The Twin Deficits Hypothesis: Some Recent Evidence for India

The objective of the present study is to test the long-run and short-run relationship between fiscal deficit ( FD) and current account deficit (CAD) for India for the period 1978- 2011. In the economic literature, the relationship is widely known as the twin deficits hypothesis". This hypothesis asserts that any increase in the FD will result in a widening of the CAD and vice versa. To test the validity of the twin deficits hypothesis, we use the Auto Regressive Distributed Lag (ARDL) bound tests and Error Correction Method (ECM ) procedures. Since the study includes both pre-reform and post-reform periods, the hypothesis was verified for both the pre-( 1978-1990 ) and' postliberalization'(1991-2011 )periods. The empirical results suggest that, for the pre-liberalization period, there is no evidence of a co-integration relationship between FD and CAD, thus invalidating the twin deficits hypothesis. However, for the post-liberalization period, the results support validation of the twin deficits hypothesis both in the long run and in the short run. In addition, the results produce interesting evidence of reverse causation. In other words, the current account deficit appears to be a prime cause of fiscal deficit, and it has stronger statistical significance similar to previous studies by Bose and Jha (2011 and Anoruo and Ramchander (1998).