The Indian chapter of current account deficit and fiscal deficit: Twins or cousins

Abstract

This paper aims to analyze the empirical relationship between the CAD and FD of India and determine whether the twin-deficit hypothesis holds true for the country or not. The paper analyzes the impact of the Fiscal Responsibility and Budget Management (FRBM) Act enacted in 2003 on the relationship between the twin deficits with the objective to see whether fiscal consolidation post its enactment had a positive or negative impact on the current account deficit. To do so, we have taken the data for the two deficits (as a % of GDP) for India for different time periods since 1980 and conducted a temporal analysis of the two deficits for these time periods. We began by conducting the regression analysis for longer time frames and the deep diving into shorter time frames to determine the specific impact attributable to the FRBM Act. Our results show that there is a statistically significant negative relationship between the two deficits during the period 2003-2008 (post FRBM Act and pre-2008 economic recession). This is supported by a declining FD and a rising CAD during this period. The declining FD is attributable to the government’s efforts in reducing its discretionary expenditure, while a rising current account deficit is attributable to rising global oil prices during 2004-2008. This proves that the twin deficit hypothesis does not hold true for India during the time period 2003-2008. Rather, the two deficits move in opposite directions implying that fiscal consolidation is accompanied by a deteriorating current account balance.