Impact of Indias Current Account Deficit and National Debt on Its Foreign Exchange Rate (vs. Us$): A Study of India from 1990-2018

Abstract

The Current Account Deficit and National Debt of a country are two major factors that can impact the foreign exchange rates it has with the currencies of other nations. This study empirically analyses the impact of India’s Current Account Deficit (in million USD) and National Debt (in million USD) on the nation’s Foreign Exchange Rate (vs. US$). The Current Account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest, and dividends. A deficit in the current account shows that the value of the goods and services it imports exceeds the value of the products it exports. In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the country\'s exchange rate (exchange rate depreciation). Thus the model presents a negative or inverse relation between Current Account Deficit and its impact on the Foreign Exchange Rate. Government debt is public debt or national debt owned by the central government. A country with increasing government debt is less likely to acquire foreign capital, leading to inflation. Foreign investors will sell their bonds in the open market if the market predicts government debt within a certain country. As a result, a decrease in the value of its exchange rate will follow.

Introduction

 ACKNOWLEDGMENTS

I take this opportunity to thank everyone who has helped me in the completion of this paper.

It would have been impossible to complete this without the helpful guidance, consistent cooperation and tremendous support of my Econometrics professor, Mrs Reshmi Ganguly. Last but not the least, I extend a vote of thanks to all those who gave me their invaluable encouragement, support and guidance at various phases of this paper, including my friends and classmates.

I. INTRODUCTION

A current account deficit is a trade measurement that says a country imported more goods, services, and capital than it exported. A nation creates a current account deficit when it relies on foreigners for the capital to invest and spend. Depending on why the country is running the deficit, it could be a positive sign of growth. It could also be a negative sign that the country is a credit risk.

In the short-run, a current account deficit is helpful to the borrowing nation. Foreigners are willing to pump capital into it. That drives economic growth beyond what the country could manage on its own. In the long run, a current account deficit saps economic vitality. Foreign investors may start to question whether the country's economic growth will provide enough return on their investment. Demand weakens for the country's assets, including the country's government bonds.

As foreign investors withdraw funds, bond yields rise. The national currency loses value relative to other currencies. That lowers the value of the assets in the foreign investors' strengthening currency. It further depresses investor demand for the country's assets. This can lead to a tipping point where investors will dump the assets at any price. A country with a current account deficit should invest the foreign capital it receives wisely. It should build roads and ports, and educate its workforce, to boost international trade. The country's leaders should create a current account surplus as soon as possible. They should improve domestic productivity and the competitiveness of its local businesses. It should also seek to reduce imports of basic necessities, such as oil and food, by boosting that ability at home. In the short run, National debt is a good way for countries to get extra funds to invest in their economic growth. National debt is a safe way for foreigners to invest in a country's growth by buying government bonds.

When used correctly, National debt improves the standard of living in a country. It allows the government to build new roads and bridges, improve education and job training, and provide pensions. This spurs citizens to spend more now instead of saving for retirement. This spending by private citizens further boosts economic growth.

The testing has been done using Ordinary Least Squares Method under Classical Linear Regression Model.

II. LITERATURE REVIEW

Mirchandani, A. (2013), analysed various macroeconomic variables that leads to the variation of the foreign exchange rate. The various factors included inflation; interest rate, current account deficit and the variation of these factors were observed to correlate with the variation in foreign exchange rate.

Khera, K., et al; (2015), observed the effect of various macroeconomic factors influencing the exchange rate post globalization. The study suggested to condense imports and to promote FDI to improve the exchange rate.

Wan Mohd Yaseer Mohd Abdoh, et al., (2016), compared the relationship of exports, interest rate and inflation on exchange rate of select ASEAN countries. They observed that exports had a significant role on the exchange rate movement.

Vidyavathi, B., et al; (2016), evaluated the leading macroeconomic indicators that influenced the exchange rate. They observed negative relationship GDP and exchange rate, inflation & exchange rate, interest rate and exchange rate, external debt and exchange rate, and a weak positive relationship between FDI and Exchange rate.

