“A STUDY OF THE SUSTAINABILITY AND VOLUNTARILY OF

THE CURRENT ACCOUNT IN INDIA”

DISSERTATION SUBMITTED TO THE MADURAI KAMARAJ

UNIVERSITY IN PARTIAL FULFILLMENT OF THE
REQUIREMENTS FOR THE AWARD OF THE DEGREE OF
MASTER OF PHILOSOPHY IN COMMERCE

SUBMITTED BY Mr. BHARAT R. PANDYA

ENROLLMENT NO---------

NAME OF THE GUIDE

DR. VASUDEV IYER
LECTURER IN TOLANI COLLEGE

DIRECTORATE OF DISTANCE EDUCATION

MADURAI KAMARAJ UNIVERSITY
TAMILNADU
DECEMBER 2007

1
“A STUDY OF THE SUSTAINABILITY AND VOLUNTARILY OF
THE CURRENT ACCOUNT IN INDIA”

Dissertation Submitted to the Madurai Kamaraj University in Partial

fulfillment of the requirements for the award of the Degree
Of
MASTER OF PHILOSOPHY
IN
COMMERCE

Submitted By
Mr. Bharat R. Pandya
Enrollment No: ----------

Name of the Guide

Dr. Vasudev Iyer

Lecturer in Tolani College

DIRECTORATE OF DISTANCE EDUCATION

(MADURAI KAMARAJ UNIVERSITY)

MADURAI
TAMILNADU
December, 2007

2
 DECLARATION

I hereby declare that the dissertation entitled

“A study of the sustainability and voluntarily of the current account in India”
submitted for the M. Phil. Degree is my original work and the dissertation
has not formed the basis for the award of any degree, associateship,
fellowship or any other similar titles.

Place:

Signature of the Student

Date:

3
Dr. Vasudev Iyer
Tolani College

CERTIFICATE

This is to certify that the dissertation entitled "Job Satisfaction of Teachers

in Senior Colleges in Mumbai" is the bonafide research work carried out by
Mr. Bharat R. Pandya student of M. Phil. (Commerce) Distance -"Education,
Madurai Kamaraj University, during the year 2007-2008, in partial
fulfillment of the requirements for the award of the Degree of Master of
Philosophy and that the dissertation has not formed the basis for the award
previously of any degree, diploma, associateship, fellowship or any other
similar title.

Place:

Signature of the Guide

Date:

4
ACKNOWLEDGEMENT

In the conduct of my research, I had received help from so many sources and
must at the outset thank my Research Guide Dr. Vasudev Iyer, Professor of
Tolani College, Mumbai for his constant encouragement. I also express my
gratitude to my M. Phil colleague Mr. Ram Kumar, for his encouragement
during the course of the study. I owe my thanks to my Principal Mr. Ravi for
making me confident during the conduct of the study.
I am extremely grateful to each of the teachers for sharing their valuable
time and extending full co-operation in frank sharing of their views &
opinions without which this study would have not been completed.
Here I also record my thanks to mainly my husband who has been morale
Support and also helped me out in completing the thesis on time. I also
thank many other peoples namely Mr. Ashish Patel, for his kind support
extended to me for completing the project, the Librarian of S.N.D.T.
University & University of Mumbai, Center of education and document for
providing the material required in the conduct of the study. I also extend my
special Thanks to Sheikh Farid of Textile Excellence, Mumbai for his
informative ideas and moral support.

Finally, I express my gratitude to my wife, children, friends, colleagues and

the typist for offering their help in the present study.

5
CONTENTS

Page Nos

List of Tables

List of Graphs

Chapter I – Introduction 1-8

Chapter II - Sustainability -of the current account in India 9-

Chapter IV - Current account deficits in India:

How Excessive and Volatile? 44-72

Chapter V - ‘Twin deficits and the role of saving and investment:

Indian evidence in a Co integrating- var framework’ 73-
112

Chapter VI - Investment and the current account in an open economy:

An s-var (structural vector auto regression) approach 113-
129

Chapter VII – Conclusions 130-

132

Appendix I – Bibliography 133-

139

6
LIST OF TABLES

--------------------------------------------------------------------------------------------
-------
Title of the Tables Page
No
--------------------------------------------------------------------------------------------
-------
1 Ordinary Least Squares Estimation
29

2 Unit Root Test for MM and Exports

31-32

3 Fully Modified Philips-Hansen Estimates

32

4 Test of Co integration
33

5 Unit root test for importers inclusive of interest

40

6 Fully Modified Philips-Hansen Estimates

41

2.1 Unit Root Test

55

2.2 Unit Root Test

57

2.3 Vector Auto regression Estimation Results

57

7
2.4 Likelihood Ration Test
58

2.5 Individual Test

59

2.6 Joint Test

59

2.7 F-Test
60

2.8 T-Test
61

2.9 Var Results

64

2.10 Diagnostic Tests

64

2.11 Estimating y via Generalized Method of Moments

70

2.12 Ordinary Least Squares Estimation

71

3.1 Unit Root Test

82

5.11 Educational Qualification & its usefulness in the job

69

5.12 Essential duties

72

5.13 Reaction to New educational policy & New Pay scale

75

8
5.14 Recommendation of a career & choosing of occupation in teaching
78

5.15 Importance of teaching in Job market

80

5.16 Overall satisfaction on the Job.

82

6.1 Levels of Job Satisfaction

84

6.1 Levels of Job Determinants by Arts Teachers

87

6.2 Ranks of Job Determinants by Commerce Teachers

87

6.3 Ranks of Job Determinants by Science Teachers

88

6.4 Ranks of Job Determinants by Science teachers

6.5 Comparative order of preference of Job Determinants by

90
Arts, Commerce & Science teachers

6.6 Ranks of Job Detriments by Arts teachers

94

6.7 Ranks of Job Detriments by Commerce teachers

95

6.8 Ranks of Job Detriments by Science teachers

96

6.9 Comparative order of preference of Job Detriments by

97
Arts, Commerce & Science Teachers

9
LIST OF GRAPHS
--------------------------------------------------------------------------------------------
-------
Title of the graphs Page
No
--------------------------------------------------------------------------------------------
-------
1 Rolling ADF 37

