1. Introduction. Applied Econometrics and International Development Vol (2014) India.

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1 ON THE ESTIMATION OF THE DETERMINANTS OF THE CURRENT ACCOUNT DEFICITS: A CASE OF INDIAN ECONOMY SESHAIAH, S. Venkata 1 Abstract: The performance in the current account of the balance of payments of India remains as a political and controversial issue and hence attracted considerable attention in recent years. To our knowledge very limited work has been done on the determents of the current account deficits especially after liberalization in India. Using vector error correction mechanism, Variance decomposition and Johansen Cointegration technique we have identified the short run as well as long run determinants of the current account deficits. Empirical findings suggest that there is a significant long run equilibrium relationship between current account deficit and investment, savings &openness of the economy. The openness of the economy influenced current account deficits by 33.96% where as fiscal deficit, savings, real exchange rate and output gap put together influenced the current account by 35.42%. JEL Codes Keywords 1. Introduction The determinants of current account deficits (CAD) became the most favorite topic to the researchers because of the recent experiences of various countries including USA. Much of the work has been done by experts to assess the determinants of current account deficits. To our knowledge there three basic frame works mostly used by the researchers, First elasticity approach where the current account balance solely determined by the real exchange rate, domestic and foreign output. Khan and Knight (1983) investigated 32 non oil developing countries and found that both internal factors such as fiscal deficit, the appreciation of real effective exchange rates and external factors the terms of trade and declining domestic output are major factors for current account deficits. The second approach is savings and investment or absorption approach. This approach assumes that savings and investment decisions of a country are the outcomes of CAD. The related literature Feldstein and Horioka (1980) Puzzle, covering 16 OECD countries using data for the time period , they found high correlation between Domestic savings and investment that suggested the existence of limited capital mobility. They also observed small CAD in spite of policy changes towards international capital mobility. This study gave rise to a new way of measuring international capital mobility derived from the extent of correlation between savings and investment. Ghosh and Ostry (1995) use a current-account solvency model for some developing countries to explain the correlation of savings and investment co-movement in advanced and developing economies. Their approach takes into account demand-side factors. Coakley, Hasan and Smith (1999) extend the study and find that the correlation is low in LDCs, which could be attributed to country-specific macroeconomic policies and not high mobility. The third approach is inter temporal approach to the current account balance, this approach is largely based on 1 Dr.S Venkata Seshaiah, Professor of Economics and Finance, IBS Hyderabad, IFHE University, India.

2 the microeconomic analysis and it assumes current account balance behavior is solely depends on the collective behavior of economic gents. Calderon, chong and Loayza (2002), increase in the public and private savings, higher growth rates in industrial countries and higher international interest rates have favorable impact on the current account balance. Jansen (1998) suggests that correlation between savings and investment in the long run is determined by one or more of these factors - limited capital mobility, current account targeting by the Government and inter-temporal budget constraint and the short run co-movements are due to capital mobility. In addition, the paper also finds that the short-run correlation seems to vary across countries and is determined by country-specific business cycles (in line with Leachman, 1991; Jansen, 1996 and Taylor, 1996). Moreno (1997) extends the study to Japan along with the U.S. In this section we present the Indian Economy at glance and Theoretical frame work, Section 3 deals with History of current account deficits, with Data and Section 4 deals with influence variables, Data and Methodology; Section 5 deals with the Empirical Investigation and discussion and finally Section 6 Conclusion and suggestions. 2. Indian Economy at glance: The Indian economy is currently going through a challenging phase as GDP slowed to 4.8% which is more than a decade low. The reasons might be the domestic factors such as high public expenditure, depleting savings and investment, fiscal deficit, depreciation of Indian rupee (INR), increase in gold imports and the external factors such as terms of trade, exchange rates, international economic conditions etc., The current account deficit for the financial especially October - December quarter is 6.7% of GDP which is 61% jump on year on year (YOY) basis. The trade deficit rose to record of 59.6 billion from $48.6 billion a year ago, as exports were flat and the imports grew by 9.4% on balance of payments (BOP) which led to huge current account deficit. In , the real GDP of the Indian economy with the base year was crores and it has reached crores. For the past four decades Indian economy has grown on an average 5.5%.. Overall the Indian economy GDP growth rate moved out from the infamous Hindu growth rate. However the growth has not been uniform in all the years not only in aggregate level but also across the sectors (See figure 3). It may be observed from figure 3that the agriculture contribution towards GDP in was 41.66% and in is 13.92% indicating a continuous decrease in Agriculture sector contribution, where as the contribution of manufacturing sector towards GDP is marginal (in was 13.94% and is 19.34% overall the contribution is flat) and the contribution of service sector increased unambiguously. It seems the policy makers have given more importance to service sectors neglecting the agriculture sector as well as industry sector. It may be observed from figure 1 that both current account deficit to GDP (CAD/GDP) and Gross fiscal deficit to GDP (FD/GDP) continuously increasing indicating the problem of twin deficit or double deficit, it may also observe from the figure the continuous depreciation of currency. It may be observed from figure 2 that though the national savings rate and investment rate is increasing, the national savings rate fell below the domestic investment rate indicating insufficient savings to finance the domestic investment and therefore borrowings from abroad. The investment rate increased from 17.8 % in to 38% 204

