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WELLCOME 1 Determinants of current account deficits in Central and East European Countries: Stylized Facts Mihai Antonio Ciobanu The views expressed in this Dissertation Paper are those of the author and do not necessarily represent those of the DOFIN or ASE Bucharest. 2 Determinants of current account deficits Objective – To examine the empirical linkage between current account deficits and a broad set of economic variables proposed by the theoretical and empirical literature for a panel of CEE countries. 3 Determinants of current account deficits Abstract: – This paper provides an empirical investigation of the determinants of current account deficits for a sample of CEE countries. – The analysis is based on a reduced form approach that highlights the roles of the fundamental macroeconomic determinants of current account deficits. – Within-country and cross-country regression techniques are used to characterize the properties of current account deficits across countries and over time. – I use a heterogeneous group of 5 CEE countries over a relative medium time period (1990 – 1998). 4 Determinants of current account deficits Contents: – The first section contains a discussion of some theoretical models germane to the empirical modeling of current account deficits. – The second section presents the empirical results from regressions. – The final section emphasize the concluding remarks. 5 Review of the literature Introduction – Economic theory provide some conceptual tools for analyzing a country’s current account position, as well as some useful insights about the behavior of its current account balance in response to shifts in the stance of economic policies or other autonomous shocks. – The models, that I will present shortly, progressively shifts the emphasis in analyzing the current account from trading relationships to financial variables and the role of capital markets, reflecting the changes in the determinants of international transactions in the last two decades. 6 Review of the literature 1. The Mundell – Fleming Analysis – It describes simple adjustment mechanism in a model of stationary flow equilibrium and static exchange rate expectations. – The model determines the combinations of real interest rate and real output at which markets for goods, money and foreign exchange are in equilibrium. – It neglects the impacts of net investment on the capital stock and of current account deficits on the net international indebtedness. – Do not describe the longer-run path that result from the interaction of stocks and flows. 7 Review of the literature 2. The Savings-Investment Gap – CAt = Spt + Sgt – Igt – Ipt – In countries where the opportunities for investment in productive capital have been sizeable relative to saving propensities, current account deficits might be sustainable for longer period of time. – Ricardian equivalence (Barro 1974). Since an expansionary fiscal policy represents a decrease in government savings, it might induce a compensating increase in private savings, as individuals may lower their current consumption to pay higher future taxes. 8 Review of the literature 3. The Consumption-Smoothing Approach – Focuses on the long-run saving and investment decision of private agents. – The intertemporal sustainability of current account. What determines the current account position of a particular country is the saving-investment gap, which ultimately depends on the willingness of foreigners to hold their liabilities. – The net present value of investment project should be positive, whereas the geographical source of financing is irrelevant (a sort of Modigliani-Miller Irrelevance Theorem of international macroeconomics). 9 Review of the literature 3. The Consumption-Smoothing Approach – The current account balance is influenced by two factors: the deviations of the key variable from their “permanent” levels and the discrepancy between the world market discount rate and the residents’ impatience relative to the interest rate. • (Obstfeld and Rogoff 1996). 10 Review of the literature 4. Overlapping Generations Models – The preceding approach suppose that the labor force is homogenous, neglecting life-cycle considerations. – Diamond , Peter 1965 “National Debt in a Neoclassical Growth Model”. – When population growth rate increases the savings rate goes up because the number of the younger people (savers) rises relative to that of elder people (dissavers). As a consequences, the current account will reflect the age composition of the population and the participation in the workforce. 11 Review of the literature 5. Capital Flows and Uncertainty – Obstfeld and Rogoff 1996 “Foundations of International Macroeconomics”. – Current account deficits are not undesirable, but in order to attract and enjoy the benefits of foreign financing, a country must maintain a steady and appropriate stance of both fiscal and monetary policy, and must improve the functioning and transparency of its markets. 12 Review of the literature The Current Account in Economic Policymaking – The essence of policymaking is to determine a set of policies that will yield: Reasonable economic growth performance Price stability A sustainable fiscal position Low unemployment A sustainable current account position (the society’s choices about savings and investment balances are consistent with the amount of financing that the rest of the world is prepared to lend or to borrow at prevailing interest and exchange rates). 