2.1 Actual Auto regression Estimation Results 57

2.2 Actual versus optimal net foreign liabilities 62

Persistence Profile of the effect of a system-wide shock to CV’(s) 25

4.2 Distribution by Age & Marital Status 27

4.3 Distribution by Interest & Hobbies 29

4.4 Distribution by Dependants & Independent Earners 31

4.5 Distribution by Religion 33

4.6 Distribution by Years of Residence in Mumbai 34

4.7 Distribution by Educational Qualification 36

4.8 Distribution by Salary 38

4.9 Distribution by Length of service & Nature of appointment 41

5.1 Salary Range & its Fairness 45

5.2 Salary Satisfaction & its Adequacy 47

5.3 Fringe Benefits & Allowances 49

10
5.4 Adequacy of working conditions 51

5.5 Factors affecting working conditions 53

5.6 Job Security 55

5.7 Management Role & Rating & its policies 58

5.8 Physical Distance from work 60

5.9 Promotional Prospects & present position 63

5.10 Attitude towards Job content 67

5.11 Educational Qualification & its usefulness in the job 70

5.12 Essential duties 73

5.13 Reaction to New educational policy & New Pay scale 76

5.14 Recommendation of a career & choosing of 79

Occupation in teaching

5.15 Importance of teaching in Job market 81

5.16 Overall satisfaction on the Job 82

6.1 Levels of Job satisfaction of teachers 85

6.2 Comparative order of preference of Job Determinants by 91

Arts, Commerce & Science teachers

6.3 Comparative order of preference of Job Detriments by 98

Arts, Commerce & Science Teachers

11
 CHAPTER 1
INTRODUCTION
The tiger economies or the East Asian countries were always considered
far superior then the South Asian countries for a long time, in all aspects
fundamentally or economically. Over time, a contrary pattern began to
emerge. Almost all the affected countries had three things in common:

 Strong asset prices in the years preceding the crisis.

 Large exposure to international markets, including a large stock of
short- term debts denominated in foreign exchange.
 A weak financial sector, notably banks of dubious solvency because
of a large volume of non-performing loans.

All these characteristics pertain to open capital accounts and pegged

exchange rate regimes and consequently relate to the external sector.
Explicit analysis must then be carried out in an open-economy framework.
Closer home, discussion has long been underway, following upon the
recommendations of the Tarapore Committee, about the gradual phasing out
of the controls on the movement of the short-term capital. In this context, a
study on the current account and its various aspects is timely. We have
studied the current account, that is, its sustainability, its excessiveness, the
causes for its occurrence and its volatility in the subsequent chapters.
The vulnerability of the economies referred to earlier was built up due to
the poor regulation of the financial sector. Export and import of goods and
services constitutes a major part of the current account transactions.
Naturally, import and export finance (credit) can be appropriately thought of
1

12
as the driving force in the crisis that engulfed the South-East Asian countries
in 1997-98. International crises occur because of the increase in the
dimension of the state space within which agents must operate. We focus on
the recent financial turbulence worldwide in which 1. banks had a role to
play and 2. economies collapsed despite all their fundamentals being in a
virtuous relationship. The framework used is that of Wynne Godley and the
exercise has been conducted jointly with my guide, Dr. Vasudev Iyer.
The theoretical literature on open-economy macroeconomics employs
standard optimization techniques that includes the budget constraints of
agents. There is limited empirical testing of whether these constraints bind.
In line with the arguments developing the notion of sustainable internal
deficits, a case can be made for the .sustainable current account deficit of a
country. In other words, we emphasize the external sector constraint.
The current account and the capital account are the mirror images of
each other. Just as the government cannot borrow from the internal market
indefinitely to finance its budgetary deficit, it cannot borrow from the global
capital market forever. The sustainability of the current account is the theme
of the third chapter. Further, persistent current: account deficits are often a
cause for concern to policymakers. They are conceived of as harbingers of
problems on the external sector front and are critical for exchange-rate
policy. The importance of, current account performance is especially
important against the background of a series of Latin American and the
South-East Asian crises. The persistence of current account deficits (CADs)
raises the question of their sustainability in the long run. Current account
sustainability has been interpreted in different ways. Different approaches
advocate different criteria for assessing the persistence of CADs. There is no
2

13
consensus on the optimal degree of the current account deficit. A 40/0 CAD
is regarded as high for some economies while even a 15% CAD, is regarded
as manageable for others. There are essentially two approaches to the issue
of sustainability. One is the accounting approach that involves calculation of
the foreign debt to GDP ratio and checking whether it is constant over time
under the given targeted growth rate and constant real rate of interest. In
another approach with a less restrictive interpretation, the CAD is
sustainable if the country is solvent in the sense that its present value inter
temporal budget constraint is satisfied. This implies that the country must be
able to generate, sufficient trade surpluses in the future to repay its debt.
Here, the focus is on the net present value of the external debt and net
present value of the current account surpluses and in seeing whether, in the
limit tending to infinity, they equal zero. This is the Present Value
Constraint (PVC) approach.
We have seen consistent negative current account surpluses in India.
Hence we investigate the issue of sustainability of the CAD in the Indian
context taking the present value approach. So far no such tests have been
carried out in India. The extant, work pertains mainly to the United States of
America. The studies are applicable to the sustainability issue of fiscal
policy (the government budget constraint.) We wish to extend the same to
the external sector in the Indian context. Here the testing procedure will
differ according to the auxiliary assumptions made in the theoretical
construction of the constraint. Assumptions such as whether the real interest
rate is constant or not can generate different testable implications. Thus, we
carry out different tests depending upon the alternative specifications of the
current account.

