A nonlinear investigation of the twin deficits hypothesis over the business cycle: Evidence from Turkey

•The validity of the Twin deficits hypothesis is investigated for Turkey.•A two-regime TVAR model is utilized as a nonlinear estimation methodology.•Twin deficits hypothesis is only the case in the upper regime.•The divergence is lower regime can be attributed to the cyclical behavior of output.

In this paper, we analyze the twin deficits hypothesis covering the period from 1994 to 2012 in Turkey. In contrast to previous studies on Turkey, the existence of twin deficits is investigated by regime-dependent impulse response functions and forecast error variance decompositions based on a multivariate two-regime threshold VAR (TVAR) model. Our results suggest that the dynamics between the current account and budget account variables are affected by macroeconomic activity: twin deficits are only the case in the upper regime, when the economy operates above its potential level. When the economy is in the lower regime, budget and trade deficits show divergent movements. The results are consistent with Kim and Roubini (2008), indicating that the divergence of fiscal balance and current account might be explained by the cyclical fluctuations of output.