The Current Account Deficit and National Debt are some of the most vitals factors to consider when determining a country’s Foreign exchange Rate, which is precisely why these indicators was chosen as the independent variables.

III. DEPENDENT VARIABLE – FOREIGN EXCHANGE RATE (INR PER USD) (Y)

A foreign exchange rate is the price of the domestic currency stated in terms of another currency. In other words, a foreign exchange rate compares one currency with another to show their relative values. Since standardized currencies around the world float in value with demand, supply, and consumer confidence, their values change relative to each over time. Many factors can influence the exchange rates, including inflation, political stability, recession, speculation, terms of trade etc.

When selling products internationally, the exchange rate for the two trading countries' currencies is an important factor. Foreign exchange rates, in fact, are one of the most important determinants of a countries relative level of economic health, ranking just after interest rates and inflation. Exchange rates play a vital role in a country's level of trade, which is critical to most every free market economy in the world. Consequently, they are among the most watched, analyzed, and manipulated economic measures.

A currency is freely floating if there does not exist a system of fixed exchange rates and if the Central Bank of the country in question does not attempt to influence the value of the currency. However, in reality this kind of situation does not exist.

In most of the countries Governments attempt to influence movements of exchange rate either through direct intervention in the exchange market or through a mix of fiscal and monetary policies. Under such circumstances, floating is called as ‘managed’ or ‘dirty float’. A number of countries use a pegged float as a system of exchange rates. The value of one currency is pegged to the value of another currency that itself floats. In a joint float, currencies in a particular group have a fixed exchange value in terms of each other, but the group of currencies floats in relation to other currencies outside the group.

A. Independent Variable – Current Account Deficit (in million USD) (X1)

The current account deficit is a measurement of a country’s trade where the value of the goods and services it imports exceeds the value of the products it exports. The current account represents a country’s foreign transactions and, like the capital account, is a component of a country’s balance of payments (BOP). A country can reduce its existing debt by increasing the value of its exports relative to the value of imports. It can place restrictions on imports, such as tariffs or quotas, or it can emphasize policies that promote export, such as import substitution, industrialization, or policies that improve domestic companies' global competitiveness. The country can also use monetary policy to improve the domestic currency’s valuation relative to other currencies through devaluation, which reduces the country’s export costs. While an existing deficit can imply that a country is spending beyond its means, having a current account deficit is not inherently disadvantageous. If a country uses external debt to finance investments that have higher returns than the interest rate on the debt, the country can remain solvent while running a current account deficit. If a country is unlikely to cover current debt levels with future revenue streams, however, it may become insolvent.

B. Independent Variable – National Debt (in million USD) (X2)

As the government's revenue from taxes and other sources fall short of its spending requirements, the government resorts to borrowings from markets and external sources. Public debt is the total liabilities of the central government contracted against the Consolidated Fund of India. Government debt can be categorized as internal debt (owed to lenders within the country) and external debt (owed to foreign lenders). Moderate increases in the debt will boost economic growth. However, an ever-increasing national debt slowly dampens growth over the long term. The only way to reduce the debt is to either raise taxes or cut spending. Either of those can slow economic growth. They are two of the tools of contractionary fiscal policy.

Cutting spending has pitfalls. Government spending is a component of GDP. If the government cuts spending too much, economic growth will slow. That leads to lower revenues and a larger deficit. The best solution is to cut spending on areas that do not create many jobs. Tax increases beyond the 50% bracket can slow growth. The industries or groups that pay higher taxes will get angry.

Most governments can safely finance their debts instead of balancing the budget by issuing government bonds.

Based on the spending targets and likely resource mobilisation on tax and non-tax front, the government announces its borrowing programme for the fiscal in the Budget.

IV. EMPIRICAL ANALYSIS

A. Objective

To determine the impact of India’s Current Account Deficit and National Debt on the country’s Foreign Exchange Rate (vs. USD).

B. Data Source

Secondary data has been collected for all the variables from 1990-2018. Following are the sources of the data:

1. Current Account Balance by Organisation for Economic Cooperation and Development (OECD) Data
2. Forex Rate Data from Handbook of Statistics by Reserve Bank of India
3. National Debt Data by www.countryeconomy.com

C. Methodology and Results

Simple Linear Regression and Multiple Linear Regression using Ordinary Least Squares Method under the assumptions of Classical Linear Regression Model.