3 Seshaiah, S.V. On The Estimation of the Determinants of the Current Account Deficits in India in where as the savings rate increased 15.5% in to 32% in Hence the current account is in deficit continuously. It is also observed from the figure that both the periods and savings are not supporting investment except in few years. In India, the presentation of annual budget by the Central Government is one of the celebrated events. As against most developed countries, in India, ordinary citizens, investors and corporate bodies look at the tax rates (income tax, corporate tax etc.) and economists and academia look at the budget deficits because the performance in the current account of the balance of payments of India remains as a political and controversial issue. 205

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5 Seshaiah, S.V. On The Estimation of the Determinants of the Current Account Deficits in India The budget deficits cause account deficits, since the public sector activity can have both direct and indirect effects on the current account balance. Construction projects by the public sector may require imports of investment goods, there by exerting a direct influence on the external balance. Financing budget deficit by issuing bond leads to higher consumption expenditure due to wealth effect and they raise interest rates. Other things being equal, these higher interest rates appreciate the currency and because of the resulting loss in competitiveness, worsen the current account balance leading crowding out. The second view Ricardian equivalence hypothesis (Barro 1989), states that an increase in budget deficits due to reduced taxes increase the private savings, insofar as the private sector full discounts the future tax liabilities associated with the fiscal deficit. India is facing Twin deficits problem. (See figure 1) 2.1. Theoretical Frame work: Theoretically the national income accounting identities are employed to provide the linkage between the government budget balance and trade balance. Y = C + I +G + (X-M) ---- (1) Where Y is the Income, C is consumption, G is government purchases, X is the exports and M is the imports. The national income identity can also be written as Y = C + S +T (2) Where S is savings and T is taxes Now C +S +T = C+I+G +(X-M) ---- (3) Equation 3 can be written as T- G = (X-M) + (I-S) -- (4) Equation 4 indicates that the budget balance comprises of trade balance and the excess of investment over private savings. The equation also provides the fundamental information of twin deficit which is equal to the Keynesian proposition. The budget deficits and trade deficits are closely related because the government debts crowed out the funds available to the private player s investment which leads to the increase in interest rates, higher interest rates attracts the foreign investment which drives the domestic currency to appreciate. The appreciation of currency worsens the export sectors and benefits the importing sector; therefore pull towards the current account deficit. 3. History of Current Account Deficits: The current account on balance of payments classified as merchandise and invisibles. As per the IMF norms on balance of payments, imports and exports (Merchandise) should be presented a free of board (f.o.b) that is without including freight and insurance costs. 207

