CURRENT ACCOUNT DEFICIT AND FISCAL DEFICIT A CASE STUDY OF INDIA

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1 CURRENT ACCOUNT DEFICIT AND FISCAL DEFICIT A CASE STUDY OF INDIA Anuradha Agarwal Research Scholar, Dayalbagh Educational Institute, Agra, India 121anuradhaagarwal@gmail.com ABSTRACT Purpose/originality/value: This study is an attempt to examine the relationship between current account deficit and fiscal deficit in India from to Design/methodology/approach Quarterly data have been taken to test the stationarity of two variables by using ADF unit root test and cointegration regression and also applies VAR techniques to test the existence and direction of causality. Findings The study reveals the presence of stationary linear combination between CAD and FD, impulse response shows the positive impact of Fiscal deficit to CAD whereas causality test shows the unidirectional relationship i.e. FD as a granger cause of CAD but not vice-versa. Research limitations/implications This study is limited to India only and based on CAD and FD as the percentage of GDP. Therefore, a larger empirical study would be useful to replicate the results of this study. Practical implications In order to improve the large amount of CAD and FD, it is very necessary to increase in the amount of foreign investment, leads to increase in the budget surplus and current account surplus by improving the value of currency. Keywords: Current account deficit (CAD); Fiscal deficit (FD); India INTRODUCTION In recent years, the Indian economy has been characterized by soaring fiscal deficits and deteriorating current balances. Fiscal deficit happen when government spending is higher than tax revenue. It represents a negative value in national saving, which will reduce the whole value of national saving and raise the real interest rate and encourage foreigners to invest in the domestic economy, leading to exchange rate appreciation. This makes domestic goods and services more expensive relative to foreign goods. So the country imports more and exports less, increasing the trade deficit. Many analysts suspect that the fiscal deficit and current account balance are closely, and perhaps even causally, related. Indeed, national income accounting identities guarantee that fiscal deficit must create either an excess of private saving over investment or an excess of imports over exports. It is suggested by Standard economic reasoning that government borrowing decreases the domestic supply of funds available to finance new investment, which creates an inflow of funds from overseas. According to the hypothesis called as a twin or double deficits hypothesis, fiscal deficit lead to the current account deficit. On the other hand, according to the reverse hypothesis of twin deficits, the current account 20

2 imbalance leads to the fiscal deficit. Moreover, in accordance with the Ricardian equivalence hypothesis, fiscal deficit does not affect or affects negatively the current account balance but in accordance with the hypothesis of Feldstein-Horioka (1980) fiscal deficit and current account balance interact mutually. Therefore I have taken this study to know the relationship between twin deficit i.e. fiscal deficit and current account deficit. The India s Current Account Balance & Fiscal Deficit The figure 1 shows that the current account deficit has been widening, especially after 2004 and consistently faces the situation of growing the deficit with so many fluctuations. The large amount of CAD was occurring in the 3 rd Quarter of i.e. 6.9 which is again come to 3.8 % in the last quarter. In fact, during the last 8 years of the selected period, the deficit on the current account grew with 3.9 % of GDP from 2004 to The figure 1 also depicts the path of India s fiscal deficit since , which was not always consistent with the trends in the current account. The figure shows the higher fiscal deficit as the percentage of GDP in the 1 st quarter of i.e % and come to 1.11% in Source: own calculation based on IMF world outlook Figure 1. Current Account Deficit And Fiscal Deficit In India LITERATURE REVIEW Empirical analysis on the relationship between the balance of state budget and the balance of current account can be divided in three groups. In the first group of analysis treats the current account deficit as the causes of the budget deficit (Anoruo, Ramchander 1998; Khalid, Guan 1999; Alkswani 2000; Kim, Kim, 2006; Marinheiro 2008). In the second group of study the researcher analysis the budget deficit as the cause of the current account deficit (Abell 1990; Bachman 1992; Cash 1994; Islam, 1998; Piersanti 2000; Leachman, Francis 2002, Cavallo 2005, Erceg, Guerrieri, Gust 2005; Misala 2007). And in the third group of study indicate the bi-directional causal relationship between budget balance and current account balance, where both variables is affected to each other (Laney, 1984; Miller, Russek 1989, Boucher 1991, Evans 1993; Papaioannou, Yi 2001; Kaufmann, Scharler, Winckler 2002; Baharumshah, Lau 2007). 21

