Causal relationships between the capital account and the current account: an empirical investigation from India

Abstract

This article provides an empirical investigation of the causal relationship between the current account (CA) and the capital account (KA) in the case of Indian economy. The results indicate the nonexistence of causal relationship between the CA and the KA. Furthermore, we examine the causal relations between the components of the KA and the CA along with exchange rate as the linking factor between them. The causal findings, in the above mentioned case, show different results. Our finding suggests that there exist a causal relationship from Nondebt flows to the CA via the real effective exchange rate. This implies that decomposition of the KA helps in identifying the source of flows that drives the CA the most. The results also indicate that volatile capital flows may deteriorate the CA balance and therefore, emphasis should be laid on improving the soundness of the financial sector before moving towards the full KA convertibility.

Keywords:

• granger causality test
• balance of payments
• capital account
• current account

JEL Classification:

• C32
• F21
• F32

Notes

¹ Prasad et al. (2004) discussed the impact of KA liberalization on economic growth and other macroeconomic factors. Other studies include Wang (1990) and Klein (2003).

² India’s CA has been persistently in deficits for most of the period since 1990s, while on the other hand the KA has been in surplus during this period.

³ Unit root test results suggest that both DF and NDF are stationary at levels at 1% significance level.

⁴ Unit root test results suggest that both FDI and FPI are stationary at levels at 1% significance level.