Current Account Imbalances

The paper also explores whether participation in EMU has altered the importance of various fundamental factors that typically determine current account positions, or the speed of current account adjustment. As regards the latter, there are two main channels through which a monetary union may contribute to slower adjustment of current account imbalances. The first channel relates to the fact that, in the absence of national currencies, country-specific shocks tend to result in more persistent current account imbalances. 1 The second channel is associated with deeper financial market integration, as markets become more transparent and transaction costs are diminished. The increased financial integration among the countries that participate in a monetary union usually leads to larger financial flows, as the home bias that normally characterises national financial portfolios tends to be reduced 2 , making external financing more readily available. This, in turn, implies that countries would run current account deficits (or surpluses) for longer periods of time compared with the situation where they face borrowing (or lending) constraints.

These results suggest that the EMU has increased capital market inte- gration in Europe, with the result that capital flows are now more in line with what neoclassical growth theory predicts. As capital flows from high– to low–per capita GDP countries, these flows can be expected to pro- mote economic convergence among the euro area countries. This means that the allocation of capital is becoming more efficient in Europe and that the observed current account imbalances indicate that the monetary union works well. By implication, a fiscal expansion in the surplus coun- tries would tend to absorb more of their domestic savings and slow capi- tal flows to poorer countries, thus rendering the EMU less efficient.

promoting excess credit. However, it is also believed that this is only true if banks are able to securitize mortgages and sell them to third party investors as Collateralized Debt Obligations (CDO), essentially securitization and exotic financial innovation is present in these economies (Mian and Sufi, 2008). In countries such as Brazil, Russia and Uruguay where exotic financial securities remains uncommon if not unavailable, banks do not have a way to transfer credit risk from subprime mortgages off their balance sheet and therefore are more prudent in giving out house financing which could explain the indirect negative relationship between real estate and excess credit through banks. Next, current account imbalances are found to be very weakly significant to excessive credit in model (5). However, in all five models, a positive coefficient is found which could hint at a possible positive relationship between current account imbalances and excessive credit which is in line with Obstfeld and Roggoff (2009). We suspect that a lagged form of current account may imbalances may be significant to excessive credit due to the fact that the current account imbalances this year may only end up as excess credit for next year, this is because institutional investors needs time to transform the current account surplus in one country into debt securities in another country.

To unravel the mechanism of problems such as inflation differentials, therefore, a model that explicitly describes the behavior of government as well as those of households, firms, and the central bank is needed. In this paper, such a model is constructed. In particular, the government and the central bank are treated as different entities, and their behaviors are clearly separated in the model. The model shows that inflation accelerates if the time preference rate of government is higher than that of the representative household. To stabilize inflation, therefore, the government’s time preference rate needs to be controlled by delegating monetary policies to an independent central bank. The model in this paper indicates that if there is more than one government but only one central bank (as is the case with the euro area), the central bank cannot sufficiently control the time preference rate of each member government. Thus, inflation differentials can be generated, and accordingly, current account imbalances are widened and fiscal balances are governed by complex non-linear processes. All of the model’s predictions are basically consistent with the abovementioned facts about the euro area economy.

Turning to the employed fiscal variables, it is evident that all of them exhibit a statistically significant contribution and thus the employed variables should be seen as potential policy instrument to constrain current account imbalances.Public wage appears to marginally have a significant and negative contribution to current account balance, thus implying a feedback mechanism between wage increases (reductions) and current account deterioration (improvements), a result consistent with Keynesian view. Our results confirm that increases in this specific expenditure item feedback a current account deterioration. In the case of public gross fixed capital formation (gfcf), our results indicate a more Ricardian view since gfcf appears to result to the confinement of current account deficit (which is the case for Greece during the entire examined period). This is explainedbythe significant contribution that the public gfcf for controlling the Greek external balance (Public investment program (PIB)) through the financing of large investment and infrastructure projects thatsupportproductivity and competitiveness gains for the Greek economy.

