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Analyzing the Sustainability of India's Current Account Position Following the Reforms of the Early 1990s

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Analyzing the Sustainability of India's Current Account Position Following the Reforms of the Early 1990s
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    1 ANALYZING THE SUSTAINABILITY OF INDIA’S CURRENT ACCOUNT POSITION FOLLOWING THE REFORMS OF THE EARLY 1990S  Niloufer Sohrabji *    Abstract Following the 1991 crisis, India undertook reforms that liberalized trade and investment. India faced current account deficits for most of the period following these reforms. This paper analyzes sustainability of India’s current account position over the last decade using the intertemporal solvency model of Hakkio and Rush (1991) and Husted (1992). In this theoretical framework, the intertemporal solvency constraint is satisfied if there is cointegration between inflows and outflows of the current account. This paper finds cointegration between the series when allowing for a structural break using the Gregory and Hansen (1996) procedure. Dynamic GLS estimation shows a strong relation between India’s current account inflows and outflows. Based on the empirical results, this paper concludes that there has been an improvement in trade  patterns and despite experiencing deficits, India’s current account position is sustainable. Keywords : Cointegration, current account sustainability, dynamic GLS, India, intertemporal solvency  JEL   Classification : C32, F32 and F41 *  Correspondence to: Simmons College, Fenway, Boston 02115, email: sohrabji@simmons.edu, phone: 617-521-2587, fax: 617-521-3175. I am indebted to two anonymous referees for their insightful feedback. All errors remain mine.    2 1.   INTRODUCTION This paper examines the solvency of India’s current account position over the last decade. Large and deteriorating current account deficits have played a role in the Mexican peso crisis in 1994, the East Asian crisis in 1997-1998 and Turkey’s crisis in 2001. India experienced large current account deficits in the late 1980s and suffered a balance of payments crisis in 1991. Following the crisis, India undertook reforms that liberalized trade and investment. For most of the period since these reforms, India has experienced trade and current account deficits. This raises concerns about the liberalization reforms, including the possibility of another crisis, and makes it important to study India’s current account position in this period. Trade and current account deficits need not be problematic. If trade deficits are linked to  poor terms of trade or because of a weak production base, then high import bills are a drain on the economy. On the other hand if a country is increasing imports of capital goods it indicates improvement in productive capacity which helps future trade balances. This is the basis of the intertemporal solvency model proposed by Hakkio and Rush (1991) and Husted (1992) which analyzes cointegration between exports and imports and other outflows of the current account. Using the above theoretical framework this paper analyzes sustainability of the Indian current account since the reforms of the early 1990s. While cointegration between inflows and outflows is rejected for the period as a whole, there is evidence of cointegration when allowing for a structural break. Taken together these results indicate that there is an improvement in the current account position in this period. Based on cointegration results, the long run relationship between exports and imports and other debits is estimated. This paper finds evidence of a strong relation  between current account inflows and outflows and concludes that despite the deficits, India’s current account position is sustainable.    3 The paper is organized as follows: the next section provides background on India’s current account position which is followed by a review of the literature. Section 4 presents the theoretical framework and empirical methodology for examining current account sustainability. Section 5 discusses the empirical results and the last section concludes. 2.   BACKGROUND To determine the current state of India’s external position it is useful to analyze the major changes in the current account over the last few decades. Figure 1 plots the trend in the overall current account position for India from 1980 to 2006 using two measures, levels of current account balances and the ratio of current account balances to GDP. Figure 2 maps out the different components of the current account including merchandise trade balance, services trade  balance, net unilateral transfer account and net investment account. Together these graphs  provide an interesting portrait of the Indian current account position over the last three decades. India had a deteriorating current account position in the late 1980s (figure 1). The current account deficit was approximately $ 2 billion in the early 1980s (1980-1984) which jumped to over $ 4 billion by 1985. This trend continued for the remainder of the decade with the deficit exceeding $ 7 billion by 1990. This same trend is observed in the current account deficit to GDP ratios. This ratio was approximately 1% in the early 1980s which jumped to 2% by the mid-1980s and ending up at 2.24% in 1990. Three of the four components of the current account recorded deficits in this period (figure 2). These include merchandise trade balance, services trade balance and net investment income. While the net unilateral transfer account was in surplus for the entire decade, it was not enough to reverse the deficits in the other three accounts. Expectedly, merchandise trade account had the largest deficit and was the main driver of the current account deficit.    