Estimating the Relationship Between the Current Account, the Capital Account and Investment for India

Published date01 February 2019
Date01 February 2019
Subject MatterArticles
03_FTR810832.indd Article
Estimating the
Foreign Trade Review
54(1) 29–45, 2019
Relationship Between
©2018 Indian Institute of
Foreign Trade
the Current Account,
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the Capital Account and
DOI: 10.1177/0015732518810832
Investment for India
Ashima Goyal1
Vaishnavi Sharma1
Causality from the capital account (KA) to the current account (CA) of the
balance of payments indicates disruption from capital flows while the reverse can
indicate smooth financing of the CA that allows investment to exceed domestic
savings. A three-variable vector autoregression tests for Granger causality
between the Indian CA, KA, KA components, and gross fixed capital formation
(GFCF) over 2000–01Q1 to 2015–16Q3. Since a CA deficit indicates an excess
of investment over savings it is useful to estimate which type of capital flows
affect investment. No causality is found to exist in any direction between the
KA and the CA. There is only indirect causality through some components.
Of the capital flow components, only FDI affects GFCF. The latter consistently
affects the CA. The CA affects debt portfolio flows and non-resident deposits,
suggesting these were used to finance the CA, but they were not causal for
GFCF. Volatile flows, therefore, did not deteriorate the CA, but they also did
not contribute to GFCF. India’s gradual KA convertibility may have mitigated
shocks from the KA. Long-term sustainability, however, requires FDI to increase
as compared to other types of flows.
JEL Codes: F21, F32
Current account, capital account, balance of payments, Granger causality,
gross fixed capital formation
1 Indira Gandhi Institute of Development Research, Mumbai, India.
Corresponding author:
Ashima Goyal, Indira Gandhi Institute of Development Research, Gen. A.K.Vaidya Marg, Goregaon
East, Mumbai, Maharashtra 400065, India.

Foreign Trade Review 54(1)
The balance of payments (BOP) accounts of almost all nations show large deficits
or surpluses in the recent period of financial liberalization. Given the BOP
identity, an imbalance in the current account (CA) is reflected in the capital
account (KA) plus a change in reserves. Causality from the KA to the CA can
indicate disruption from these capital flows while the reverse can indicate smooth
financing of the CA.
The economic literature does not provide a clear picture of the relationship.
Nevertheless, some studies suggest that for advanced economies, causality runs
from the CA to the KA so that capital flows finance the CA rather than aggravate
it, while in developing nations, the causality is reversed.1
A current account deficit (CAD) allows much needed investment to exceed
domestic savings for an emerging market. Causality from a KA component to the
CA can imply that the component is used to finance a CAD. But it is also neces-
sary to assess whether the financing is indeed used for investment. Various com-
ponents of the KA, such as foreign direct investment (FDI), foreign portfolio
investment (FPI) and ‘debt flows’,2 can be expected to have differing impact on
the CA and on investment. FDI is a more stable, long-term component while FPI
and debt flows are relatively volatile, easily influenced by global risk factors.3 The
Indian post 1991 industrial policy reforms opened opportunities for foreign
investment4 in various sectors. All this has led to growing KA surpluses in recent
years. There have been periods when the CA also widened. This study, therefore,
tries to analyse these broader aspects of the causal relationship between the two
accounts for India for the time period 2000–01Q1 to 2015–16Q3.
Granger causality tests in a three-variable vector autoregression (VAR) indicate
whether the prediction of one variable is significantly improved by including lags
of other variable. In a first step, we check for any causality between the CA and
the KA in the presence of investment. Second, we check for causality between the
CA and the main components of the KA, namely equity flows and debt flows,
again controlling for investment. In a third step, the equity and debt flows are
further disaggregated. We take FDI–equity5 and FPI–equity as the disaggregated
components of total equity flows and from debt flows we take the four major
components of the total debt portfolio namely FPI–debt flows, short-term (ST)
credit, non-resident Indian (NRI) deposits and external commercial borrowings
(ECBs). So, we check for a total of nine causalities.
There is no extensive study on the causal relationship of disaggregated compo-
nents of total debt flows on investment and the CA. The results have implications
for financial and macroeconomic stability and for policy. A previous multivariate
causality study of the CA and the KA for India (Garg & Prabheesh, 2015) included
the real exchange rate. It did not find any causal relationship between the two
accounts, but found FPI flows to affect the exchange rate and, therefore, the CA.
Although FPI and equity flows are more volatile, a managed float with active
foreign exchange intervention prevented persistent deviations from equilibrium
real exchange rate in India. It is more important, therefore, to check for causality
with investment as a control. We try to fill this gap.

