Does the twin deficit hypothesis exist in India? Empirical evidence from an asymmetric non-linear cointegration approach

Abstract

This paper explores the dynamic relationship between the current account deficits and fiscal deficits in India. This paper has used the very much familiar Enders and Siklos (2001) and Hansen and Seo (2002) regime-switching threshold cointegration with an asymmetric error correction approach and non-linear ARDL model developed by Shin et al. (2014) to examine the non-linearity, short and long-run asymmetry, and asymmetrical adjustment between the current account deficits and fiscal deficits in India. Initial results validate the asymmetric adjustment between current account deficits and fiscal deficits, indicating the twin divergence hypothesis. However, the posterior sensitivity analysis suggests the twin deficit hypothesis, which seems more robust. Moreover, empirical results reveal that the interaction between these deficits is asymmetrically related, and fiscal deficits' upward and downward movement substantially affect India's current account deficits in the short-run and long run. The asymmetrical lead-lag relationship between current account deficits and fiscal deficits harms the current account sustainability, balance of payments, exchange rate, bond, and financial markets. Therefore, the study argues in its policy solution that the central bank of India must try to overcome the prolonged current account deficits and maintain stability in the domestic currency.