The effect of oil shocks and cyclicality in hiding Indian twin deficits

Purpose - The purpose of this paper is to estimate the relationship between the current account (CA) and fiscal deficit (FD), and the real exchange rate for India, for the managed float period 1996 Q2 to 2015 Q4, after controlling for output growth and oil shocks. It also examines the cyclicality of the CA, the size of each shock, and assesses whether aggregate demand, forward-looking smoothing, or supply shocks dominate outcomes. Design/methodology/approach - The authors use several variants of structural vector autoregression (SVAR), implemented with quarterly Indian data, to control for effects of oil prices, and the output cycle, and then see how FD shocks affect the current account deficit (CAD) and the real exchange rate. For robustness, the authors tried different identifications, changed variable definitions, added new variables, or substituted with other variables. The cyclicality issue is addressed by examining the effect of growth shocks. The relative size of each shock is assessed through co-movement decompositions of the forecast errors. Responses to shocks help identify dominant influences on India’s CAD. Findings - The CAD is found to be countercyclical. A FD shock raises the CAD, but high impact growth shocks and large variance oil shocks lead to overall divergence of the deficits. There is some support for the aggregate demand channel, but it is moderated by supply shocks and compositional effects. Consumption is sticky rather than forward-looking. Originality/value - The paper contributes to the literature by including supply shocks, compositional effects, cyclicality, real interest and exchange rate in a theoretically and empirically consistent way for the analysis of twin deficits. The large empirical literature on twin deficits in EMs has not yet done this. There is no study using quarterly data in an SVAR allowing the dynamic relationship between the variables to be explored. The extensions bring in the supply side and compositional effects qualify the working of both the channels, with empirical exercises supporting theoretical predictions.