Capital Flows and the Current Account

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Capital Flows and the Current Account

• By
• Sebastian Edwards
• UCLA and NBER
• December, 2002

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Outline

• 1. Introduction
• 2. Evolving Views on the Current Account Models
  and Policy Implications
• 3. How Useful are Models of Current Account
  Sustainability?
• 4. Current Account Behavior since the 1970s
• 5. Current Account Deficits and Financial
  Crises How Strong is the Link?
• 6. Concluding Remarks

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1. Introduction

• The current account is one of the least
  understood concepts in economics
• It is equal to foreign savings
• It is a sign of external imbalance
• If the deficit is too large, it may signal an
  imminent crisis
• Purpose of talk
• Analyze current trends
• Discuss historical regularities
• Ask Does the current account matter?

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The U.S. Current Account Deficit
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How is the deficit financed?(Billions of US,
Net)

• 1999 2000 2001
• FDI 146 135 13
• Treasury -21 -53 -23
• Other bonds 220 275 409
• Equities -7 86 -11

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Is the dollar too strong?
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Capital flows to Emerging markets (net), 1994-2003
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Capital Flows to Latin America
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Current Account Balances 1995-02
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2. Evolving Views

• 2.1 The Early Emphasis on Flows
• 2.2 The Current Account as an Intertemporal
  Phenomenon The Lawson Doctrine and the 1980s
  Debt Crisis
• 2.3 Views on the Current Account in the Post
  1982 Debt Crisis Period
• 2.4 The Surge of Capital Inflows in the 1990s,
  the Current Account and the Mexican Crisis
• 2.5 Views on the Current Account in the Post
  1990s Currency Crashes

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Lawsons Doctrine

• If my analysis is correct, much of the growth
  in LDC debt reflects increased in investment and
  should not pose a problem of repayment... This is
  particularly true for Brazil and Mexico (Sachs
  1981, p. 243. Emphasis
• added).

• An increase in the current account deficit
  that results from a shift in private sector
  behavior a rise in investment or a fall in
  savings should not be a matter of concern at
  all (Corden 1994, p. 92, emphasis added).

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Post 1982 Debt Crisis Views

• The primary indicator of a looming crisis is
  the current account deficit. Large actual or
  projected current account deficits or, for
  countries that have to make heavy debt
  repayments, insufficiently large surpluses --,
  are a call for devaluation. (Fischer, p. 115).

• If the current account deficit is
  unsustainableor if reasonable forecasts show
  that it will be unsustainable in the future,
  devaluation will be necessary sooner or later.
  (Fischer, p.115).

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The Early 1990s

• Lawson, once again
• ...the current account deficit has been
  determined exclusively by the private sectors
  decisions...Because of the above and the solid
  position of public finances, the current account
  deficit should clearly not bee a cause for undue
  concern. (Banxico, 1993. P. 179-80, emphasis
  added)

• Some disagreements
• the Mexican current account deficit is huge,
  and it is being financed largely by portfolio
  investment. Those investments can turn around
  very quickly and leave Mexico with no choice but
  to devalue(Fischer, 1994)

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Where do we stand today?

• Caution
• Current account deficits cannot be assumed to be
  benign because the private sector generated
  them... (Larry Summers, 1995)

• Sustainability
• What persistent level of current account
  deficits should be considered sustainable?
  Conventional wisdom is that current account
  deficits above 5 of GDP flash a red light
  (Milesi Ferreti and Razin, 1996).

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3. Current Account Sustainability

• Miless-Ferreti and Razin (1996)
• Goldman Sachs (Ades, 1998)
• Deutsche Bank (Rojas-Suarez, 2000)
• SCAD (g ?w ) (L/Y)

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Foreigners Desired Holdings of a Countrys
Liabilities ( GDP)
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Sustainable Current Account Deficit (SCAD) ( of
GDP)
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4. Historical Analysis Current Account
Behavior Since the1970s
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Current Account Sample
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Median CA deficits
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Third quartile of CA deficits
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Sudden Stops and CA Reversals I
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Sudden Stops and CA Reversals II
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Reversals and Investment
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Reversals and GDP Growth
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5. The Current Account and Currency Crises How
Strong is the Link?
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Frequency of Crises
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Reversals and Crises
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Sustained Reversals and Crises
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Probit Model of Crises
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Probit Model of Crises II
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Crises Excluding Africa I
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Crises Excluding Africa II
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Crises Excluding Africa III
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6. Concluding Remarks Does the Current Account
Matter?

• If this question is interpreted broadly, as
  meaning that there are costs involved in running
  very large deficits, the answer is a yes.
• Current account reversals are quite common and,
  even if they do not always lead to crises, they
  are costly.
• Moreover, the evidence presented here suggests
  that, for some regions, a higher CA deficit will
  increase the probability of a currency crisis.