Cover of EconPol Working Paper 68

Current Account Targeting Hypothesis versus Twin Deficit Hypothesis: The EMU Experience of Portugal

António Afonso and José Carlos Coelho (EconPol Europe, ISEG - Lisbon School of Economics & Management, Universidade de Lisboa; REM/UECE)

This Working Papaer analyses the relation between Portugal’s government budget balance and current account balance from 1999 (Q1) – when Portugal joined the Euro – until 2019 (Q4). The study arrives at three main conclusions: First, a tightening of fiscal policy improves the external balance of the Portuguese economy, although not substantially. Second, the share of public consumption on GDP has a negative impact on the current account balance. This means, that any policy that stimulates economic activity leading to an increase in public consumption needs to be applied carefully. Finally, the research shows that the investment rate negatively affects the cyclical component of the current account balance, suggesting a high degree of integration of the Portuguese economy in international financial markets. Even though public policy measures promoting investment have a negative impact on external accounts in the short-term, they contribute to the structural improvement of the government balance in the long-run.

Abstract

We study the relationship between the government budget balance and the current account balance for Portugal, using quarterly data from 1999 to 2019. On the one hand, the causality tests find a unidirectional relation running from the current account balance to the government budget balance. On the other hand, IV estimations show a bi-directional relationship between these variables, and the existence of a bilateral relationship between the structural components of both balances. Even so, the policy implication is that the use of fiscal policy to correct the external imbalance, especially in an economic crisis, is not substantial, due to the small size of the estimated impact. In addition, with an ARDL model, we find a negative long run relationship between the share of public consumption on GDP and the current account balance. As expected, the variation of real public consumption produces an adverse accumulated response on the current account balance. Finally, the investment rate negatively affects the cyclical component of the current account balance and contributes to the structural improvement of the budget balance.
 

Citation

António Afonso, José Carlos Coelho: "Current Account Targeting Hypothesis versus Twin Deficit Hypothesis: The EMU Experience of Portugal", EconPol Working Paper 68, July 2021