6 These should be covered under the item of invisibles. Due to the data constraints the Indian authorities present the imports on c.i.f (cost, insurance and freight) while the exports are presented on f.o.b. basis. Current Account Deficit in 1970 s The current account deficit of India during seventies was quite comfortable. The first oil shock of could not affect much the current account deficit because of increased exports, transfer receipts and increased flow of aid. During the same period the effective depreciation of rupee occurred due to the link with pound sterling until 1973 and later, the prices have not increased much relative to the other countries and hence private transfers raised seven fold from $296 million to $2175 million in , and it has finance roughly 80% of the trade deficit. Within two years of the first oil shock the current deficit turned in surplus (See Table 2) indicating the better utilization the aid. Current Account Deficit in 1980 s: The second oil shock 1979 has affected the Indian economy during 80 s. The imports almost increased by five times between and and where as the exports increased by 4 times. The exchange rate between dollar and rupee increased from 8.2 rupees per dollar to 16.2 rupees per dollar. The current account deficit during the same period increased from 0.2% of GDP to 2.3% GDP. (See Table 2) Current Account Deficit during to : The second oil-price hike of 1979 which had a serious, adverse impact on the borrowings by India hiking up their debt servicing charges and hence In 1991 India found itself in its worst balance of payment crises since India's deficit on the current account increased throughout the eighties. From the mid-eighties it was pushed into greater dependence on high interest commercial loans from international banks to finance their deficits. The net outcome was that India s external debt tripled during this decade of high growth. IMF provided a Standby Credit of $2.2 million in the year 1991 to come out of the mess. The Anti inflationary pursued by the advanced capitalist countries extended the impact of recession into the Third World countries. The recession in their markets led to lowered demand for developing country exports further adversely affecting their trade balances. The growth in private savings could not finance most of India s investment especially in mid-1980s because they were already at a quite high level. As a result, during the late 1980s India depended heavily on foreign sources, which led to a balance of payment crisis in 1990 s. 4. Influence of variables, Data and Methodology: Influence of variables: 1. Investment and savings: It may be observed from figure 2 that the gross savings are not supporting the gross domestic investment. Hence felt that government should borrow to fill the gap which leads to current account deficits. 2. Openness of the Economy: As pointed by Milesi-Ferretti and Razin(1996) that greater openness of the economy may increase a country s vulnerability to external shocks and weakens country s ability to sustain deficit. It may be 208

7 Seshaiah, S.V. On The Estimation of the Determinants of the Current Account Deficits in India observed from figure 5 that the openness of the economy has increased since 1990 and the CAD/GDP ratio is increasing. 3. Real exchange rate: The real exchange rate influence the economic activity by altering the relative returns in tradable as well as in non tradable sector. 4. Output Gap: It may be observed from figure 4 and 5 that the output gap is positive in all the period except in 1970; however the positive output gap is more after 1990 s. The positive output gap creates inflationary pressure in the economy and leads current account deficits. 5. Fiscal Deficit: It may be observed from figure 1, the Fiscal deficit to GDP ratio is continuously increasing indicating the government revenue is less than government spending. To meet the expenses the government has to borrow which leads to current account deficit. Data: For the study we used annual data on current account deficits (CAD), real GDP, Investment(Inv), Savings(sav), openness of the economy (OPEN) (calculated as [(exports +imports)/gdp], output gap (Ogap) (Calculated using appropriate methodology), real exchange rate (rer) and Fiscal Deficits (FD) from the reserve bank of India data base ( We use annual data for the period to After collecting the data we have calculated CAD/GDP, Savings/GDP, Investment/GDP, Fiscal deficit/gdp ratios and then Savings/GDP, Investment/GDP, Fiscal deficit/gdp ratios are converted to log values. Methodology: Using vector error correction mechanism, Variance decomposition and Johansen Cointegration technique we have identified the short run as well as long run determinants of the current account deficits 5. Results and discussion: We have used ADF, PP and KPSS tests to find the existence of unit root, based on the unit root tests results that are reported in table-1, we performed Johnsen s Cointegration to see whether any combination of the variables are coningrated. The results are reported in Table-2 and Table-3. It may be observed from the tables that the current account deficits exhibit long run relationship with the chosen variables for the study. After checking the long run relationship among the variables questioned, we proceed further to verify the short run relationship between the chosen variables. We have examined with a lag of 5 and 10 years hoping such a period would be adequate to get effects of one variable on the other. The results are reported in Table-4(a) and 4(b). It may be observed from the table that there exists unidirectional casual influence of the current account deficits on fiscal deficit, investment, real exchange rate indicating the influence of current account deficit on fiscal deficit, investment and real exchange rate in 5 years period, where as current account deficits influenced savings only in 10 years period and openness of the economy influenced the current account deficit in ten year period indicating the influence of the openness of the economy on current account deficits. Investment and fiscal deficits, output gap and fiscal deficit, openness of the economy and fiscal deficit, savings and investment showed bidirectional casual influence on each other in five year period where as only investment and fiscal deficit, openness of the economy and fiscal deficit showed bidirectional casual influence in 10 year period, 209

