Current and Capital Account Dynamics in India: An Empirical Analysis of the Post-Reform Period

Published date01 February 2022
Date01 February 2022
Subject MatterOriginal Articles
Current and Capital
Account Dynamics in
India: An Empirical
Analysis of the
Post-Reform Period
Tanveer Ahmad Khan1
This article analyses the dynamics between current account (CA) and capital
account in post-liberalisation India. Contemporaneous occurrence of CA defi-
cit along with capital account surplus suggests the possible causal relationship
between the two accounts. The theoretical debate around capital account liberal-
isation (KAL) is developed with the intention to lend support to empirical results
for policy formulation. The analysis of arguments for and against KAL liberates
us in interpreting the empirical results. Within the framework of KAL, this article
proceeds to estimate the relationship between current and capital account. A set
of econometric tests are performed on an Indian quarterly data over the period
from 1996 to 2018. Econometric analysis reveals that capital account affects CA
negatively. Short-run capital and debt flow also affect CA negatively, while foreign
direct investment (FDI) affects it positively. We find debt flow to be an important
factor, contributing to CA imbalance. Such dynamics is critical for any decision
about KAL. From the analysis, it is observed that India needs to encourage FDI,
while maintaining strict control over short-term capital, which is highly disruptive,
and proceed cautiously towards full KAL.
JEL Codes: C32, F21, F32
Capital account, current account, interest rate, capital flows, cointegration,
Granger causality
Original Article
1 Institute of Development Studies, Kolkata, West Bengal, India.
Corresponding author:
Tanveer Ahmad Khan, Institute of Development Studies, Kolkata, West Bengal 700064, India.
Foreign Trade Review
57(1) 41–65, 2022
© 2021 Indian Institute of
Foreign Trade
Reprints and permissions:
DOI: 10.1177/00157325211037101
42 Foreign Trade Review 57(1)
India embarked on the path of liberalisation in 1991, with the introduction of
market-oriented reforms. Prior to 1991, India was a closed economy, following
conservative model of development, which entailed restrictions on private sector
and external sector. The new approach consisted of liberalising the economy,
including the external sector. The process of liberalisation was extended to current
account (CA) in 1994, with arrangements to be made for subsequent liberalisation
of capital account (KA). The currency regime was shifted from fixed-adjustable
to market-determined exchange rate regime pegged to the US dollar. For smooth
transition to capital account liberalisation (KAL), India set up the Tarapore
Committee (1996) to prepare a road map for an orderly transition. The Committee
specified three preconditions that needed to be satisfied before embracing KAL.
The three conditions were fiscal consolidation, moderated inflation rate and
resilient financial sector.
However, before India could proceed as per recommendations of the committee,
the world witnessed the cataclysmic East Asian crisis of 1997. The crisis brought
the dangers of KAL to the forefront, and India postponed the process till 2006. The
Reserve Bank of India (RBI) started the process again in 2006 on the suggestions
of Prime Minister Manmohan Singh (The Hindu, 2006). In the 1990s, when
neoliberalism was reigning high, the International Monetary Fund (IMF) even set
up a committee to include KAL in its Articles of Agreement but subsequently
dropped the idea after the Asian crisis (Arora et al., 2013). India followed the
gradual path towards KAL, and, now, it is considered a highly liberalised country.
It is in this era of liberalisation that India has run a persistent CA deficit vis-à-vis
KA surplus. The gap between the two has increased since the introduction of
reforms. Such a perennial deficit in CA is an indication of the unsustainable external
sector and of macroeconomic weakness of the economy. Corsetti et al. (1999) view
that persistent deficit in CA may result in a currency crisis. The national income
identity of an open economy expresses the interdependence between the two
accounts, with CA just the mirror image of KA. This interdependence may signify
the causal connection. Causality can have interesting policy implications and will
serve as a guiding principle for any decision on KAL. The topic has received serious
attention in the recent past, and various studies have been performed to find the
direction of causality between CA and KA. Some studies report that causality runs
from KA to CA, while others reported the opposite (Wong & Carranza, 1999; Yan,
2005, 2007). However, no logical conclusion can be drawn from empirical studies
about the direction of causality between CA and KA.
Within this context, an attempt is being made in this article to analyse the
short-run and long-run dynamics of CA and KA over the period from 1996 to
2018 using quarterly data. In the case of India, this field is still in its nascent stage
with few quality studies available (Chakraborty & Guha, 2007; Garg & Prabheesh,
2015). These studies have used various policy variables like investment rate and
exchange rate to capture the dynamics of the interdependence. Garg and Prabheesh
(2015) in a multivariate causal study find that there is no direct causality between
CA and KA. However, causality exists indirectly through the real exchange rate.

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