papers follow a direct approach that treats structural reforms as macroeconomic shocks. There are at least three competing theories which explain why struc- tural reforms, in particular labor market reforms, inuence the current account directly. The rst one sees structural reforms as to be painful today but to promise future gains (Obstfeld and Rogo, 1995). It would, therefore, be ratio- nal for countries to borrow today in order to be compensated for the current pain of structural reforms. Hence, the current account balance should decline in the short run. However, since future gains of structural reforms will be used to pay back the loans in the future, we should observe a reversal and a positive change of the current account in the future. However, returns of reforms in the future are uncertain. Another argument concerning the impact of structural reforms on current account balances has been propagated by Kennedy and Slok (2005). They argue that, in a rst step, wages and prices decline as result of structural reforms. Hence, the country receives a price advantage and exports increase and imports decline. As a result, the current account balance improves in the short run. Protability increases with a time lag and the internal interest rate increases. Investment goes up and foreign capital is attracted which, in turn, tends to reduce capital exports and, therefore, goods exports. In the long run, the current account surplus should thus decline. Bertola and Lo Prete (2009) analyze the eects of rising income growth and income risk as a result of labor market deregulation. They argue in the same vein as Kennedy and Slok (2005) that labor market deregulation should improve the current account balance of the reforming country without much delay, since forward-looking individuals increase their precautionary savings because of higher uninsurable risk. An- other explanation for rising current account balances is that purchasing power shifts towards individuals with higher saving propensities. Hence, the impact of structural reforms on the current account balance is a priori not clear and disputed in the empirical literature. In this context, Kennedy and Slok (2005) analyze the role of structural policy reforms for the solution of global current account imbalances for 14 OECD countries. They nd a signicant but small contribution of structural policy indicators to explain current account positions. Chen et al. (2013), however, doubts a strong contribution of labor market re- forms, arguing that the presence of asymmetric shocks results in strong current account imbalances.

SUMMARY The evolution of global current account imbalances, especially the huge and growing US current account deficit, has been the most alarming global economic develop- ment in recent years. So far, European policymakers seem to have watched the growing imbalances without much concern, in the hope that the EU will be largely unaffected by the inevitable correction of the US external deficit. This apparent complacency is unwar- ranted. Europe may not be part of the global current account problem, but it is bound to be part of the solution. The US current account deficit must narrow eventually and this process will almost certainly involve a significant depreciation in the dollar. The more stubbornly Asian countries refuse to adjust their exchange rates and current account sur- pluses, the larger will be the appreciation of the euro and the resulting deterioration in the euro area’s current account balance. The sharper the adjustment and the larger the share of this adjustment that falls on Europe, the greater the risk of deflationary pressures and a severe recession in the euro area.

The s t at i s t i cal es t i mat es f r om t he economet r i c anal ys es per f or med i n t hi s paper t end t o br oadl y sugges t t he i nval i di t y of t he TDH i n t he cont ext of Bangl ades h as per cei ved f r om t he r ever se causat i on bet ween BD and CAD. However , upon di s aggr egat i on of t he nat i on’ s cur r ent account bal ance and us i ng t he TD as a pr oxy i ns t ead, t he r esul t s s eem t o be mi r r or opposi t e i n cer t ai n cases . St at i s t i cal evi dence f r om bot h t he r egr es s i on and causal i t y t es t s i mpl i ed t hat t he nat i on’ s budget and t r ade bal ances move t oget her i n t he same di r ect i ons whi ch t end t o have pr ovi ded s uppor t t o t he val i di t y of t he TDH. Ther ef or e, i n l i ght of t he r es ul t s , i t can be concl uded t hat BD and CAD i n Bangl ades h ar e mor e of di s t ant cous i ns r at her t han bei ng t wi ns.

While the current account balance for the euro area as a whole has been in balance, divergences in current account positions among the euro-area members have widened since the introduction of the common currency euro. During the last 13 years Portugal, Greece and Spain have run large and persistent current account defi cits, whereas Luxembourg, the Netherlands, Finland or Germany have displayed during the same period large and persistent surpluses. However, there is no unambiguous agreement among economists, whether this divergence of current account positions of the euro-area countries mirrors growing intra-euro-area imbalances (Gros, 2012) or just refl ects proper functioning of the European integration process (Schmitz and von Hagen, 2009). Therefore, the aim of this paper is to estimate equilibrium current account position for each of the original 12 euro area countries so that it is possible to assess whether the divergence of intra-euro current account balances could be explained on the basis of economic fundamentals or it just refl ects misallocation of resources and thus macroeconomic imbalances. The equilibrium current account balance is estimated using a panel-econometric technique for a sample of 30 industrial countries, which represent euro-area member states and their main business partners, over the period 1993–2011. Economic fundamentals aff ecting the equilibrium current account position are selected on the basis of the saving-investment balance, the trade balance and the net income balance, to ensure that we take into an account all theoretically important explanatory variables. We fi nd that the main determinants of current account norms in our sample are fi scal balance, a country’s net international investment position, oil balance and a country’s stage of economic development. The major part of the euro-area countries exhibits current account positions close to their equilibrium levels with the exception of the Netherlands and Finland which have persistently higher surpluses, while Portugal and Greece run larger current account defi cits than is their norm.