8 fiscal deficit and saving showed unidirectional relationship in both the periods indicating the influence of fiscal deficit on savings. It is also observed the unidirectional casual influence of fiscal deficit on real exchange rate and savings, influence of openness of economy on investment, output gap influence on real exchange rate, savings influence on output gap in a period of five years and unidirectional casual influence of fiscal deficit on savings, output gap influence on investment and openness of the economy influence on investment in the period 10 years Variance Decomposition: We have presented the variance decomposition results in table 5(a) and 5(b). It may be observed from the tables that the current account deficits are influenced fiscal deficit, investment, savings, real exchange rate, output gap and openness of the economy. The openness of the economy influenced current account deficits by 33.96% where as fiscal deficit, savings, real exchange rate and output gap put together influenced the current account deficit by 35.42%. Openness of the economy influenced the fiscal deficit, investment, savings, real exchange rate, and output gap by 46.91%, 25.19%, 41.57%, 14.23%, 59.87% respectively. The openness of the economy was influenced by output gap by 22.28%. Overall the influence of the openness of the economy is high in all the variables chosen. The results of the Granger causality using VECM are reported in table-6. Empirical findings suggest that there is a significant long run equilibrium relationship between current account deficit and investment, savings &openness of the economy. However we have not observed any significant relationship between current account deficit and fiscal deficit, real exchange rate and output gap. It is also observed the bidirectional causality between current account deficit and investment and current account deficit and savings, indicating the influence of current account deficits on savings and investment Discussion: 1. India is predominantly dominated by unorganized or informal sector, till today 66% of the population living in rural area are away from banking facilities and no room for savings and hence difficult to get data on savings from these population. 2. Since 64% of the people depend on agriculture sector and this sector always suffers from crop failure, because of drought or floods, there is always a need for money. Though investment in Indian capital market gives reasonably good returns people prefers to invest in informal capital markets because of higher returns compared to the capital market returns. 3. Because of the boom in the real estate sector most of the money is moving to that sector where market value is greater than that of the government value. The difference money is not accounted anywhere. 4. India's deficit on the current account increased throughout the period and hence it is pushed into greater dependence on high interest commercial loans from international banks to finance their deficits. The growth in private savings could not finance most of India s investment throughout the period except in some years; the point 2 above may be the reason. 5. The rise in savings could not finance investment even after 1990 s, this might be because of the new financial innovations in the Indian economy such as GDRs, ADRs and FCCBs, infrastructure bonds etc., coupled with lower interest rates in other countries 210