14
 3
We have also tried to explain persistent current account deficits in India.
This phenomenon in itself and more so against the background of the South-
Asian meltdown has put us on alert as far as occurrences on the external
sector front are concerned.
There are three different reasons why a current account deficit would
occur throwing light on the following possible explanations for large Indian
current account deficits:
1) High consumption: recession or any other temporary fall in output
might alter consumption. Agents might smooth consumption in the
face of such temporary shocks.
2) Higher government spending (or fall in taxes) leads to large deficits
which is typically the twin deficits hypothesis.
3) High investment: This is justifiable only if it raises output in future
as Sachs (1981) has emphasized.
Each of the above potential explanations is evaluated in the later
exercises.
The intertemporal to the current account (ICA) approach views the current
account as an outcome of forward-looking dynamic saving and investment
decisions. The simple inter temporal model implies that a country's current
account surplus should be equal to the present value of expected future
declines in output, net of investment and government purchases. When a
current account deficit is attributed to the difference between private saving
and private investment, there is no role for government intervention (fiscal
tightening) designed to inhibit the creation of private liabilities by altering
the dynamic path of domestic investment and consumption (McDermott and

15
Cashin 1996)?

4
We have tested whether this lCA model is operational in India or not.
We compare here the forecasts derived from the model with that of the
actual current. The observation made in this exercise is that the actual
current account deficit (consumption smoothing) is more volatile than the
model generated counterpart of it. The reason that we have explored such
behavior is that agents might be showing habit persistence. Another
hypothesis is the consumption of durable goods. This possibility seems ruled
out due to the positive correlation between the (optimal) current account
forecasts and actual current account series. Therefore, the habit persistence
parameter for the Indian economy is computed.
In-our earlier exercise we harvested the conclusions that-are derived
from the Inter temporal model of the current account. The results support the
hypothesis that there is no optimal consumption smoothing by agents in
India. When such is the case, there is no role for government intervention
(fiscal tightening) in the sense that government policy cannot alter the
dynamic path of domestic investment and consumption.
Though the current account is broadly defined as the difference
between exports and imports, it is essentially a gap between saving and
investment. It is indeed interesting to know which of the two bears the
burden in the long run in response to the changes in current account
balances. The fall in savings or the increase in investment could be
performing the role of financing the current account.
This dynamic interrelationship between savings, investment, budget deficit
and the current account deficit is aptly captured in the VAR (Vector Auto

16
regression) framework in the next exercise here. Using the same open
economy national income accounting identity,
5
other related problems can be explored as well. The "twin deficits"
hypothesis can be tested in the Indian context. We conduct causality tests to
determine the nature of causation among the variables under study. The
block erogeneity tests should equip us to pass informed remarks on the
validity or the invalidity of the Ricardian Equivalence Theorem (RET). This
is our next objective. The RET has assumed importance against the
backdrop of the current discussion of the Fiscal Responsibility Act in India.
We carry out Impulse Response Analysis illustrating the dynamic effects of
the impact of the unitary shocks on the variables in the system. This also
helps to get a sense of the stability of the estimated model.
We carry out Variance Decomposition analysis. Here we determine
the proportion of the variability of forecast values of the endogenous
variables that are due to the shocks in the error terms. This allows us to
determine the relative importance of the exogenous shocks to the evolution
of the endogenous variables. Our later exercise tries to explicitly test for the
twin deficits hypothesis in the Indian context linking the government deficit
to the current account deficit. The direction of causality and its magnitude is
tested in this exercise in a cointegrating VAR framework. Additionally, the
mode of financing of the current account deficit is tested.
In the study referred above we will have tested the present value
external budget constraint in the Indian context. The presence of a
government budget and the external budget constraint implies an economy-
wide constraint as well. This economy-wide constraint implies that the total
savings and total investment must move together in the long run if both the

17
above constraints are to be satisfied. This involves a test of co integration
between the two variables. Additionally,
6
the saving investment relationship has implications for capital mobility in
the country. A low saving-retention coefficient is an indication of capital
mobility while a high coefficient is associated with low capital mobility.
Most of the highly industrialized nations were found to have low capital
mobility in the 1980s. This is the famous Feldstein-Horioka puzzle. The
recent evidence for some of the developing nations of a high coefficient is
equally puzzling (Schneider, 1999). The savings-investment relationship is
studied in a Kalman Filter framework against the ordinary least squares
estimation (OLS).
The savings-investment relationship and the current account-
investment relationship are the two sides of the coin. Against this
background a small, recently open economy like India is a natural choice for
carrying out the following test. We carry out time series analysis again in a
VAR framework. The savings-investment correlation is a quantity approach
to capital market integration, while the price approach answers the question
whether the returns from assets are equalized. We can also comment on the
nature of shocks to investment as transitory or permanent. We apply Kalman
filter estimation in order to refine the analysis. As against this, the Kalman
filter technique models the coefficient variability ex ante. The recursive
nature of estimation of the coefficients in the transition equation makes it a
Bayesian method. We then make a comparative study of the estimates from
the standard OLS procedure and the system estimated via Kalman filtering
with time varying parameters. Whether the liberalization of the economy has

18
brought any change in the savings retention coefficient and hence qualifies
as a structural break can be commented upon.