13 Review of the literature The Current Account in Economic Policymaking – The challenge of determining the aspects on which the policymakers need to concentrate in each particular case. – What paradigm is most appropriate to the specific circumstances of the country? – The broad spectrum of options that should guide their decisions. 14 The empirical framework Data – I use an unbalanced panel of 153 annual observation from 5 CEE countries over the period 1990 – 1998. – Detailed definition and sources are presented in the Appendix. – The main sources are World Bank – World Development Indicators and IMF – International Financial Statistics. 15 The empirical framework Econometric Methodology – Time-series and cross-country data. – Within-country and cross-country effects. – Inertial properties in the current account deficits. – All explanatory variables are assumed to be exogenous. 16 The empirical framework Econometric Methodology – Pooled Least Squares method No heteroskedasticity. No contemporaneous correlation. – GLS (Cross Section Weights) method No contemporaneous correlation. – Seemingly Unrelated Regression method My preferred method of estimation. 17 The empirical framework The dependent variable – Current account deficit as ratio to GDP The independent variable – The lagged current account deficit – The domestic output growth rate – Private and public savings ratios with respect to GDP – The share of exports in GDP – The real effective exchange rate – The terms of trade – The output growth rate of industrialized countries – The international real interest rate 18 The empirical framework Within-country effects – Regression on yearly data. – Fixed-effects estimator method. – It emphasize the current account response to over-time changes in a given country. – De-emphasize the cross-sectional variation of the data in favor of its time-series counterpart. – yit = ηi + yit-1β + Xitβm + ε 19 The empirical framework Within-country effects – Persistence The lagged current account deficits 0.22 – moderate persistence of transitory shock. Controlling for country-specific factors, the current account deficit is stationary (Ghosh and Ostry 1995) Statistical significant estimator 20 The empirical framework Within- country effects – Public and private saving - 0.58 – public saving - 0.20 – private saving It appears that shocks in private saving rate are accompanied almost one-to-one by investment rate shocks. Private savings provide a significant but not complete Ricardian offset to changes in public saving. Government budget deficits tend to induce current account deficits by redistributing income from future to present. The “twin deficit” discussion of the 1980. Statistically significant estimators. 21 The empirical framework Within-country effects – Domestic Output Growth 0.22 Although a rise in growth may be associated with an increase in saving rate, it seems that its correlation with the investment rate is somewhat larger, thus leading to a worsening of the current account deficit. Statistically significant estimator. 22 The empirical framework Within-country effects – Exports -0.08 The transmission mechanism is most likely through the trade balance. Statistically significant estimator. 23 The empirical framework Within-country effects – Real effective exchange rate 0.04 – consistent with the prediction of the MundellFleming model. A depreciation of the exchange rate has the effect of reducing the current account deficit. 0.03 – REER current year + 0.03 – REER lagged one year No evidence in support for the J-curve hypothesis. Statistically significant estimators. 24 The empirical framework Within-country effects – Terms of trade – consistent with Harberger-LaursenMetzler effect. -0.04 – Adverse transitory terms of trade shocks produce a decline in current income that is greater than in permanent income. Hence, a decline in savings follows and, thus, a deterioration in the CA position ensues. Statistically significant estimator. 25 The empirical framework Within-country effects – Output growth rate of industrialized countries -0.21 Rise in the demand for the exports of developing countries and increased capital flows between industrialized countries at the expense of flows to developed countries. Statistically significant estimator. 26 The empirical framework Within-country effects – International real interest rate -0.34 Net debtor countries widen their demand for international capital in response to interest rate reduction. Lower interest rates induce international investors to look for investment opportunities in CEE countries. Statistically significant estimator. 27 The empirical framework Within-country effects – External indebtedness 0.13 The transmission mechanism is likely though the revenue balance. Statistically significant estimator. 28 The empirical framework Within-country effects – “Stages of development hypothesis” The size of current account deficit decreases as a country develops in relation to the rest. Relative per capita income – the log of ratio of per capita GDP of CEE country to the per capita GDP of USA. 0.4 – no support for the hypothesis Not statistically significant coefficient. 29 The empirical framework Within-country effects – The demographic profile of the population Age dependency ratio -2.25 Demographic factors play a more important role in the current account variation than through the saving channel. 