9 Seshaiah, S.V. On The Estimation of the Determinants of the Current Account Deficits in India attracted Indian private as well as public sector and hence a part of domestic savings must have moved to unorganized sector. 6. Conclusion and suggestions: The purpose of this paper is to investigate the determinants of the current account deficits of India. The result are quite interesting showing that the openness of the economy influenced current account deficits by 33.96% where as fiscal deficit, savings, real exchange rate and output gap put together influenced the current account by 35.42%. Though the policy makers have taken measure to control the current account deficits, the impact of these measures are unnoticed. For example to reduce the import of gold the policy makers increased the excise duty yet the gold prices have not reduced in India and the import of gold constitutes roughly 36% to current account deficits. Since in India the economic activity predominantly run by the unorganized capital market or informal capital market most of the savings must have moved to unorganized sector and hence domestic saving are not supporting the domestic investment which led to current account deficit, Venkata Seshaiah (2012). Because of the financial innovations such as credit card, interest free loans etc., conspicuous consumption has increased from most of the middle class families which has led to inflationary pressure and positive output gap which has lead to the current account deficit. Hence the policy makers in India always strive to find out solutions to the issues like managing the growth inflation dynamics, short tradeoffs with long term sustainability and managing fiscal consolidation under so many political economy constraints. Suggestions: 1. It is suggested that the policy makers of India should come up with the savings policy that attracts the savers to save in formal capital markets of India by adopting proper mix of monetary and fiscal policies. 2. Policy makers should come up with the policies that control the black money in the country. 3. May move to one family one job for a particular level of incomes which reduces conspicuous consumption and increase the employment opportunities. 4. Should come up with the policies that motivate both agriculture sector as well as manufacturing sector instead of encouraging only service sector. References: Calderon, C.A., Cjpmg, A amd N.V. Loaza (2002), Determinants of current Account deficits in Developing countries, Contributions to Macroeconomics, 2(1). Coakley, J., Hasan, F. and Smith, R. (1999) Saving, Investment, and Capital Mobility in LDCs, Review of International Economics, 7, pp Feldstein, M. and Horioka, C. (1980) Domestic saving and international capital flows, Economic Journal, 90, pp

10 Khan, M.S. and M.D. Knight, 1983, Determinants of Current Account Balances of Non- Oil Developing countries in the 1970s: An Empirical Anlyisis. IMF Staff Papers Vol.30, PP Ghosh, A. and Ostry, J. (1995) The Current Account in Developing Countries: A Perspective from the Consumption-Smoothing Approach, World Bank Economic Review,9, pp Jansen, W.J. (1996) Estimating Saving-Investment Correlations: Evidence for OECD Countries Based on an Error Correction Model, Journal of International Money and Finance, 15, pp Jansen, W.J. (1998) Interpreting saving investment correlations, Open Economies Review, 9, pp Leachman, L.L. (1991) Saving, Investment and Capital Mobility Among OECD Countries, Open Economies Review, 2, pp Moreno, R. (1997) Saving-investment dynamics and capital mobility in the US and Japan, Journal of International Money and Finance, 16, pp Taylor, A.M. (1996) International Capital Mobility in History: The Saving-Investment Relationship, NBER Working Paper Indian Economy Since Independence Edited By Uma Kapila, 22 nd Edition, Academic Foundation, New Delhi. Venkata Seshaiah.S. (2012) Savings and investment in India: The Feldstein Horioka Puzzle, Applied Econometrics and International Development Vol (2012) 212

11 Seshaiah, S.V. On The Estimation of the Determinants of the Current Account Deficits in India Table :1 Battery of Unit Root Test results Series ADF PP KPSS Log FD Levels Log Inv Levels Log Rex Level Log sav levels ogap Levels Open Levels CAD levels Log FD Differences * * ** Log Inv Differences * * ** Log Rex Differences * * ** Log sav Differences * * ** Ogap Differences ** ** ** Open Differences ** * ** CAD Differences * * * Note:* and ** Rejection of null of Non stationary at the 1% and 5% significance level respectively Table - 2 Multivariate Co integration (Trace statistics) Lags interval (in first differences): 1 to 1 Unrestricted Cointegration Rank Test (Trace) at 0.05 level of significance Hypothesized No. of CE(s) Eigenvalue Trace Statistic 0.05Critical Value Prob.** None * At most 1 * At most 2 * At most 3 * At most 4 * At most At most Trace test indicates 5 cointegrating eqn(s) at the 0.05 level * denotes rejection of the hypothesis at the 0.05 level **MacKinnon-Haug-Michelis (1999) p-values 213