7
To study the investment-current account relationship in detail, we run
it two-variable structural VAR, so that simple coefficients of ordinary least
squares can be given a structural interpretation.
This technique used here is a crude version of the technique used by
King and Watson (1997) to test the long run neutrality proposition where the
focus was on the relationship between money and output. The shocks to
money and output are taken to be shocks to technology and labor supply
respectively. Instead, we treat the shocks to current account as global shocks
and the shocks to investment as country-specific shocks. We interpret the
results in terms of global and country-specific shocks.
Thus, we present a unified picture of various aspects of the Indian
current account of baliu1ce of payments.

19
 8
CHAPTER 2
SUSTAINABILITY -OF THE CURRENT ACCOUNT IN INDIA

1. INTRODUCTION

The theoretical literature in open-economy macroeconomics works

with standard optimization calculus that includes the budget constraints of
agents. There is limited empirical testing of whether these constraints bind.
Two budget constraints operate simultaneously when the economy under
consideration is open One is the government budget constraint and the other
is the external sector constraint. A variety of crises have highlighted the
importance of the viability of the external balance. The natural question that
comes to mind in evaluating the viability of external imbalances is whether
the country is solvent, that is, whether it has the ability to generate sufficient
trade surpluses in the future to repay existing debt.

The notion of solvency discussed above has little behavioral content

and hence limited policy relevance. Herein lays the notion of sustainability
of current account balances. The current policy stance is sustainable if its
continuation for an indefinite period does not violate the solvency constraint.
It is important to notice here that the notion of sustainability based on
solvency considerations is simpler for fiscal imbalances, given that they are
based on decisions on taxation and public expenditure much more directly.

20
Current account sustainability instead is difficult to interpret as it is the joint
effect of the interaction between the savings and investment decisions of the
private sector and government on one hand and the lending decisions of
9
foreign investors on the other.
The concepts of solvency and sustainability are binary, that is, a
country is either solvent or insolvent and a path of current account deficits
either sustainable or unsustainable. The first concept, based on the
intertemporal budget constraint, can accommodate a variety of future
behavior patterns. The second is based on a continuation of the current
policy stance and therefore imposes more structure on future behavior.
Sometimes the two concepts are used analogously. Two conceptual
approaches have been used in the literature for analyzing sustainability: the
accounting approach and the present value constraint (PVC) approach. We
briefly summarize both the approaches while our emphasis will be on the
latter approach.
The accounting approach to fiscal/external balance sustainability is
often interpreted as a way to assess the mutual consistency among a number
of macro policy targets. In any event, the approach focuses on a particular
debt ratio, typically debt to Gross Domestic Product (GDP), b = B/Yt. In the
accounting approach a deficit (or surplus) is defined as sustainable if it
generates a constant (rather than increasing) debt/GDP ratio, given a
specified GDP growth target and constant real interest rate, The use of an
accounting approach can be found in Salop and Spitaller (1980), who
suggest an operational indicator of solvency, that national saving must be at
least equal to wealth times the rate of growth of population, which implies
non-decreasing levels of national wealth per capita. This, in turn, implies

21
that foreign liabilities per capita are not rising faster than the capital stock
per capita. A similar indicator often quoted is based on the condition for a
non-increasing debt (or, strictly speaking, foreign liabilities) to GDP ratio.
10
This condition requires that the country must not run persistent trade
deficits where these are associated with the world rate of interest above the
growth rate of the economy for a debtor country. To do so would cause the
debt to GDP ratio to increase. This differs from the Salop and Spitaller
criterion in that it ignores the capital stock and is expressed as a ratio to
GDP rather than a per capita ratio. Expressing the stock of debt as a ratio to
GDP is more restrictive than a per capita ratio. On the other hand, ignoring
the capital stock may render the constant debt to GDP condition more or less
restrictive than the Salop and Spitaller condition depending on what is
happening to the capital stock.
One criticism of the above criteria, however, is that the trade deficit is
assumed to be exogenous with respect to national indebtedness. Wickens
and Uctum (1993) point out that the trade balance is a "highly endogenous"
variable being a function of, an10ng other things, wealth and therefore debt.
It is quite possible that an optimal path towards a steady state may appear
unsustainable because of a trade deficit accompanied by an interest rate
exceeding the" growth rate for many years along the path, only for the trade
deficit to turn into a persistent surplus further along the path. In terms of the
Salop and Spitaller criterion, this means that national saving may be
negative initially and positive later on.
A more restrictive interpretation of sustainability is given by Frenkel
and Razin (1996) who define an unsustainable path as one which wall it
eventually require a "drastic" policy shift which would lead to either a large

22
recession, which can be regarded as politically infeasible, or a "crisis" such
as an exchange rate collapse or an inability to service external obligations.
Such crises may occur along an optimal path, implying that some optimal
11
paths may be infeasible, as shown by Pitchford (1995), or it may occur as a
result of current account deficits which are misaligned, in the sense of being
greater than their equilibrium values. This is the most restrictive
interpretation of current account sustainability.

In this chapter, we have tested whether India satisfies the external

sector borrowing constraint, that is, whether its current external (balance)
stance is sustainable or not. We adopt the present value approach.

