects of a fiscal deficit and inflation using the autoregressive distributed lags (ARDL) and the granger causality test from 1970-2009.

The fiscal deficit/GDP causes inflation, however, no feedback mechanism was observed. The results from the ARDL test confirm a significant negative relationship between growth in fiscal deficit (% of GDP) and inflation as the above results confirm the priori expectation.

Velnampy and Achchuthan (2013) studied fiscal deficit and economic growth in Sri Lanka.

Data on the fiscal deficit and economic growth from the year 1970 to 2010 was collected for the purpose of this study. The results revealed that there is no significant impact of fiscal deficit on the country’s economic growth. There is also no significant relationship between fiscal deficit and economic growth from the Sri Lankan economic perspective.