‘Twin Deficits’ Hypothesis

AuthorAnantha Ramu M.R.
Date01 February 2017
Publication Date01 February 2017
/tmp/tmp-17vQ9JKGsLhZBg/input Article
‘Twin Deficits’ Hypothesis:
Foreign Trade Review
52(1) 15–29
An Assessment of
©2017 Indian Institute of
Foreign Trade
Relationship and
SAGE Publications
Transmission Mechanism DOI: 10.1177/0015732516650825
in India
Anantha Ramu M.R.1
Higher and persistent level of fiscal deficit and current account deficit is the
problem of the day for Indian economy. There exists an argument that higher
fiscal deficit is the major factor behind worsening balance of payments position.
However, there is no identical perception on the relationship between fiscal
deficit and current account deficit both theoretically and empirically. Hence this
article is a revisit to the existing debate to see whether fiscal deficit and
current account deficit can be called as ‘twin deficits’ pertaining mainly to Indian
economy. Using long-term annual data for the period 1980–1981 to 2012–2013
on Indian economy and using vector error correction method, this article seeks
to prove that there exists long-term positive association between fiscal deficit
and current account deficit, and hence can be called as ‘twins’. Using structural
VAR method it has been proved here that fiscal deficit is in line with the pattern
illustrated in Keynesian absorption theory and Mundell–Fleming model in regard
to its impact on current account deficit. This article negates the relevance of
Ricardian equivalence theory in Indian context.
JEL: E62, F32, C32
fiscal deficit, current account deficit, VEC, structural VAR
1 PhD Scholar, Centre for Economic Studies & Policy (CESP), Institute for Social and Economic
Change (ISEC), Nagarabhavi, Bangalore, Karnataka, India.
Corresponding author:
Anantha Ramu M.R., PhD Scholar, Centre for Economic Studies & Policy (CESP), Institute for Social &
Economic Change (ISEC), Dr VKRV Rao Road, Nagarabhavi, Bangalore, Karnataka 560072, India.
E-mails: anantharamu@isec.ac.in; anantharamu.m.r@gmail.com

Foreign Trade Review 52(1)
Fiscal deficit is said to be an important determinant of external sector variables
like current account deficit (CAD), trade deficit and exchange rate. However,
there is no identical view on the relationship between fiscal deficit and CAD in
the theoretical and also empirical literature. The association between fiscal deficit
and CAD has been portrayed as ‘twins’, because the changes in fiscal policy, say
a rise in fiscal deficit will cause the CAD to rise in the balance of payments. In
short, higher the fiscal deficit, higher will be the CAD and vice versa. Exchange
rate of currencies plays a vital role in the mechanism in which fiscal deficit is
passing through and impacting the CAD; also there are evidences of direct rela-
tion between fiscal deficit and exchange rate of currencies.
Theoretically, there are three distinct views: Keynesian theory and Mundell–
Fleming frame work prove the existence of twin deficit relation, whereas the
Ricardian equivalence theory negates any such relationship. Empirically also,
certain studies prove the existence of twin deficit relation, whereas several others
challenge and prove that the two deficits have no relation with each other. Even in
the Indian context, the empirical results are mixed. This article attempts to study
the relevance of ‘twin deficits’ hypothesis in the Indian context on a long-term
basis. Using 33 years data, that is, from 1980–1981 to 2012–2013, this article
analyzes the association between fiscal deficit and CAD, and also attempts to
capture the transmission mechanism.
The article is divided into four sections. The first section provides a brief
review of available literature in the Indian context. The second section contains
the data and methodology part. The third section is a discussion on the result
obtained. The fourth and last section sums up the conclusion.
Literature Review
This review of literature concentrates mainly on Indian studies on ‘twin deficits’
hypothesis. Literature available on Indian economy is limited in this respect. By
considering five Asian economies, namely Indonesia, Korea, Malaysia and
Philippines along with India, Anorno and Ramchander (1998) checked the exist-
ence of twin deficit hypothesis. Their study covered the period from 1957 to 1993,
though the years varied across the countries depending on data available in respec-
tive countries. Variables considered in their analysis are trade deficit, fiscal defi-
cit, short-term government interest rate, trade-weighted exchange rate, GDP and
inflation. Using Granger causality tests, they proved that fiscal deficit is not causing
the trade deficit for all countries except Malaysia. Interestingly, it has been found
that trade deficit is causing the fiscal deficit. Inflation, GDP and interest rate
caused trade deficit in India but not in other countries.
Non-availability of quarterly data on Indian economy on many variables is the
real challenge for researchers. Basu and Datta (2005) tried to generate the quar-
terly data using interpolation method for the variables like combined gross fiscal
deficit (GFD), yield of government dated securities for 10 years, real effective
exchange rate (REER), GDP at factor cost and M1. The quarterly data on trade

Ramu 17
deficit were readily available. They did not find any cointegration between fiscal
deficit and trade deficit, supporting Ricardian equivalence hypothesis. They
argued that savings and influx of invisibles played a crucial role in decoupling
India’s external and internal deficits. By adopting a similar econometric method
and using annual data from 1970–1971 to 1999–2000, Parikh and Rao (2006)
found a result contrary to the earlier calculation. By considering variables like
CAD, fiscal deficit, investment and real exchange rate, they found that an increase
in fiscal deficit by 1 per cent cause the CAD to increase by 0.35 per cent and also
proved that appreciation of real exchange rate widened the CAD.
The main conclusion that can be drawn from the review of literature part is that
evidences of ‘twin deficits’ hypothesis is inconclusive at the Indian context. One-
to-one direct relationship between fiscal deficit and CAD may not reveal the true
picture, and in order to capture the movements or mechanisms, several important
intermediate variables like interest rate, investment, income level and real
exchange rate need to be considered in the analysis. This literature review finds
the gap and points to the requirement of a long-term empirical analysis by consid-
ering the important determinants of CAD to capture the mechanism thoroughly if
such relation indeed exists in the Indian context.
Data, Variables and Methodology
The trends in external sector variables are depicted in Figure 1. The movement of
fiscal deficit along with trade or current account balance cannot be traced clearly.
In the early 1980s, early 1990s and in the last 10 years, all the variables were
found moving together, but in the mid-1990s and early 2000s fiscal deficit was
moving inversely to changes in the external sector variables, that is, CAD declined
along with fiscal deficit in the mid-2000s and it turned into surplus in subsequent
years. A significant decline in the fiscal deficit after 2004 and till 2008 is mainly
P 8
As % of GD 0

Figure 1. Trends in Fiscal Deficit, Current Account Balance and Trade Balance
(as % of GDP)
Source: RBI Database on Indian Economy, 2015.

Foreign Trade Review 52(1)
due to fiscal consolidation followed by the Indian government, and along with
this, economic growth rate almost approached the double digit in 2008. Again,
due to the 2008 global financial crisis, fiscal deficit started rising again along with
the deficit in current account of the BoP.
The time period of the study is from 1980–1981 to 2012–2013. The data are
drawn from RBI Database on Indian Economy. The time series econometric
technique will be used for the analysis. However, a suitable econometric...

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