2. IS THE EXTERNAL BUDGET CONSTRAINT FULFILLED IN

INDIA?
It has been argued that there is enough evidence to predict the 1997
East Asian currency crises through testing the sustainability of the inter
temporal current account (Yan, 1999). Instead of specifying the ratio of the
current account deficit relative to the gross domestic product as a warning
signal, this paper suggests looking into the sustainability of the inter
temporal current account under a variety of specifications. India has
experienced persistent current account deficits all these years. Although it
has varied between 0.1% to 3.5% of GDP, its gradual increase in recent
years has been definitely a cause for concern to policy makers in India.
Sustainable current account deficits are not only important in themselves,
they implies'" sustainable capital flows equivalently. After the opening of

23
the capital account, the idea of sustainable capital flows certainly will gain
importance. Therefore it is important to see if India can run sustainable
current account deficits.
12
Three types of tests have been developed so far mainly in the context
of fiscal sustainability. These tests differ in the assumptions they make:

1. Hakkio and Rush1 (1991), whose test amounts to the test of co integration
between government revenue and government spending inclusive of
interest.
2. Trehan and Walsh2 (1991) employ a test where the constraint implied is
tested in personal value terms. This test requires the first difference of the
stock of debt be stationary for the fiscal policy to be sustainable.

3. Another type of test, though not used here, is a VAR (Vector

Autoregression) based test. It is a test of fulfillment of the cross equation
restrictions implied by the VAR model. Wickens and Uctum (1993) show
that although the U.S. current account is non-stationary, the U.S. still
satisfies its present value constraint since it exhibits a significant negative
feedback between net national indebtedness and the trade deficit and thus
satisfies the root condition associated with its transversality condition.
We proceed to test intertemporal budget balance. The idea behind
applying alternative tests is to see whether external sustainability is
robust to a variety of specifications of the current account deficit.

24
 13
3. THE INTER TEMP ORAL BUDGET CONSTRAINT IN AN OPEN
ECONOMY

We first describe a country's intertemporal budget identity

arithmetically and then discuss the derivation of the solvency
condition for international borrowing. The basic accounting identity
for an open economy during period t is as follows
GDPt + (Bt-Bt-1) + TRt = rBt+ {Nt-(1+Jt) N t-1} (1)
where GDP is the gross domestic product, B is the net external debt (gross
debt minus gross assets), TR is the net transfer receipts, A is the total
expenditure of domestic residents on goods and services (domestic
absorption), r is the nominal interest rate, N is the foreign currency reserves
of the central bank and j is the interest rate on these reserve & The left-hand
side of (1 )denotes the economy's aggregation iQcol1)e at the end 9 the
period t, and the right -hand side stands for the total expenditure.
The trade balance of the country, TB, can be expressed as

TBt ≡ EXt -1Mt = rBt-1 - (Bt -Bt-1) - TRt + {Nt - (1 +Jt) Nt-1}(2)

where EX and 1M are nominal exports and imports, respectively, of goods

and services during the period t. From Eq. (2), we get the dynamic budget
equation which describes the evolution of the external debt

25
 Bt-Bt-1= rtBt-1-St (3)

In (3), S is defined as

St ≡ TBt + TRt - {Nt- (1 +Jt) Nt-1

and we can interpret St as the external surplus which can be used to meet
external debt payments. Recursively, solving this difference equation to
obtain the forward-looking solution in terms of Bt, we obtain

∞
Bt = lim BN ∑ Sm
N-t m-1
n→∞
∏ (1+rt-p) ∏ (1+rt+1)
P=1 m=t+1 t=1

Economic agents cannot know the future values of variables at time t but
only ex ante values. The assumption of perfect foresight is abandoned. Thus
under rational expectations, an expectation operational on time t is added to
the above. Expression and then this equation can be written as3

∞
Bt =Et lim BN
N-t
Et ∑ m-1
Sm
n→∞
∏ (1+rt-p) ∏ (1+rt+1)
P=1 m=t+1 t=1

26
Et denotes the expectation of economic agents based on information
available at time t. Thus, the solvency condition of the external debt
payments can be defined as follows
∞
Sm
m-1
Bt = ∑
m=t+1 ∏ t=1 (1+rt+1)
(4)

Eq. (4) states that the external debt outstanding "at the end of time t must
equal the present value of the future net surplus if the country is solvent.
This criterion is equivalent to the following condition

lim BN
Et =0 (5)
N-t
n→∞
∏ (1+rt-p)
P=1

if the country is to be solvent. This condition is the so-called No-Ponzi

Game condition in the macroeconomics literature, that is, a country cannot
rollover its external deficits forever. If the left-hand side of eq. (5) is greater
than zero and the debt stock is greater than the-future expected payments,
them country has a debt overhaul problem and it -is bubble- financing the
external deficit using Ponzi schemes.
3.1 TEST I (Trehan and Walsh, 1991)
Trehan and Walsh (1991) use the time series behavior of the stock of U.S.
government debt to determine whether the U.S. government budget

27
constraint is expected to be intertemporally balanced. According to them, the
solvency condition of the above equation is satisfied if (1 + r t) is a stochastic
process strictly bounded below by (l–δ(δ>0) in expected value and (1 – L)Bt
is a stationary process, where L is the lag operator. This is sufficient
condition for the holding of the solvency condition. We apply the condition
to the external budget constraint.
Assuming that rt, the nominal interest rate on debt payments to be
positive and therefore Et( 1 + r t) to be greater than 1 for all positive m, and
using augmented Dickey-Fuller tests shown below, we can test for the
stationarity of the time series (1 - L)Bt.
M
2
(1-L) Bt=αo+ α1t + βO(1-L)Bt-1+ ∑ β j (1-L)2Bt-1+u1
j=1

