External shocks, consumption-smoothing and capital mobility in India: evidence from an intertemporal optimization approach

We examine the solvency of India’s current account (CA) in the post-liberalization period using intertemporal optimization approach to the CA. Using quarterly data ranging from 1996Q1 to 2014Q2, we estimate a benchmark consumption-smoothing model and an extended model that incorporates external shocks. Overall, we find that the predicted optimal CA in both the models can track the actual CA movements and the extended model performs better over the benchmark model. Further, we also find that the optimal CA is more volatile than the actual CA which implies that the capital flows have been less than optimal and thus makes an interesting case for further liberalization of the capital account. Our findings suggest that policies aimed at further liberalization of capital flows will allow larger CA deficits to achieve higher economic growth since it will help agents to further smoothen their consumption without worrying about risks associated with insolvency