The Effect of Oil Shocks and Cyclicality in Hiding Indian Twin Deficits

The paper estimates the relationship between the current account and fiscal deficit, and the real exchange rate, in a structural vector auto regression, with Indian data for the managed float period 1996 Q2 to 2015 Q4, after controlling for output growth and oil shocks. It also examines the cyclicality of the current account, the size of each shock, and assesses whether aggregate demand, forward-looking smoothing, or supply shocks dominate outcomes. The current account deficit (CAD) is found to be counter cyclical. A fiscal deficit shock raises the CAD, but high impact growth shocks and large variance oil shocks lead to overall divergence of the deficits. There is some support for the aggregate demand channel, but it is moderated by supply shocks and compositional effects. Consumption is sticky rather than forward-looking.