30 The empirical framework Within-country effects – Foreign direct investment 0.12 – a positive correlation The likely mechanism is through the trade balance. No statistically significant estimator. 31 The empirical framework Cross-country effects – Regression on yearly data. – Country specific factors are not controlled. – Focus on trends. – Show how the differences in current account deficits across countries are driven by their respective characteristics. – yit = yit-1β + Xitβm + ε 32 The empirical framework Cross-country effects – Persistence Empirical result: A moderate positive degree of persistence – Public and private saving Empirical result: Countries with higher public and private saving present lower current account deficits. 33 The empirical framework Cross-country effects – Domestic output growth Theory: The effects of GDP growth on saving behavior is not clear cut. Empirical result: Countries with higher domestic growth rate have larger current account deficits. – Exports Theory: The capacity that more open economies have to generate foreign exchange earnings might signal a better ability to service external debt and make a country attractive to foreign capital. Empirical result: Countries with larger exports (relative to GDP) present smaller current account deficit. 34 The empirical framework Cross-country effects – Real effective exchange rate Empirical result: A positive correlation between real effective exchange rate and the current account deficit. – Terms of trade An important determinant of short-term fluctuations in the current account balance. Influence the investment and saving behavior of the economic agents. Empirical result: Higher terms of trade are associated with smaller current account deficits, consistent with the notion of this augmentation inducing more trade balance surpluses. 35 The empirical framework Cross-country effects – Output growth rate of industrialized countries Empirical result: In periods when the industrialized output growth rate is larger, the current account deficit of CEE countries is reduced. – International real interest rate Empirical result: In periods when international real interest rate is higher, the current account deficit is reduced. 36 The empirical framework Cross-country effects – “Stages of development hypothesis” Theory: The size of current account deficit decreases as a country develops in relation to the rest. Relative per capita income – the log of ratio of per capita GDP of CEE country to the per capita GDP of USA. Empirical result: Positive and significant effect of relative per capita GDP on the current account deficit, which gives no support to the stages of development hypothesis. 37 The empirical framework Cross-country effects – Demographic profile of the population Age dependency ratio Empirical result: The estimated coefficient is consistently negative and statistically significant. Higher dependency ratios are associated with smaller current account deficits. Demographic variable affect a country’ propensity to run current account deficits beyond their effect through private saving. 38 The empirical framework Cross-country effects – Foreign direct investment Theory: The increase in the foreign direct investment will lead to an increase in the current account deficit. Empirical result: No statistically significant association between FDI and current account. – External debt Empirical result: Countries with larger external debt tend to have smaller current account deficits because of the external financing constraints. 39 Concluding remarks There is a moderate level of persistence in the current account deficit beyond what can be explained by the behavior of its determinants. The domestic output growth rate has a positive impact on the current account deficit, indicating that the domestic growth rate is associated with a larger increase in the domestic investment than in national saving. 40 Concluding remarks The growth rate of industrialized countries contributes to reduce the current account deficits of CEE countries. Changes in private and public saving rates contribute to an important decrease in the current account deficit. The increase in exports lowers the current account deficit, likely through a direct effect on the trade balance. 41 Concluding remarks An appreciation of the real effective exchange rate generates an increase in the current account deficit. The terms of trade are positively correlated with the current account deficits in CEE countries. 42 Concluding remarks Reductions in the international real interest rates generate an increase in current account deficits. This is consistent with an increased demand for foreign financing and a rise in the supply of foreign capital when international real interest rates are low. The stages of development hypothesis couldn’t be validated by the empirical findings: countries whose per capita GDP is closer to that of US do not tend to run lower current account deficits 43 Concluding remarks The stylized facts presented in this paper have left a number of important questions unanswered, presenting a fertile agenda for future work: – the dynamic effects of shocks with different degree of persistence on the current account deficits, from an intertemporal perspective. – the channels through which different shocks could affect variations in the current account deficits (for example, via the trade balance or other components of the current account). 44 THE END 45
