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Current account adjustment and capital flows - February 2005



BIS Working Papers
No 169


Current account adjustment
and capital flows
by Guy Debelle* and Gabriele Galati**




Monetary and Economic Department
February 2005


* Reserve Bank of Australia
** Bank for International Settlements


JEL Classification Numbers: F3 F32 F41
Keywords: International Finance, Current Account Adjustment,
Open Economy Macroeconomics





















BIS Working Papers are written by members of the Monetary and Economic Department of the Bank
for International Settlements, and from time to time by other economists, and are published by the
Bank. The views expressed in them are those of their authors and not necessarily the views of the
BIS.



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© Bank for International Settlements 2005. All rights reserved. Brief excerpts may be reproduced
or translated provided the source is cited.

ISSN 1020-0959 (print)
ISSN 1682-7678 (online)
1

Abstract
This paper examines episodes of current account adjustment in industrial countries over the past 30
years. We find that they were typically associated with a sizeable slowdown in domestic growth and a
large exchange rate depreciation. There was no discernable change in the nature of capital flows in
the period just prior to an adjustment, with the possible exception of non-residents holdings of
currency and deposits. This suggests that a current account adjustment may be an endogenous event
responding to the resolution of domestic imbalances rather than an exogenous event where the
size of the current account deficit itself precipitates the adjustment in the domestic economy and the
exchange rate. Econometric evidence suggests that global developments trigger the adjustment,
possibly because they trigger the unwinding of the domestic imbalances. We find that the bulk of the
ex post adjustment of the financial account was in private sector flows, primarily on the part of foreign
investors. Finally, we document some notable differences in the adjustment of the current account in
the United States in 1987 compared with that observed in the other episodes.
2
Contents
1.

Introduction.................................................................................................................................... 3

2.

Theories and empirical studies of the determination and sustainability of the current account.... 3

3.

Current account dynamics, macroeconomic factors and the capital account............................... 5

3.1

Current account adjustments in industrial countries since 1973: an event analysis........... 6

Macroeconomic factors ....................................................................................................... 6

The capital account ............................................................................................................. 7

3.2

Econometric evidence......................................................................................................... 8

Explaining the likelihood of substantial current account deficits ......................................... 8

Explaining reversals ............................................................................................................ 9

The impact of reversals on output and exchange rates.................................................... 10

4.

Current account dynamics in the United States .......................................................................... 11

5.

Conclusions ................................................................................................................................. 12

References ............................................................................................................................................ 14

Tables .................................................................................................................................................... 16

Graphs ................................................................................................................................................... 23

3

1. Introduction
1

How do current account balances adjust? Are the adjustments disruptive to the macroeconomy or can
they proceed relatively smoothly? What role do financial flows play in the adjustment process? This
paper addresses these questions by examining 28 episodes of current account adjustments and the
associated financial flows in 21 industrial countries over the past three decades.
Our paper is similar to the analysis in Milesi-Ferretti and Razin (1998, hereafter MFR), who examine
current account reversals in a large cross-section of countries. In contrast to MFR, we focus on current
account reversals in industrial countries, because it appears that there are substantive differences in
the nature of adjustment between industrial and emerging market economies, particularly in terms of
the behaviour of financial flows. Freund (2000) also focuses on industrial economies, but we extend
her analysis to highlight the role that changes in financial flows play in the adjustment process.
First, we investigate the possible determinants of current account reversals, where a reversal is
defined as a significant reduction in the size of a current account deficit. We examine the role of
domestic macroeconomic factors such as output growth and the real effective exchange rate and
external factors such as world growth and global interest rates. In addition, we ask whether financial
factors, and in particular the composition of capital flows, help predict the timing of adjustments. We
present graphical evidence and then estimate a Probit model of the likelihood of reversals.
Second, we examine the adjustment mechanisms. We show that the exchange rate and output growth
contribute significantly to the process of adjustment, and document the change in domestic saving and
investment patterns that accompany the adjustment. We then examine the behaviour of financial flows
during the episodes. We find that the more volatile types of flows, which tend to be primarily influenced
by interest rate differentials, generally adjust the most. Moreover, the adjustment is driven to an
important extent by the behaviour of private sector foreign investors, rather than local residents.
We caution that these results imply nothing about causality. That is, they do not imply that a large
current account imbalance, in and of itself, brings about the adjustment in the real economy and
financial flows. Instead, one plausible explanation of our graphical evidence is that during adjustment
episodes the current account position is purely a reflection of other domestic macroeconomic
imbalances. The adjustment in the current account coincides with the unwinding of these other
imbalances. By contrast, our econometric results highlight that current account dynamics to a large
extent result from contemporaneous global factors.
These apparently different results can be reconciled in two alternative ways. First, macroeconomic
imbalances might be drivers of a current account adjustment but the available sample size does not
allow us to find supportive econometric evidence. Alternatively, while external imbalances can reflect
imbalances elsewhere in the economy, it takes an external shock to trigger a correction of those
imbalances. Given our small sample size, we cannot distinguish between these alternatives.
Finally, we also examine the adjustment of the US current account in the late 1980s, to see whether it
differs from adjustment episodes in other countries. We show that while the 1987 reversal of the US
current account deficit shared some features with the episodes in other industrial countries, there were
also some important differences, notably the role played by official sector capital flows.
2.
Theories and empirical studies of the determination and sustainability

of the current account
A number of approaches have been taken to assess the determinants and the sustainability of current
account positions. This section reviews the contributions that are most relevant for the analysis

1
We would like to thank Claudio Borio, Tony Richards, Camilo Tovar and William White for useful comments on an earlier
draft and Pat McGuire for helpful discussions. Michela Scatigna provided excellent research assistance. The views
expressed in this paper are those of the authors and do not necessarily represent those of the Bank for International
Settlement