Abstract
The paper investigates cyclical fluctuations in the current and financial accounts of the balance of payments and major underlying components for nine industrial countries. Explanatory variables are domestic output growth, price inflation, real exchange rate fluctuations, energy price inflation, global growth, and regional growth. The evidence indicates the importance of fluctuations in output growth to the cyclicality of the current and financial balances. High domestic growth tends to stimulate financial inflows and provides adequate resources to finance a large current account deficit. Other factors appear to be less important to the cyclicality of the current and financial balances and their negative correlations.
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Notes
The authors would like to thank Patricia Brenner, Bianca Clausen, Samir El-Khouri, Andrew Feltenstein, Peter Tillmann, and three anonymous referees for providing valuable comments and to Natalie Baumer, Asmahan Bedri, and Randa Elnagar for providing editorial assistance. An earlier version of the paper was published as an IMF Working Paper (2005). The views in the paper are those of the authors and do not necessarily represent the IMF views or IMF policy.
Questions have arisen about the sustainability of current account deficits [Milesi-Ferretti and Razin 1996], in the sense that they can be regarded as sustainable if there is no need for significant changes in domestic macroeconomic policies.
We use the wording “improvement” or “worsening” not in a normative sense, but only to indicate in which direction the current or the financial account is developing.
Our data follow the definition of the Balance of Payments Manual issued by the International Monetary Fund [IMF 1993]. Since 1993, the former capital account is redesignated as the capital and financial account. While the financial account includes portfolio and direct investments, the “new” capital account registers unilateral transfers such as debt forgiveness. Since the capital account in the current definition is of no major economic significance in industrial countries, we will only be looking at the financial account in the following.
For related empirical work on sources of economic fluctuations, see Blanchard and Quah [1989], Ahmed and Park [1994], Clarida and Gali [1994], Baxter [1995], Eichenbaum and Evans [1995], Chari et al. [1998; 2001], Lane [1999], Gali [1999], Prasad [1999], and Stock and Watson [2003].
Kraay and Ventura [2002] document the impact of income fluctuations on the current account. Countries smooth their consumption by raising savings when income is high and vice versa. In the short run, countries invest most of their savings in foreign assets. Fluctuations in savings lead to fluctuations in the current account that are equal to savings times the share of foreign assets in the country portfolio. The ability to purchase and sell foreign assets allows countries not only to smooth their consumption but also their investment. Foreign assets and the current account absorb part of the volatility of these other macroeconomic aggregates.
Unanticipated shocks are random components of an observed variable that have, by construction, a zero mean. Thus, they should have only temporary effects on a variable that cancel out over time. Forecastable growth, by comparison, is the domain of real growth factors that are more likely to have longer lasting effects on a variable.
Theoretical small open economy models are rare in New Open Economy Macroeconomics. Obstfeld and Rogoff [1995] provide the starting point for the analysis. In their model, however, the current account is always in equilibrium, even in the short run. Lane [1999] presents a small open economy model that allows for short-run current account imbalances and offers limited empirical support for his model.
The cyclicality of domestic investment relative to national savings is crucial to determine the cyclicality of the current account balance. In countries where domestic savings are low, boom periods do not result in a significant increase in savings. Other components of national savings, namely net foreign income and current transfers, are likely to be less dependent on domestic cyclical conditions. Hence, the cyclicality of domestic investment is likely to be more dominant in determining cyclical fluctuations in the current account balance than net foreign income and current transfers.
Given the varying effects of real growth based on demand and supply channels, we control for the change in the exchange rate in the empirical model.
It is possible, however, that currency depreciation may worsen the trade balance initially. This is consistent with a J-curve effect. In cases where the economy is highly dependent on imports, depreciation increases the value of imports, worsening the trade balance.
Bergin and Sheffrin [2000] develop a testable inter-temporal model of the current account that allows for variable interest rates and exchange rates. They view these additional variables as channels through which external shocks may influence the domestic current account. In their words (p. 555), “the current account of a small open economy is likely to be affected not only by shocks to domestic output or government expenditure, but also by external shocks to the economies of large neighbors. Such external shocks should be expected to affect the domestic economy via changes in the world interest rate and the country's real exchange rate, both of which set the terms by which the small open economy can trade inter-temporally with the rest of the world.” In our model, we capture the external channels through the real effective exchange rate, global growth, and growth of major trading partners.
