Does Twin Deficit Hypothesis Exist in India? A Structural Break Co-integration Analysis

Abstract

The primary focus of this study is to examine the long-term and short-term impact of fiscal deficit (FD) on the current account deficit (CAD) in India over the period of 1980 to 2021 in the presence of inflation and exchange rate. For the estimation of data series, the study employed autoregressive distributed lag (ARDL) co-integration test and Gregory Hansen (GH) co-integration test with endogenous structural break. The empirical results from ARDL bounds tests fail to provide a long-run relationship for the variables. The threshold co-integration test (GH) estimation suggests a strong evidence of a co-integration relationship for the variables and the break year is found in 2005. Thus, the findings validate the twin deficit hypothesis in the long-run as the FD has a positive significant effect on a CAD in India. Similarly, the long-run estimates of inflation have a positive significant effect on the CAD. It implies that an increase in rate of inflation distorts the CAD in the long-run. Consequently, the government of India should control the price hike and make macroeconomic situations favourable for domestic tradable sectors. The results from the Granger causality technique show bidirectional causality between FD and CAD implies the twin deficit in India. Based on the empirical findings, it may be argued that the Central Bank of India should try to reduce the prolonged CADs and retain stability in the domestic currency.