Goyal and Sharma 31
The remainder of this article is organized as follows: (a) brief review of the lit-
erature, (b) a theoretical background for the present study, (c) some stylized facts
giving an overview of the Indian BOP, (d) the data set and the variables employed,
(e) the methodology, (f) the empirical findings and (g) the conclusion.
Literature Review
Both the CA identity of the BOP, which measures net international trade in goods
and services, and the KA of the BOP, which records capital flows, show large
deficits or surpluses for almost all nations since the start of this globalization
period. Cross border capital flows provided developed nations (capital surplus
countries where rate of interest was low) with ample investment options and the
deficit nations (where rate of interest was high) with funding. Given the BOP
identity, the imbalances in one account is reflected in the other. However, it is not
clear whether the increase in these cross border holdings have led to the imbal-
ances in the CA or whether the CA imbalances lead to surges in the outflow or
inflow of the capital. This is a very important question in the context of develop-
ing (or, emerging) countries because this would help understand sources of mac-
roeconomic instability of these nations whose economies are vulnerable to
disturbances from abroad.
Capital inflows and the CA imbalances interact differently between developing
(or, emerging) and developed nations. The existing literature does not provide a
lucid picture of the relationship between the two. Ersoy (2011) in his study on
Turkey finds the existence of a unidirectional causality running from the KA to
the CA. He infers that the capital inflows to Turkey cause imbalances in their CA,
therefore, leading to CADs. Lau and Fu (2011) in their study on four developing
Asian countries of Indonesia, Korea, the Philippines and Thailand find the causal-
ity running from CA to the KA. They suggest that CA can be used as the control
policy variable for the flows of capital in these countries. C.-H. Kim and Kim
(2011) find the existence of a bi-directional causality between the KA and the CA
in the case of Korea. Faroque and Veloce (1990) in their study of the Canadian
economy also find a feedback relationship between the CA and the long-term KA.
Garg and Prabheesh (2015) in their study on India do not find any causal relation-
ship between the two accounts.
Majority of the studies in this context concentrate on the differing relationship
between the two accounts in case of developing versus developed countries
(Fry, Claessens, Burridge, & Blanchet, 1995; Yan, 2005; Yan & Yang, 2008,
2012). In general, the studies conclude that in the case of developed nations, the
causality runs from the imbalances in the CA to the KA while in the case of the
developing nations, this causality is reversed.
A number of studies in the existing literature further disaggregate the KA to
identify the sources of imbalances in the CA. Focusing on the various components
of the financial account may provide a clearer picture here. This is so because these
components, ‘equity flows’ comprising FDI and FPI and ‘debt flows’, respond

Foreign Trade Review 54(1)
differently to domestic and international economic scenarios. FDI is considered the
stable component of capital flows, is determined by structural and domestic factors
and is considered a long-term engagement, while FPI is considered the most volatile
component easily influenced by global risk factors. Debt mainly consists of cross-
border bonds and loans and is also relatively volatile.
Yan (2007) finds FDI to cause CADs in case of Phillipines and Canada while
FPI causes CADs in case of Mexico. Garg and Prabheesh (2015) find causality
running from non-debt flows to the CA for the Indian economy, mediated by a real
appreciation. Their results also suggest that volatile capital flows lead to deterio-
ration in the CA balance.
In the present study, gross fixed capital formation (GFCF) is included in the
analysis to pick up the...

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