3 Lau, Baharumshah and Khalid (2006) 1 analyzed the relationship between budget deficit and current account deficits in reference to four Asian countries (Indonesia, Malaysia, Philippines and Thailand) for the period Namely, they have proved the presence of long-run relationship between budget deficit and current account deficit. They confirmed the existence of the twin deficits hypothesis in the case of Thailand, the perverse hypothesis of twin deficits in the case of Indonesia and the Feldstein-Horioka hypothesis in the other two countries. Marinheiro (2008) 2 examined the relationship between the fiscal deficit and the current account deficit in Egypt during the period and using a vector autoregressive model. Summing up, the vast majority of empirical studies concerned the relationship between the budget deficit and the current account deficit indicates that there are significant causal links between these deficits. Thus, the authors of such studies reject the possibility of the Ricardian equivalence hypothesis in practice. Hakro (2009) 3 used multivariate time series on data from Pakistan. The estimates of vector autoregressive (VAR) model demonstrate that causality link of deficits is flowing from budget deficits to prices to interest rate to capital flows to exchange rates and to trade deficits. Dillon Alleyne, Beverly and LugayMichele Dookie (October de 2011) 4 addressed the question as to whether the current account balances cause the fiscal balance or vice versa, Granger causality tests an and (VARMA) framework were employed. The study support the hypothesis that causation runs from the current account to the fiscal balance in which case the solution to the fiscal problem is only partially addressed by expenditure adjustment. Rita Lénárt-Odorán Zoltán Reppa (September 8, 2011) 5 examined whether fiscal policy contributed to external imbalances and the accumulation of external debt in the past and also in the future, whether fiscal caution can help resolving external vulnerability. And find that most of the mean impulse responses have the correct sign, but are statistically not significant. There is important exclusion, however: the current account responds negatively to fiscal loosening, while at the same time private consumption increases. This suggests that fiscal policy contributed to the outdoor imbalances, which is most likely occurred through the non-ricardian behavior of households. Suchismita Bose And Sudipta Jha (DECEMBER.2011) 6 India s Twin Deficits: Some Fresh Empirical Evidence examined the causal linkages between the government budget deficit and the current account deficit for India, within a multi-dimensional system with the exchange and interest rates acting as the interlinking variables. The study concludes that Bringing in oil prices helps complete the chain of reverse causation in the twin deficit hypothesis for India, as the direction of causation is unambiguously seen to run from oil prices to the external deficit to the fiscal deficit. Research Gap After analysing some empirical studies, researcher fined that Current Account Deficit and Fiscal Deficit has a bidirectional relationship which affects to whole economy and the value of currency also. Current account balance in India has a lot more potential to study. Furthermore, many researchers work on it but still the fiscal deficit and current account deficit in India is not as much focused earlier. So this is the main starvation of the course. 22

4 RESEARCH METHODOLOGY & DESIGN OBJECTIVE To examine the relationship between current account deficit and fiscal deficit in India over a period of to SCOPE OF THE STUDY The current account deficit and fiscal deficit as the percentage of GDP in India from to have been taken for the study purpose HYPOTHESIS For the purpose of this study, the following null hypothesis is formed Ho : The current account imbalance or deficit and fiscal deficit in India are independent to each other. RESEARCH METHODOLOGY Economic theory provides ample explanations of the possible interrelationships between current account and Fiscal balances which have been become an empirical issue. Following the recent literature we investigate the twin deficits hypothesis by employing a number of econometric techniques. First, we test the stationary of the variables using Augmented Dickey Fuller (ADF) test. Second, we test cointegration of the variables using Johansen method. Then we go further with the Vector Autoregression (VAR) methodology to estimate the relationship between the variables of interest. This model treats all variables on an equal footing, and there is no priori distinction between endogenous and exogenous variables. From the VAR model, we will derive the Impulse Response Function (IRF). Finally, we will determine the Granger-causality directions Data The analysis uses monthly data of CAD and the FD from to Data on the CAD and the FD were extracted from the World Bank and IMF database. EMPARICAL RESULTS Unit Root Test Results The test for a unit root is based on the t-statistics on the coefficient of lagged dependent variable. This has to be compared with specific calculated critical values. If the calculated value is greater than critical value, then the H 0 of a unit root is rejected, and the variable is taken to be stationary. Null Hypothesis: CAD and FD has no stationarity Table 1. Unit Root Test Results (with intercept) VARIABLES ADF(level) P value ADF(first difference) P value CAD [0] *** [2] *** FD [3] [2] *** 23