We test the following hypothesis,

Ho: βo= 0 against H 1: βo< 0
The Ordinary Least Squares (OLS) estimation results are presented below.
Table: Ordinary Least Squares Estimation
Dependent variable is (1 - L)2 Bt
Regressor Coefficient Standard Error Ratio[Prob]
Constant -400.0710 392.6944 -1,0188 (.315)
time 36.7175 19.4276 1.8900(.066)
(1-L)Bt-1 -.18214 .084117 -2.1653 (0.37)
(1-L)2Bt-1 .75023 .13104 5.7251(.000)
(1-L)2Bt-2 -.43992 .15535 -2.8318(.007)

(R-Squared = .50693)

28
The Durbin-Watson statistic has a value 1.93, which does not indicate any
possibility of autocorrelation. This is also confirmed with the chi-squared
statistic having a very low value of 0.31283, which is clearly insignificant.
As is evident, the coefficient on (1- L) B t-1 is less than zero and is
significant. Additionally, we performed the Wald test of restriction(s)
imposed on the parameter, βo = O. The Wald Statistic follows a chi-squared
distribution with one degree of freedom (equal to the number of restrictions)
and has a value 4.6887, which is greater than the critical value of 3.84146 (at
5% level of significance). Therefore, we reject the null hypothesis and
conclude that the process is stationary. Other diagnostic tests too have been
performed. They include tests of serial correlation, heteroelasticity,
normality,
and functional form4. They have yielded satisfactory results. In short,
this test indicates that the India's current account deficit is on a sustainable
path.

3.2 TEST II (Hakkio and Rush, 1991)

Though the intertemporal borrowing constraint is generally written as

Eq. (1), Hakkio and Rush (1991) choose to write an alternative equation to
derive testable implications. Assume that the interest rate is stationary; with
an unconditional mean equal to r. Subtract rB t-1 from both sides of Eq. (3) to
obtain

Et + (1 +r)Bt-1= Xt + Bt (7)

29
Where Xt = EXt + TRt + (1+j) Nt+1, Mt = (rt-r) Bt-1 and it holds in each
period. Now, taking the first difference of this equation, we get

ΔBt = (1 + r) ΔBt-1 + ΔEt - ΔXt

Where Δ presents the first difference, solving the equation forward and
substituting it in the basic equation, ΔBt = rtBt-1 + Mt - Xt, we arrive at the
following

∞
lim ΔBt+p ΔXm - ΔEm
MMt=Xt + ∑ (8)
n→∞ (1 + r )p (1 + r ) m-1
m=t+1

30
where MM Alt is defined as Mt + rtBt+1
Now, assume that X and M are non-stationary and obey an 1(1) processes,
so that ΔXt and ΔMt are stationary. In particular, assume that X and M
follow random walks with drift:
Xt = a1 + Xt-1 + u1t, (9)
Et= a2 + Et-1 + u2t (10)

In this case, Eq. (8) can be written as

∞
MMt=Xt + lim ΔBt+m + a1 - a2 + ∑ (u1m - u2m
m→∞ (1 + r )m r (1 + r ) m-1 (11)
m=t+1

We proceed with testing on the basis of this equation.

Assuming the solvency condition is satisfied, the second term of the right
hand side of Eq. (11) will become zero. We can write the equation in the
form of a regression equation below:
Xt = a + bMMt + ut

If MM and X are non-stationary, then the null hypothesis IS that MM and

X are cointegrated. Following are the results of the stationarity test on both
the variables.

31
 Table 2: Unit Root Tests for MM and Exports
FOR MM

CONSTANT CONSTANT AND A TREND

DF -1.1181 DF -2.4301
ADF(1) -0.97796 ADF(1) -2.3037
(CRITICAL VALUE = - 2.9303) (CRITICAL VALUE = -3.5162)

FOR EXPORTS
CONSTANT CONSTANT AND A TREND
DF 12.9127 DF 8.1083
ADF(2) .97726 ADF(2) .39942
(CRITICAL VALUE = - 2.9303) (CRITICAL VALUE = -3.5189)

We have conducted a cointegration test with the Fully Modified Ordinary

Least Squares (FM-OLS) method which renders support to a cointegrating
relationship between the two variables. As the following table shows, the
coefficient on the variable MMt is 0.76 and it is clearly less than one and
highly significant.

Table 3: Fully Modified Phillips-Hansen Estimates

Dependent variable is EXPORTS
Regressor Coefficient Standard Error T -Ratio[Prob]
Intercept -158.2602 397.0744 0.39857[.692]
MM t 0.76302 0.0079616 92.6641 [.000]

32
 The cointegration between the variables X t and MM, is confirmed
with the maximum given value test and the trace test as well.

Table 4: Tests of Cointegration

Cointegration LR Test Based on Maximum given value of the Stochastic
Matrix

Between Xt and MMt

Null Alternative Statistic 95% Critical Value 90& Critical Value
r= 0 r = 1 16.2302 11.0300 9.2800
r<= 1 r= 2 4.7579 4.1600 3.0400

Cointegration LR Test Based on Trace of the Stochastic Matrix

Null Alternative Statistic 95% Critical Value 90%Critical Value

r= 0 r>= 1 20.9881 12.3600 10.2500
r<= 1 r=2 4.7579 4.1600 3.0400
The residuals from the above (estimated) cointegrating regression are also found to be
stationary using the augmented Dickey-Fuller test of unit root as follows:

(l-L)εN = βoεt-1 + ∑ Βj(1-L)εN-j +v

j=1

The βo is found to be statistically different from zero and therefore the

estimated residuals are stationary and the hypothesis of cointegration cannot
be rejected. This test thus suggests that the intertemporal external budget
constraint is satisfied in India.
3.3. TEST III