12 Table- 3 Multivariate Co integration (max eigen statistics) Unrestricted Cointegration Rank Test (maximum eigenvalue) at 0.05 level Hypothesized No. of CE(s) Eigenvalue Max-Eigen Statistic 0.05Critical Value Prob.** None * At most 1 * At most At most At most At most At most Max-eigenvalue test indicates 2 cointegrating eqn(s) at the 0.05 level * denotes rejection of the hypothesis at the 0.05 level **MacKinnon-Haug-Michelis (1999) p-values Pairwise Granger Causality Tests Table: 4 (a) Lags: 5 Null Hypothesis: Obs F-Statistic Prob. INFD does not Granger Cause CAD CAD does not Granger Cause INFD ININV does not Granger Cause CAD CAD does not Granger Cause ININV INREX does not Granger Cause CAD CAD does not Granger Cause INREX INSAV does not Granger Cause CAD CAD does not Granger Cause INSAV OGAP does not Granger Cause CAD CAD does not Granger Cause OGAP OPEN does not Granger Cause CAD CAD does not Granger Cause OPEN ININV does not Granger Cause INFD INFD does not Granger Cause ININV INREX does not Granger Cause INFD INFD does not Granger Cause INREX INSAV does not Granger Cause INFD INFD does not Granger Cause INSAV OGAP does not Granger Cause INFD INFD does not Granger Cause OGAP

13 Seshaiah, S.V. On The Estimation of the Determinants of the Current Account Deficits in India OPEN does not Granger Cause INFD INFD does not Granger Cause OPEN INREX does not Granger Cause ININV ININV does not Granger Cause INREX INSAV does not Granger Cause ININV ININV does not Granger Cause INSAV OGAP does not Granger Cause ININV ININV does not Granger Cause OGAP OPEN does not Granger Cause ININV ININV does not Granger Cause OPEN INSAV does not Granger Cause INREX INREX does not Granger Cause INSAV OGAP does not Granger Cause INREX INREX does not Granger Cause OGAP OPEN does not Granger Cause INREX INREX does not Granger Cause OPEN OGAP does not Granger Cause INSAV INSAV does not Granger Cause OGAP OPEN does not Granger Cause INSAV INSAV does not Granger Cause OPEN OPEN does not Granger Cause OGAP OGAP does not Granger Cause OPEN Pairwise Granger Causality Tests Sample: Table 4(b) Lags: 10 Null Hypothesis: Obs F-Statistic Prob. INFD does not Granger Cause CAD CAD does not Granger Cause INFD ININV does not Granger Cause CAD CAD does not Granger Cause ININV INREX does not Granger Cause CAD CAD does not Granger Cause INREX INSAV does not Granger Cause CAD CAD does not Granger Cause INSAV

14 OGAP does not Granger Cause CAD CAD does not Granger Cause OGAP OPEN does not Granger Cause CAD CAD does not Granger Cause OPEN ININV does not Granger Cause INFD INFD does not Granger Cause ININV INREX does not Granger Cause INFD INFD does not Granger Cause INREX INSAV does not Granger Cause INFD INFD does not Granger Cause INSAV OGAP does not Granger Cause INFD INFD does not Granger Cause OGAP OPEN does not Granger Cause INFD INFD does not Granger Cause OPEN INREX does not Granger Cause ININV ININV does not Granger Cause INREX INSAV does not Granger Cause ININV ININV does not Granger Cause INSAV OGAP does not Granger Cause ININV ININV does not Granger Cause OGAP OPEN does not Granger Cause ININV ININV does not Granger Cause OPEN INSAV does not Granger Cause INREX INREX does not Granger Cause INSAV OGAP does not Granger Cause INREX INREX does not Granger Cause OGAP OPEN does not Granger Cause INREX INREX does not Granger Cause OPEN OGAP does not Granger Cause INSAV INSAV does not Granger Cause OGAP OPEN does not Granger Cause INSAV INSAV does not Granger Cause OPEN OPEN does not Granger Cause OGAP OGAP does not Granger Cause OPEN

15 Seshaiah, S.V. On The Estimation of the Determinants of the Current Account Deficits in India Tables 5 and 6 to be included. 217