THE INTERTEMPORAL APPROACH TO INDIA’S CURRENT ACCOUNT DYNAMICS: SOLVENCY, SUSTAINABILITY, AND DETERMINANTS

Garg, Bhavesh and K P, Prabheesh (2018) THE INTERTEMPORAL APPROACH TO INDIA’S CURRENT ACCOUNT DYNAMICS: SOLVENCY, SUSTAINABILITY, AND DETERMINANTS. Masters thesis, Indian Institute of Technology Hyderabad.

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Abstract

This thesis is divided into three research objectives. The first is to examine the intertemporal solvency of India’s current account balance. The second objective is to investigate the sustainability of India’s current account balance. The first two objectives reflect India’s ability to repay and willingness to repay, respectively. Finally, the third objective is to uncover the major drivers of India’s current account balance. To achieve these objectives, the thesis uses quarterly data from the post-liberalization period from 1996-2014. First, the intertemporal solvency is examined by applying the two variants of the present value models of the current account. The theoretical framework is based on the permanent income hypothesis, in which agents are forward-looking. We test a benchmark model in which the agents’ information set includes only shocks to domestic variables, and an extended model in which shocks to external variables are added. The econometric results show that both the models are able to trace the actual current account path. However, present value model that includes changes in the external variables outperforms the one that excludes them. Second, the sustainability of India’s current account balance is examined. We use an intertemporal model to test if the current account balance in India is sustainable or not. The results suggest that India’s current account is sustainable once the cointegration relationship accounts for endogenous structural breaks. As a next step, we calculate the time-series of a sustainable current account path and then apply a fan chart approach for prediction. Finally, robustness checks are done by predicting an in-sample forecast. Third, we identify the major domestic and external factors that affect India’s current account balance. For this purpose, we test a benchmark empirical model and then extend the model by incorporating external factors relevant to the Indian economy. Various hypotheses such as Ricardian equivalence versus Twin-deficit hypothesis and Feldstein-Horioka hypothesis were tested. The econometric results suggest that Feldstein-Horioka hypothesis is rejected; implying private saving only partially finances private investment. We also found evidence in favor of Twin-deficit hypothesis and against Ricardian equivalence. The results also indicate the importance of oil price volatility and foreign income in affecting India’s current account balance.

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