How to test this hypothesis? When sovereign bond markets in the eurozone are gripped by fear and panic (as they have since 2008), bondholders sell the bonds of countries they distrust and buy the bonds deemed safe. This has the effect of raising the government bond yields of the countries that are distrusted and lowers the bond yields of the safe countries. Thus the movements of the government bond yields can be used as indicators of movements of fear and panic (see De Grauwe & Ji, 2012). When such speculative movements arise, we are likely to observe imbalances in Target2. Sovereign debt crises tend to spill over into debt crises in general. Thus, for example when Spain was hit by a sovereign debt crisis, private Spanish debtors were also caught by the crisis, i.e. foreign creditors, say Germans, stopped rolling over their loans to Spanish financial institutions. These then turned to the Bank of Spain for funding, and the German creditors unloaded their claims onto the Bundesbank. Thus in times of fear and panic both the spreads between the debtor and the creditor countries increase and the Target imbalances surge. In Appendix A we present a theoretical model that analyzes the link between the spreads and the Target2 balances.

Developments in Malawi's external current account have been influenced to a large extent by effects of exchange rate movements on import demand and the performance of the tobacco sector. In the early 70s when the exchange rate was under a pegged regime, and the economy had favourable terms of trade, the country’s external sector was performing extremely well. However, from 1976 the position of Malawi’s balance of payments began to weaken and indeed since then the current account, which predominates the behaviour of the balance of payments, has been in persistent deficits. These perennial external imbalances have been a reflection of several factors, both external and domestic. On the international scene, the continuous terms of trade losses, exacerbated by disruptions to the traditional trading routes, oil price shocks, and exchange rate and interest rate changes, contributed to the deterioration of the current account.

Chinn$ and$ Prasad$ (2003)$ emphases$ that$ instead$ of$ capital$ controls$ country’s$ financial$ development$is$positively$correlated$with$current$account$balance$in$developing$countries.$ Contradicting$this$result,$Cheung$et$al.$(2010)$and$Mendoza$et$al.$(2009)$show$that$financial$ sector$ development$ measured$ by$ private$ credit$ ratio$ has$ a$ negative$ impact$ on$ current$ account$ balance.$ Such$ negative$ relation$ might$ arise$ from$ the$ fact$ that$ developed$ financial$ system$ and$ legal$ investment$ protection$ regulation$ may$ divert$ the$ capital$ flows$ into$ other$ countries$ with$ more$ liquid$ assets$ and$ competitive$ market$ (Bernanke,$ 2005,$ Ju$ and$ Wei,$ 2006).$ $ Similarly,$ Alfaro$ et$ al.$ (2008)$ confirms$ that$ domestic$ and$ international$ market$ imperfection,$ low$ institutional$ quality$ and$ weak$ governance$ structure$ in$ developing$ countries$increase$the$investor’s$high$risk$of$return.$Thus$capital$is$uphilling$in$the$relatively$ more$ stable$ and$ developed$ financial$ system$ particularly$ in$ European$ and$ North$ American$ economies$ (Caballero$ et$ al.,$ 2008).$ Besides,$ based$ on$ an$ empirical$ research$ of$ a$ panel$ of$ developing$countries$Calderon$et$al.$(2002)$reveals$that$high$current$account$deficit$tends$to$ associate$ with$ output$ growth,$ terms$ of$ trade$ shock$ and$ currency$ appreciation.$ However,$ past$global$economic$shocks$such$as$Asian$crisis,$Latin$American$crisis$and$recent$financial$ crisis$ reduce$ the$ investment$ levels$ (Reinhart$ and$ Rogoff,$ 2008,$ Chinn$ and$ Ito,$ 2007,$ Eichengreen,$2006).$$