5 Table 2. Unit Root Test Results (with intercept and time trend) VARIABLES ADF(level) P value ADF(first difference) P value CAD [1] *** [2] *** FD [3] [2] *** 1. The results of Table 1-a are based on assuming the existence of a constant in the regressions, while the results of Table 1-b are based on assuming the existence of a constant and a time trend in the regressions. 2. The *, **, and *** indicate rejection the null hypothesis of unit root at 10%, 5%, and 1% significant levels, correspondingly. 3. The lag length of the ADF unit root test is specified in [ ] brackets. Stationarity of the variables - current account deficit (CAD) and Fiscal deficit (FD) - was tested using Augmented Dickey-Fuller (ADF) test. Tables (1-a) and (1-b) report the results which suggest the rejection of the unit root null hypothesis of no stationarity for CAD at the level at 5% level of significance, However, all variables were found stationary at their first differences. Cointegration Test Results Cointegration test is used to know the stationary of a linear combination of two or more time series despite being individually nonstationary. Null Hypothesis- CAD and GBD has no Cointegration Table 3. Johansen Cointegration Test Results Note: Johansen Cointegration test indicates 2 cointegrating equations at the 0.05 level of significance, * denotes rejection of the hypothesis at the 0.05 level Interpretation The results of trace and maximum Eigenvalue Statistic are reported in Table (2). They suggest the rejection of the null hypothesis of no Cointegration at 5% level indicates the presence of stationary linear combination between CAD and FD. VAR and IRF Specifications Results IRF is another way to check the relationship between current account deficit and fiscal deficit as it particularly explains how a shock in one of these variables would affect the course of the other variable. First, this paper estimates VAR model that includes all variables that help estimating the shocks to each variable. Based on that, the IRF can be constructed. The impulse response function traces the effect of a one-time shock to one of the innovations on current and future values of the endogenous variables. 24

6 Figure 2. Responses of each variable to shocks in other variables In figure 2, Row 1 shows the response of current account deficit to shocks to the variable itself and to shocks in Fiscal deficit, Current account deficit responds negatively to a shock in itself and positively fluctuate to a shock in fiscal deficit. The reason for that is because an increase in the FD involves more spending on the foreign sectors (importing more) causing a decrease in the budget balance surplus and therefore a decrease in the current account Surplus. In figure, Row 2 shows the response of fiscal deficit to shocks to the variable itself and to shocks in current account deficit, Fiscal deficit responds negatively in initially period then slowly responds positively to CAD and it responds negatively to itself which is falling down slowly in the first quarter and then remains constant till the last quarter of selected period. The results of the IRF do not support the hypothesis; which requires no relationship between current account balance and Fiscal balance. However, the relationship between CAD and FD has been found positively for the India data. Granger Causality Test Results The researcher is investigating the bi-directional causality relationship between current account deficit and budget deficit through Granger causality test Table 3. Pairwise Granger Causality Test Result Null Hypothesis: Obs F-Statistic Prob. Hypothesis FD does not Granger Cause CAD Accepted CAD does not Granger Cause FD Rejected 25

7 Also, the result of Granger causality does not support to hypothesis, which requires independency of variables to each other. The figure shows that fiscal deficit is the granger cause of Cad but not vice-versa indicates unidirectional relationship between CAD and fiscal deficit. CONCLUSION The results of this paper confirm the existence of the long-run equilibrium relationship between current account and fiscal deficit. This relationship has been found positive that CAD responds positively to fiscal deficit In other words, an improvement in the fiscal deficit (usually driven by the increase in the surplus of the trade balance) will cause to decrease current account surplus and to increase its deficit. The results of granger causality test show unidirectional causality relationship between current account and fiscal deficit. These results prove that the twin deficit hypothesis (as presented by the theoretical model) was confirmed for the Indian economy over the time period of our analysis. REFERENCES Journals 1. Hakro, Ahmed (2009) Twin Deficits Causality Link-Evidence Pakistan International Research Journal of Finance and Economics, Issue 24, pp Lau Evan, Baharumshah Zubaidi (2004), On the Twin Deficits Hypothesis: Is Malaysia Different? Pertanika Journal of Social Sciences & Humanities, University of Putra Malaysia, Volume. 12, No. 2, pp Marinheiro C.F. (2008), Ricardian Equivalance: Twin Deficits and the Feldstein-Horioki Puzzle in Egypt, Journal of Policy Modelling, No Darrat A.F. (1988), Have Large Deficits Caused Rising Trade Deficits? Southern Economic Journal No 54. Working Papers 5. Rita Lénárt-Odorán Zoltán Reppa (September 8, 2011) Fiscal deficit and the current account*working paper. 6. Suchismita Bose and Sudipta Jha (DECEMBER.2011) India s Twin Deficits: Some Fresh Empirical Evidence ICRA BULLETIN Money Finance 26