33
Admitting that currency crises show themselves in a variety of ways, Non
stationarity of the intertemporal current account is an appropriate signal for
predicting their arrival (Yan, 1999). The overspending of the government or
private sector, inefficient investment or overvaluation of the currency will
explicitly incarnate in the imbalance of the current account. The persistent
insolvency of the external debt will sabotage the ability to pay and the
willingness to lend for the crisis-ridden country. The sustainability of the
current account can be explained in the same manner as the sustainability of
the internal deficit. Just as the government cannot borrow from internal
sources indefinitely for financing the budgetary deficits, the external world
(global capital markets) cannot lend to a country to finance trade account
deficits for an indefinite period. More compactly, the notion of sustainability
used here can be formulated as follows: "If maintenance of the current
policy stance is going to make a turnaround of trade deficits to surpluses
smooth, then the current policy stance is sustainable. If the, present stance
requires the reversal to occur drastically, then the importance is not
sustainable" (Yan, 1999).

We use Trehan and Walsh's (1991) argument once again, that is,
intertemporal budget balance requires stationarity of the first difference of
government debt and then present a description of the rolling ADF statistics,
which is used La identify at what point each series begins to appear
nonstationary. The same equation can be used to discuss intertemporal
balance on the current account. Here we make use of the fact that the

34
current account deficit is equal to the change in the net foreign assets. in an
accounting identity, the current account could be defined as

CAt = Ft - Ft-1 = Yt - rtFt-1 – Ct – Xt - Gt

=Spt + Sgt – Xt
=TBt + rtFt-1

where CA1 is the current account, Ft is the stock of net foreign assets, Y t is
gross domestic product; rt is the real rate, of interest, X t is total investment,
Gt is government expenditure, Spt is private savings, Sgt is public savings and
TBt is the trade balance. Interpret St (as in Trehan and Walsh's terminology)
as negative net foreign assets and d t as the trade balance on the balance of
payments account. The equation-says that the change of net foreign assets
equals the interest paid (received) by domestic residents on the net foreign
debt (assets) plus a trade account deficit (surplus) which is tantamount to the
current account.

A time series of ADF statistics (Said and Dickey, 1984) is used to

provide evidence on whether the behavior of the current account balance
(change of and foreign assets) appears non stationary at a point in time given
information up to that time. In order to maintain constant power of the
statistics, the ADF statistics are calculated using a fixed sample size that
rolls through time. Banerjee et al. (1992) proposed using the rolling ADF
statistics as a test for the stability of the coefficients in the Dickey-Fuller
model.

35
 They were explicitly looking for evidence of stationary around a trend
with an unknown break date. Alternative critical values must also be
calculated since the test relies on extreme of the ADF statistics. This is not
necessary for the test here since the hypothesis of nonstationarity is tested at
each point in time prior to the crisis. (Yan, 1999)
It is well known that the lags chosen for implementing the unit root
test are influential for generating the estimated statistics. The ADF test
focuses on eliminating the serial correlation. The simple rules for choosing
lags are therefore based on a Q-statistic, requiring at least a 90 percent
confidence interval for most of the estimated statistics. In order to test the
alternative hypothesis of stationarity around a trend, a constant and a time
trend are included.
We depict below the result of the rolling ADF test in the form of a graph of the
rolling coefficients for the whole period under consideration. It is interesting to
know that the series under consideration clearly satisfies the implicit
intertemporal external budget constraint with it being violated only once,
during the year 1973. The reason could be the oil price rise of 1971 and
subsequent pressure on imports. As can be seen from the graph, the null of
nonstationarity is rejected when the statistic falls below -3.61 at a 5 percent
significance level and -3.24 at a 10 percent significance level (McKinnon,
1991). The confidence with which the null of nonstationarity can be rejected is
greater the lower the value of the ADF statistic. Therefore, loosely, decreasing
confidence for rejection of the null is referred to as increasing evidence of
nonstationarity and vice versa.

36
We clearly reject the null of nonstationarity of the current account deficit.
The calculated value of the rolling minimum ADF statistic is 1.25710 that is
much below the critical value of -3.61. Therefore, the power of the test is
very good. All the values except one fall below the two critical limits. The
series is clearly stationary. This is the evidence in favor of the intertemporal
budget constraint being satisfied.

3.4. TEST IV
Lastly, we apply an alternative methodology along the line of Husted
(1992). He considers-a representative consumer residing in a small open
economy producing and exporting a composite good that has no
government. The agent engages in borrowing and lending of one-period
financial instruments. He maximizes his lifetime utility subject to budget
constraints whose resources are endowments of output and redistributed
profits from firms. This individual's current period budget constraint is given
by:

Co = Yo + Bo – ( 1 + ro )B-1 (1)

Where Co is consumption, Yo is ouput, Io is investment, ro is the world rate

of interest (one period) which could be positive or negative and Bo is
historically given debt. Since the above equation must hold for every period,
the period by period budget constraints can be combined to form the
country's intertemporal budget constraint. Iterating (1) forward, he goes on
to show

37
 ∞
Bo = ∑ μtTAt + lim μnBn (2)
t=1 n→∞

where TAt = Xt –Mt (Yt – Ct – It) represents the trade balance in period t, X t
equals exports, Mt equals imports, λ = 1/( 1 +ro), and μ is the discount factor
defined as the first t values of λ. The above equation says that when the last
term equals zero the amount the country borrows in the international markets
equals the present value of the future trade surpluses.

In order to derive a testable model, rewriting (1) assuming the interest rate to
be stationary with unconditional mean gives

Zt + (1 + r ) Bt-1 = Xt + Bt (3)

and Zt = Mt+(rt -r)Bt-1.