At the same time, one could argue that net financial inflows cause a real appreciation.
Sarisoy-Guerin [2003] examines the relationship between current accounts and financial accounts in a set of industrial and developing countries. Specifically, the focus is on the link between net capital inflows and the current account. Country experiences vary. The evidence implies that inflows do not cause current account imbalances in the industrial countries, nor does the inflow volatility affect current account volatility. In contrast, there is a relationship between volatility of inflows and current accounts in developing countries. During an economic downturn, sudden reversals in inflows can induce a liquidity crisis. In favorable times, there may be overlending, exceeding the optimal amount required by the consumption-smoothing hypothesis.
For description of series and data sources, see Appendix B.
The non-stationarity test follows the approach suggested by Dickey [1976]. Detailed results are omitted due to space constraints and are available upon request.
To do that, the respective dependent variable is regressed on the non-stationary domestic variables (with all variables being in levels). The residual term resulting from this OLS regression is then tested for stationarity. The lag length for the residual-based cointegration tests is chosen according to standard lag length criteria. Neither a constant nor a trend is assumed for the augmented auto-regressions (augmented Engle/Granger tests). As the asymptotic distributions of the residual-based test statistics are not the same as for ordinary series in ADF test statistics, different critical values have to be used and are taken from Davidson and MacKinnon [1993, Table 20.2, p. 722]. If the respective residual term turns out to be stationary, there exists at least one cointegrating vector that combines the stochastic common trends in the dependent and explanatory variables.
If there is no evidence of cointegration, the residual term proves to be non-stationary, we do not introduce an error-correction term into the reduced-form model specification.
Given evidence of non-stationary dependent variables, the first-difference specification renders the transformed series stationary.
Hoffmann [2003] employs inter-temporal models to identify global and country-specific shocks in a bi-variate VAR of output and the current account. Shocks orthogonal to the current account can be associated with growth in United States real GDP. Hence, shocks to the current account are country-specific. Global shocks do not affect the current account.
Right-hand-side variables may be endogenous to domestic and external developments. For example, recent research by Gourinchas and Rey [2005] find evidence that not only do exchange rate movements affect the current account through multiple channels but also financial imbalances can help predict exchange rate movements.
For related empirical work, see Billmeier [2002]. It is found that the reaction of the current account is profoundly different across countries, ranging from a J-curve effect (United States, Japan, and Italy) to purely cyclical movements (United Kingdom and Canada). Furthermore, the importance of nominal shocks in explaining the current account varies across countries, but is never the main explanatory component. He concludes that there is a need for microfounded current account models that stress country-specific particularities.
Muller-Plantenberg [2003] reports that Japan's long-lasting current account surplus as well as Germany's temporary surplus during the 1980s are the two largest current account surpluses the world has witnessed. Remarkably, net exports were rising in both countries despite the large overall appreciation of the Japanese yen and the considerable strength of the deutsche mark. He demonstrates, however, that both countries’ current accounts, while overall rising, experienced several setbacks and subsequent recoveries, with clear turning points. It further demonstrates that current account reversals were triggered by the real exchange rate appreciating, or depreciating, too strongly.
As Leonard and Stockman [2001] report “Most economists assert that a J-curve phenomenon characterizes the data: that currency depreciation leads initially to current account deficits and subsequently to current account surpluses.” Actual empirical studies on this issue, however, have shown a very mixed set of results. Leonard and Stockman's evidence is weak regarding a J-curve in the data.
The current account includes the balances of goods, services, income and current transfers accounts. Exports and imports are of goods and services. Fluctuations in the income and current transfers account may moderate the effects of exports and imports on the current account.
Inflows and outflows are based on transactions affecting direct investment, portfolio investment, financial derivatives, and other investment. The financial balance comprises other transactions that include the financial position of the government account. Fluctuations in this balance may moderate the effects of private inflows and outflows on the financial balance.