4 Figure 1: India’s current account position [1980-2006] -3-2.5-2-1.5-1-0.500.511.52-15-10-50510         1        9        8        0        1        9        8        1        1        9        8        2        1        9        8        3        1        9        8        4        1        9        8        5        1        9        8        6        1        9        8        7        1        9        8        8        1        9        8        9        1        9        9        0        1        9        9        1        1        9        9        2        1        9        9        3        1        9        9        4        1        9        9        5        1        9        9        6        1        9        9        7        1        9        9        8        1        9        9        9        2        0        0        0        2        0        0        1        2        0        0        2        2        0        0        3        2        0        0        4        2        0        0        5        2        0        0        6    P  e  r  c  e  n   t  a  g  e   B   i   l   l   i  o  n  s  o   f   U .   S .   d  o   l   l  a  r  s Current account balancesCurrent account to GDP ratio  Notes: The GDP series was expressed in Indian rupees and current account series in U.S. dollars. GDP was converted to dollars using the market exchange rate. Source: International Financial Statistics database. Figure 2: Components of India’s current account balance [1980-2006] -50-40-30-20-100102030         1        9        8        0        1        9        8        1        1        9        8        2        1        9        8        3        1        9        8        4        1        9        8        5        1        9        8        6        1        9        8        7        1        9        8        8        1        9        8        9        1        9        9        0        1        9        9        1        1        9        9        2        1        9        9        3        1        9        9        4        1        9        9        5        1        9        9        6        1        9        9        7        1        9        9        8        1        9        9        9        2        0        0        0        2        0        0        1        2        0        0        2        2        0        0        3        2        0        0        4        2        0        0        5        2        0        0        6    B   i   l   l   i  o  n  s  o   f   U .   S .   d  o   l   l  a  r  s Merchandise trade balanceServices trade balanceNet unilateral transfersNet investment income  Notes: The GDP series was expressed in Indian rupees and the components of the current account series in U.S. dollars. GDP was converted to dollars using the market exchange rate. Source: International Financial Statistics database. Given the deteriorating trend in the current account and its components during the 1980s it is not surprising that India experienced a balance of payments crisis in 1991. Following the crisis, India embarked on a liberalization program which resulted in increased foreign trade and    5 investment. While both exports and imports increased, the latter outpaced the former and thus India continued to experience trade deficits. From 1995 onwards there was once again a much worsened current account position (figure 1). By 1998, the current account deficit had reached the levels observed prior to the 1991 crisis (approximately $ 7 billion). At 1.67% however, the current account deficit to GDP ratio in 1998 was lower than those observed in the late 1980s (figure 1). The improved current account deficit to GDP ratios despite worsened current account deficits were due to the high growth levels observed in India in the 1990s. The trend in the components of the current account observed in the previous decade accelerated in the 1990s. Net investment income which was declining in the 1980s worsened further in the following decade. This showed that in the 1990s, foreign investment in India yielded higher returns than Indian investment abroad. This is not surprising given the high levels of growth in India during this period and its rise as a significant emerging economy. Increased imports due to dismantling of trade barriers led to higher merchandise and services trade deficits in the 1990s compared to the 1980s. As in the 1980s, net unilateral transfer surpluses grew in the following decade. However, these surpluses were once again insufficient to overturn the deficits in the other three accounts. Thus, India experienced high current account deficits. The 2000s started off with a significantly improved current account position for India. This was partly related to the dramatic increase in net unilateral transfer surpluses which reached $ 22  billion by 2003 (figure 2). Also, the growth of exports in both goods and services was significant leading to a decline in merchandise and services trade deficits. In fact, by 2003 trade of services recorded a surplus. Improvement in these three accounts was more significant than the deterioration of the net investment income account and thus India experienced current
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