Validity of Twin Deficit Hypothesis in Indian Case : A Myth or Reality?

In recent times, the twin-deficit hypothesis that there is a strong link between Fiscal Deficits (FD) and Current Account Deficits (CAD) is in the forefront of the policy debate. For most of the last thirty years, India has faced a 'twin deficit' situation viz. simultaneous Fiscal Deficits and Current Account Deficits. This empirical exercise is undertaken with a view to examine the linkages between the two deficits in India from 1980-1981 to 2012-2013. First, we have applied Johensen cointegration test in order to investigate the long run relationship between CAD and FD. Further, we have tested the stability of the equilibrium using VECM along with Granger Causality test to find evidence and direction of long-run causality between Current Account Deficits to Fiscal Deficits and vice versa. The study found evidence of a long-run cointegrating relation between CAD and FD, while in the short run our evidence favours the hypothesis that there exists a uni-directional Granger Causality between CAD and FD in India. It is only the Fiscal Deficits which adjusts to the external deficit. The study found evidence of unidirectional reverse causality between the Current Account Deficits and the Fiscal Deficits.