India is an important case study because the country has been struggling with rising fiscal and current account deficits. In 2012, the fiscal deficit was 5.8% of GDP and the current account deficit reached 4.7% of GDP (IMF data). Both deficits have fallen since then but continue to be a concern. In 2015, the central government’s budget deficit was 4% of GDP with an additional 3% for local governments (Horie, 2016). The current account deficit which had improved over the next few years, has once again widened. At the end of 2017, the current account deficit was 2% of GDP up from 1.4% at the end of 2016 (Nayak, 2018). The data source is the World Bank.
A rising current account deficit has important implications for the economy. As others have noted, the 1990-91 crisis was preceded by a rising current account deficit position (Jalan, 1992, Nabar-Bhaduri, 2018). Thus, understanding the factors that contribute to this deficit is important. Can the twin deficit hypothesis explain India’s deteriorating external position?
The twin deficit hypothesis has been explored for India. Ratha (2012) finds support for the twin deficit hypothesis in India in the short run but not in the long run while Banday and Rajan (2016) find the reverse. This paper adds to this literature in three ways. First, the period of study is extended from previous work to incorporate the more recent imbalances. Secondly, this paper employs the methodology developed by Bluedorn and Leigh (2011) to shed light on the twin deficit hypothesis for India. Finally, this paper explores the various channels through which there may be a link between the deficits including exchange rates, taxes, and interest rates.