Consistently, Stock and Watson [2003] report that their analysis of G-7 data indicates that, with the exception of Japan, the widespread reduction in volatility is in large part associated with a reduction in the magnitude of the common international shocks. Had the common international shocks in the 1980s and 1990s been as large as they were in the 1960s and 1970s, G-7 business cycles would have been substantially more volatile and more highly synchronized than they actually were.
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Appendices
Appendix A
ECONOMETRIC METHODOLOGY
To estimate the empirical models in (1), we form a proxy for forecasted growth in real GDP. Following the endogeneity test suggested by Engle [1982], anticipated changes are generated by regressing the first difference of the log of real GDP on a constant, two lags of its own, and two lags of the first-difference of the log values of the GDP deflator, the energy price, the REER, and government expenditure. Going through a model reduction procedure, the least significant variables are eliminated (“general to specific approach”). The variables kept in the equation are significant at least at the 10 percent level. Shocks to real growth are generated by subtracting these forecasts from the actual values of these variables.
The maintained hypothesis for estimation is that agents are rational and that the information set used to specify the proxy for expectation is the same as the set used by agents. Given these assumptions, Pagan [1984; 1986] showed that the use of regression proxies requires an adjustment of the covariance matrix of the estimators of the model's parameters. Accordingly, the expectation equations are jointly estimated with the rest of the model using 3SLS. The instrument list for estimation includes two lags of the first difference of a representative of the short-term interest rate and two lags of the first-difference of the log value of real GDP, the GDP deflator, the energy price, the REER, real GDP in the United States, real GDP in major trading partners, the money supply, and government spending.
The results of Engle's [1982] test for serial correlation are consistent with the hypothesis that the error term in the estimated empirical model is serially correlated in some cases. To filter out serial correlation, the empirical models are multiplied by the filter 1−ρL, where ρ is the serial correlation parameter and L is the lag operator. Reported estimates are after transformation to eliminate serial correlation. The error terms in the transformed models are serially uncorrelated.
Appendix B
DATA DESCRIPTION AND SOURCES
The following data come from the International Financial Statistics (IFS) database:
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1
Exchange rate: REER and bilateral nominal exchange between the national currency and the United States dollar.
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2
Output: real GDP in national currency in billions.
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3
Price: GDP deflator.
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4
Energy Price: nominal price in United States dollars.
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5
United States output: real United States GDP in billions of United States dollars.
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6
Australia output: real Australian GDP in billions of Australian dollars.
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7
Output in the Euro area: A series of real Euro area GDP was constructed by linking two series: one from Fagan et al. [2001], starting in 1970, and one from the European Central Bank's Monetary Policy Stance Division (1980–2002).
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8
Japan output: index of real GDP in Japan.
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9
Government spending: real central government total expenditure and net lending in billions of national currency.
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10
Interest rate: representatives of short-term interest rates.
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11
Balance of payments data:
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a)
Current account balance in billions of national currency.
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b)
Exports of goods and services in billions of national currency.
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c)
Financial account balance in billions of national currency.
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d)
Inflows in the financial account in national currency.
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e)
Outflows in the financial account in national currency.
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a)
Inflows comprise direct investment in the country, portfolio investment liabilities, financial derivative liabilities (if available), and other investment liabilities. Outflows are defined as the sum of direct investment abroad, portfolio investment assets, financial derivative assets (if available), and other investment assets.
The series for financial derivatives exist only partly. If available they enter the inflows/outflows series.
CONVERSION INTO NATIONAL CURRENCY
The subseries of balance of payments data are converted into national currency by using the bilateral exchange rate between the United States dollar and the national currency. To convert data series into Euros, an artificial Euro series was created for France, Italy, and Germany before the Euro was introduced in January of 1999. The bilateral exchange rate between the US dollar and the respective national currency before the start of the European Economic and Monetary Union (EMU) was multiplied with the conversion rate with which the countries entered EMU.
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Clausen, J., Kandil, M. On Cyclicality in the Current and Financial Accounts: Evidence from Nine Industrial Countries. Eastern Econ J 35, 338–366 (2009). https://doi.org/10.1057/eej.2008.16
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DOI: https://doi.org/10.1057/eej.2008.16