Following Hakkio and Rush, he then writes the above statement as

∞ ∞
Mt+rtXt-1 = Xt + ∑ λj-i [ΔXt+j- ΔXt+j]+ Lim λj-I Bt+!
∑ (4)
j=0 j→∞ m=t+1

38
 The left-hand side represents spending on imports and interest
payments on foreign debt. Subtracting X from both sides of (4) and
multiplying each side by minus one, it can be seen that the left-hand side
represents an economy's current account. Assuming further that X and Z are
integrated of order one5, equation (4) can be written as

Xt = α + MMt – lim λt+j Bt+j + εt

where

MMt = Mt + rtBt-1; α = [(1 + r)2/r ] (α1 –α2), εt =∑λt+j(ε2t – ε!t)

If we further assume that the above limit term equals zero, then the above
equation can be transformed into a standard regression equation as

Xt = a + b*MMt – et, (5)

Under the null hypothesis that the economy is satisfying it intertemporal

budget Constraint, we would suspect that b =1 and et would be stationary.

Thus if Xt and MMt are nonstationary, then under the null they are co
integrated. Following Husted (1992) we

39
have conducted cointegration test between exports and imports inclusive of
interest on the government debt. Before testing for co integration, it is
necessary to test for the order of integration for the above variables. We
present below the results of the above tests.

Table 5: Unit root tests for imports inclusive of interest

CONSTANT CONSTANT AND A.-TREND

DF 13.5655 DF 8.9693
ADF(3) 2.5192 ADF(3) 2.9719

(CRITICAL VALUE = -2.9320) (CRITICAL VALUE = -3.5189)

The first difference series of the above variable shows that it is

stationary. We have confirmed that the first differences of exports are in
fact. stationary. Once we have confirmed that the series under consideration
have the same order of integration, one, or they are I( 1) in nature, we carry
out the tests of cointegration. We: find that the two series are in fact
cointegrated and the number of cointegrating vectors is .exactly one. This
test does not require the coefficient on the Total imports in the following
regression be one. 11 could be less than or equal to unity for the constraint to
hold. This coefficient on the total imports is, in fact, found equal to 0.42 and
is highly significant. Below are the results of this exercise.

40
Table 6: Fully Modified Phillips-Hansen Estimates'
Dependent variable is Xt

Regressor Coefficient Standard Error T Ratio[Prob]

Intercept 500.1156 2490.9 0.20077[0.842]
MMt .42423 .032993 12.8581 [0.00]

The cointegration between the variables X t and MMt is confirmed with the
maximum given value test. It is important to note that both the tests validate
the existence of only one cointegrating relationship (at 5% significance
level).
We also confirm the results with the Johansen and Juselius (JJ)
methodology.
Table7: Cointegration tests
Cointegration LR Test Based OR Maximal Eigenvalue of the Stochastic
Matrix

Null Alternative Statistic 95% Critical Value 90% Critical

Value
r= 0 r=1 53.4891 11.0300 9.2800
r<= 1 r= 2 .26161 4.1600 3.0400

Thus, the above theoretical base requires us to conduct the following

analysis. We have checked separately for the stationarity of the two series X t
and MMt. If true, we have tested the beta coefficient in the above regression.
Under the Wald test of linear restrictions, and null being b=1, the Wald test
does

41
not rejects the hypothesis. The results are shown below. For the above tests
nominal
exports and nominal imports inclusive of the foreign debt interest payments
are taken. Both the series are integrated of order one. Then a possible
cointegrating relationship is exploited through the Phillips-Hansen
estimation method. Thereafter a Wald test of restriction is performed. The
calculated value with one degree of freedom is CHSQ( 1)= 717.3938[.000]
with probability value given in the brackets. Thus we reject the null of b=1.
Also note here that the cointegration is a necessary condition but b=1 is not.
The two series thus share a co integrating relationship but do not satisfy the
condition b= 1. We also test for the stationarity. of the residuals from the
regression. A visual plot of the errors shows that they lie between the two
standard deviation bands. This residuals-based cointegration test further
supports the presence of cointegration between the two series. DF unit root
tests for residuals reveal the same results. Thus we do not reject the null of
no unit roots.

4. CONCLUSION
All the above tests of cointegration and unit root on the current account
indicate that it is sustainable over a sufficiently long run. We have conducted
the tests of the sustainability of the current account taking the present value
approach in the Indian context. The current account has been described in
various ways and tests of four alternative specifications of the current
account are conducted. Therefore, India currently faces no threat from the
external sector from the violation of the budget constraint.

42
However, the internal intertemporal government budget constraint needs to
be satisfied simultaneously for the economy as a whole.

NOTES:
I. They assume that the real interest rate is stationary and that government
spending and revenue are difference stationary.
2. The assumption is that the real return on government debt is strictly
positive but need not be constant.
3. Most researchers employ this interpretation of the expectations operator
although it is not strictly correct as pointed out by Flakkio and Rush.

4. Diagnostic Tests

Test Statistics LM Version F Version

Serial Correlation CHSQ(1)=0.31283[0576] F(1, 38) =0.27210[0.605]
Functional Form CHSQ(1)=0.66021[0.416] F(1, 38) =0.57887[0.451]
Normality CHSQ(1)=10.6365[0.005] Not applicable
Hetero elasticity CHSQ(1)=1.7088[0.191] F(1, 42) =1.6971[0.200]

5. XI = aI + Xt-1 +εI t

Zt = a2 + X + &2/
where care drift parameters (possibly equal to zero) and &.it are stationary
processes.

43