(i) on structural assumptions some of which might not be compatible with the economic structure of some developing countries such as Cameroon, and also that (ii) (Kasa 2003) pointed out that the present value test of current account depend sensitively on the nature of trend specification, we complement the analysis with a non structural approach. This second method is solely based on the econometric analysis using unit root and cointegration tests of the long term relationship between quantities that directly affect current account imbalances: imports, exports and net transfer payments on foreign obligations. The tests determine whether a country is likely to sustain its current account deficits without defaulting on its foreign debt. This approach is borrowed from the seminal work of Hamilton and Flavin (1986) who established that sustainability re-quires that the stock of debt be stationary. The idea was further developed by Wilcox (1989) who came to the conclusion that the intertemporal budget constraint would hold only if the debt is stationary around a zero mean. Hakkio and Rush (1991) showed that with a stationary interest rate, testing for sustainability is equivalent to testing for the cointegration between government revenues and government total expenditures. The method was later extended by Quintos (1995) who introduced the notions of “strong” and “weak” sustainability. He further pointed out that the cointegration criterion is only a sufficient (but not a necessary) condition for sustainability, the necessary and sufficient condition being that the current account deficits remain lower than the growth rates of foreign indebtedness. Husted (1992) tested for cointegration between exports and im-ports plus interest payments abroad using a methodology similar to that of Hakkio and Rush (1991).

Due to the repercussions mentioned, current account imbalances can also have con- sequences for the entire global economy and therefore affect economies running a balanced current account. In this context, the risk of growing protectionism is partic- ularly worthy of mention. Added to this is the threat of a global devaluation race, as some economies – particularly countries running current account deficits – could try to solve their current account problems by devaluing the domestic currency. If coun- tries with export surpluses were also to respond by devaluing their currency in order to avert the threat of a slump in production and employment, this would lead to a global increase in money supply, as the increase in the supply of a country’s own currency leads to the desired devaluation of the domestic currency. The global sur- plus of liquidity would therefore continue to grow, increasing the risk of speculative bubbles.

sistent current account imbalances. Most notably the USA (but also, in Europe, the UK and Spain) have run large current account deficits, offset by corresponding surpluses in, notably, China, Japan and Germany. Total domestic consumption and investment in the US has been persistently and substantially (of the order of 5-6% of GDP) above domestic output. The gap has been met by borrowing: surplus countries have piled up financial assets which have kept long-run interest rates in the US low (and thus helped sustain the imbalances). Surplus countries have sought to export their way out of unemployment (Germany, Japan) or into rapid industrialisation (China). 4 Increasingly dissatisfied with meagre returns on safe assets, such as Treasury bills, they (alongside domestic investors) have pur- chased more complex, opaque assets provid- ed by Wall Street financial alchemists (to which we return)that offered higher rates of return. In Europe, Germany’s persistent trade surpluses are one important fundamental reason why its banks held large amounts of what subsequently proved to be toxic finan- cial products originated in the US.

Global current account imbalances have dominated discussions among policy-makers already for a number of years. The most important imbalances concern the large and rising current account deficit of the United States and the matching surplus of East Asia and the Middle East, while the current account for the euro area is roughly balanced. Nevertheless, the euro area would likely be substantially impacted by any disorderly unwinding of the global imbalances. Different scenarios show that the euro area could suffer from substantial current account and output losses, if the adjustment involves a sharp depreciation of the dollar and a recession in the United States. On the other hand the impact would be mitigated if East Asia were to increase its imports. The euro area on its own can make only a limited contribution to reducing global imbalances, primarily because its own starting position is balanced. Even a sizable increase in the euro-area’s trend output growth would not result in substantial and lasting improvements in the US external balance. However, the euro area can prepare itself to better absorb the shock that any disorderly unwinding would bring by implementing structural reforms that improve the flexibility and resilience of its constituent economies.

Do China’s current account surpluses reflect the effect of its one-child policy on savings rates or are they instead caused by exchange-rate manipulations? Similarly, do German surpluses reflect the effect of that countries’ age distribution or are they caused by its membership of the Euro zone? Similarly for deficit countries: Perhaps demographics partially explain the current account deficits of Spain, the U.K. and the U.S. Moving further afield, do the high saving rates of the fast growing East Asian economies primarily reflect their rising number of prime-aged individuals in past decades and will they decline as the population ages? These are some of the questions that we attempt to answer in this paper. We explore the extent to which observed current account imbalances between countries can be attributed to differences in the population age structure and to which extent they can be attributed to other factors such as economic policy. In particular, we take into account the statistical relationship between age structure and the current account and correct for its influence on the current account of 57 countries using data from 1980 to 2009.

Reduction of U.S. …scal de…cit has been one of the policy recommendations to reduce the current account imbalance of the U.S. but as Mussa (2007) state "it is also important to emphasize that U.S. …scal consolidation is not the be-all and end-all of policies to address the U.S. external de…cit." Furthermore "the fact is that the U.S. current account de…cit disappeared between 1987 and 1991 as the …scal de…cit expanded to a postwar peak (as a share of U.S. GDP). Then the current account de…cit widened to a new record of over 4 percent of U.S. GDP in 2000 as the …scal de…cit moved from large de…cit to signi…cant surplus". Another important stream of literature explores the behavior of the interna- tional portfolio and its implications for the U.S.current account. The increase in the U.S. demand for foreign goods and the increase in the foreign demand for U.S. assets have been thought to drive the U.S. account de…cit (Blanchard et.al, 2005). Macroeconomic imbalances re‡ect mostly private saving and investment decisions, and …scal de…cits often play a marginal role (Blanchard, 2007). At the same time, it is accepted that large current account imbalances could be corrected by a depreciation of the dollar, and that this depreciation would have an e¤ect on the trade patterns (Blanchard, Giavazzi and Sa, 2005)

Malaysia experienced the second episode of current account deficits in early 1990s but the macroeconomic environment was different from the previous one. There was a high growth due to the booming private investment and that circumstance had encouraged rapid growth in imports, particularly of intermediate and capital goods and thus caused a narrowing term of trade. Malaysia had met the large current account and budget deficits in year 1991. Since the short-term capital inflows increased significantly in 1992 and 1993 had caused appreciation of the foreign exchange rates and then current account deficit occur in year 1994 due to the unsuccessful discouraging short-term flows. Subsequently, a continued rapid growth and booming investment in 1995 had widened the current account imbalances and resulting Malaysia faced large deficits during that period.

Bussiere, Fratzscher and Muller (2004) analyzed the current account determination in 33 countries employing an intertemporal approach via regression analysis considering effects of fiscal stance of government as well as real exchange rate deviations. Authors suggest that current account balances of countries included in the model are close to their structural current account positions confirming a validity of the intertemporal approach. Abbas, Bouhga-Hagbe, Fatás, Mauro and Velloro (2011) examined relationship between fiscal policy and current account on a large sample of advanced and emerging economies using a variety of statistical methods: panel regressions, an analysis of large fiscal and external adjustments, and VAR. Authors suggest that a strengthening in the fiscal balance by 1 percentage point of GDP is associated with a current account improvement of 0.3-0.4 percentage point of GDP. The evidence is stronger especially in emerging and low-income countries, when the exchange rate is flexible, when the economies are more open, when output is above potential or initial debt levels are above 90 percent of GDP. Javid, Javid and Arif (2010) investigates the effects of fiscal policy or government budget deficit shocks on the current account and the other macroeconomic variable for Pakistan over the period 1960-2009 by employing SVAR model. Authors suggest that expansionary fiscal policy shock improves the current account and depreciates the exchange rate. The rise in private saving and the fall in investment contribute to the current account improvement while the exchange rate depreciates. Schnabl and Wollmershäuser (2012) the role of diverging fiscal policy stances on current account (im)balances in Europe since the early 1970s under alternative institutional monetary arrangements by employing pooled panel regressions. Authors concludes that divergent fiscal policy stances are an important determinant of intra-European current account imbalances both before and after euro introduction Authors highlight that after the year 2001 there is evidence that current account imbalances have been encouraged by an expansionary ECB monetary policy stance. Fidrmuc (2002) defined twin deficits as a cointegrating relationship between the current account, the fiscal balance and investment. Author investigated that both current accounts and fiscal balances have been displaying a significant degree of hysteresis. His paper shows that while twin deficits emerged in the 1980s there seems to be a lack of evidence for twin deficits in the 1990s. On the sample of OECD countries as well as emerging economies with data between 1970 and 2001 author revealed that the countries which pursue sustainable fiscal policies also display a high flexibility of the current account.