V. REGRESSIONS

A. One Dependent And One Explanatory Variable Linear Model-1

Interpretation

Foreign Exchange Rate ( INR vs. USD) and India’s Current Account Deficit (in million USD)

Y: Foreign Exchange Rate

X: India’s Current Account Deficit Yi = β1 + β2Xi + ui

Yi^ (Y hat) = b1 + b2Xi, where b1 and b2 are estimators of β1 and β2 respectively.

1) Apriori Expectations of Partial Coefficients

Here, Apriori expectations of b2 are negative because as India’s current account deficit decreases (or current account reaches balance), its Foreign Exchange Rate appreciates (or the value of INR per US Dollar decreases) in the short run. Observations may differ in the long run.

Ho : β2 = 0 Ha : β2 < 0

2) Running the Regression by OLS Method:

Model 1: OLS, using observations 1990 – 2018 (T = 29) Dependent Variable: Annual Average Forex Rate (Y)

VII. DISCUSSION OF RESULTS AND POLICY RECOMMENDATIONS

Simple Linear Regression between Forex rate and current Account Deficit indicates a negative relationship between the two variables implying that with an increase in the deficit, Forex Rate would depreciate. A deficit in the current account shows that the value of the goods and services it imports exceeds the value of the products it exports. In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the country's exchange rate (exchange rate depreciation).

Simple Linear Regression between Forex rate and National Debt indicates a positive relationship between the two variables implying that with an increase in the National Debt, value of INR per US Dollar would increase or India’s Exchange Rate depreciation. A country with increasing government debt is less likely to acquire foreign capital, leading to inflation. Foreign investors will sell their bonds in the open market if the market predicts government debt within a certain country. As a result, a decrease in the value of its exchange rate will follow.

A country should aim to minimize their Current Account Deficit and Debt in the long run to ensure economic wellbeing.

VIII. LIMITATIONS AND DIRECTIONS FOR FUTURE WORK

No work is free from limitations and this paper is no exception and thus the limitations need to be highlighted for better critical appreciation. It was hard finding accurate data for the National Debt of India. Few indicators had to be changed in order to fit the regression and obtain desired results. The apriori expectations of the impact of the Current Account Deficit on the Forex Rate were not matching with the regression results in the Multiple Linear Regression Model, possibly due to some CLRM assumptions not being satisfied, which could be rectified by using a larger database for more accurate result.

Conclusion

This study analysed the impact of India’s Current Account Deficit and National Debt on its Foreign Exchange Rate (INR vs. US Dollar). For 29 years from 1990-2018. The apriori expectations of the impact of the Current Account Deficit on the Forex Rate were not matching with the regression results in the Multiple Linear Regression Model, possibly due to some CLRM assumptions not being satisfied. Residuals were normally distributed.

References

[1] https://countryeconomy.com/national-debt/india [2] https://dbie.rbi.org.in/DBIE/dbie.rbi?site=statistics [3] https://data.oecd.org/trade/current-account-balance.htm [4] https://www.investopedia.com/trading/factors-influence-exchange-rates/ [5] https://www.thebalance.com/current-account-deficit-definition-components- and-causes-3305831 [6] https://www.thebalance.com/what-is-the-public-debt-3306294 [7] file:///C:/Users/MC%20DAS/Downloads/15716-17470-1-PB.pdf [8] http://ijbssnet.com/journals/Vol_5_No_9_1_August_2014/9.pdf [9] https://www.economicshelp.org/blog/2089/economics/exchange-rate-and- current-account/ [10] https://econclassroom.com/the-relationship-between-the-current-account- balance-and-exchange-rates/ [11] https://www.purefx.co.uk/foreign-currency-exchange-insight/view/how- does-national-debt-affect-the-foreign-exchange-rate

Copyright

Copyright © 2022 Aditi Das. This is an open access article distributed under the Creative Commons Attribution License, which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited.