Academic journal article IUP Journal of Applied Economics

The Relationship between Fiscal Deficit and Trade Deficit in India: An Empirical Enquiry Using Time Series Data

Academic journal article IUP Journal of Applied Economics

The Relationship between Fiscal Deficit and Trade Deficit in India: An Empirical Enquiry Using Time Series Data

Article excerpt

(ProQuest: ... denotes formulae omitted.)

Introduction

Twin deficits, i.e., fiscal deficit and trade deficit, play an important role in the country's economic development. Of late, identifying the relationship between the twin deficits has attracted the attention of many researchers. Some of the earlier studies that attempted to measure the relationship of twin deficits around global level could find that both deficits have close a relationship, and proved the relationship as postulated under Keynesian proposition, i.e., budget deficit causes trade deficit (Darrat, 1988; Abell, 1990; Zietz and Pemberton, 1990; and Vamvoukas, 1999), and some studies found that there exists no relationship between these deficits in line with the Ricardian concept (Evans, 1988; Dewold and Ulan, 1990; Enders and Lee, 1990; and Kim, 1995).

Identifying the relationship between both deficits is the most controversial issue in economics. Different schools of thoughts put forth different viewpoints about the relationship, i.e., relationship of fiscal deficits and trade deficits in both developed and developing economies. These twin deficits have got serious attention from the researchers as well as academicians as in many cases these deficits are feared to lead to economic impairment and indignant economic growth. Over a decade, this linkage between fiscal deficits and trade deficits of economies have spurred wide academic debate and empirical testing.

With the experience of the above said twin deficits in India, from 2007-08 the fiscal deficit increased from 6.5-7% of GDP, and it went up to 10% of GDP in the year 2009-10. Through allocation of 3G spectrum, Indian government got three times more receipt and it haggled to keep up with the fiscal deficit of 5.5% of GDP in the year 2010-11. In the year 2011-12, the road map of fiscal consolidation was to keep the fiscal deficit at 4.8%. In the present scenario, there are numerous scandals, and hence fiscal consolidation by the policy makers becomes necessary. As per the 13th Finance Commission report, it was recommended that to eliminate fiscal deficit, we have to find the way for revenue supply and carry consolidated debt to 68% of GDP by 2014-15. The report of Reserve Bank of India (RBI) found that high fiscal deficit may lead to the problem of inflation crowding out the private sector and high interest rates. For higher fiscal deficits, the government should take serious action by giving subsidy to contain the prices of petroleum products, and they should focus on revenue mobilization by extending the tax base, improving tax administration by better compliance, etc.

A number of studies have already been carried out regarding the twin deficits and different researchers have made separate analysis at micro and macro levels. In the context of India, due to globalized market and WTO liberalization of trade, there is a need for understanding the relationship between fiscal deficit and trade deficit in India. This study attempts to evaluate the long-run relationship and causality between trade deficit and fiscal deficit in India.

Literature Review

According to Friedman, if deficits are used reasonably, it is helpful for financial growth and unemployment reduction. Many economists have already examined the relationship between the twin deficits all over the world. Based on the earlier research works like Fleming (1962), Hutchison and Charles (1984), Kawai (1985), McCoskey and Chihwa (1999), and Vamvoukas (1999) claimed that fiscal deficit stimulates the increase of trade deficit. According to Hutchison and Charles (1984), an increase in the fiscal deficit is likely to increase the real interest rate and trade deficit. Korsu (2005) investigated the effect of fiscal deficit on the external sector of Sierra Leone and found that fiscal restraint improved the external sector by reducing money supply and price level. Basu and Datta (2005) studied the influence of fiscal deficit to trade deficit in India. …

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