Does Capital Mobility Finance Does Capital Mobility Finance or Cause a Current Account or Cause a Current Account

Imbalance?Imbalance?

Antonio H-D YanAntonio H-D YanUniversidad Francisco MarroquinUniversidad Francisco Marroquin

March 22, 2006March 22, 2006

Two Hot Issues in the Two Hot Issues in the International EconomicsInternational Economics

Free capital mobility: a blessing or a Free capital mobility: a blessing or a curse?curse?– Causes of capital mobility, “push” or “pull” Causes of capital mobility, “push” or “pull”

factor; policy response; sequences and paces factor; policy response; sequences and paces of financial liberalization.of financial liberalization.

Persistent current account deficit Persistent current account deficit – Recall the 1994-95 Mexican peso crisis, and Recall the 1994-95 Mexican peso crisis, and

the 1997-98 Asian financial crisis: the collapse the 1997-98 Asian financial crisis: the collapse of the pegged exchange rate regime; of the pegged exchange rate regime; inconsistent trinity; selection of exchange rate inconsistent trinity; selection of exchange rate regime. regime.

MotivationMotivationHaunted by Asian financial crises, an Haunted by Asian financial crises, an increased concern about the increased concern about the persistent and growing current persistent and growing current account deficit in the USAaccount deficit in the USA

Are capital inflows to the USA the Are capital inflows to the USA the causes or consequences of the CA causes or consequences of the CA deficits? deficits?

Richard Cooper (2001)Richard Cooper (2001)

““The U.S. deficit is ‘financed’ by net The U.S. deficit is ‘financed’ by net capital inflows only in an ex post accouncapital inflows only in an ex post accounting sense. In economic terms ting sense. In economic terms it is more it is more nearly correct to say that net capital inflnearly correct to say that net capital inflows cause the current account deficitows cause the current account deficit.”.”

William Poole (2001)William Poole (2001)

“ “That many commentators have That many commentators have expressed the mistaken view that expressed the mistaken view that the capital and financial account the capital and financial account ‘finances’ the current account. In ‘finances’ the current account. In fact, for the United States, fact, for the United States, changes changes in the capital and financial account in the capital and financial account have been driving changes in the have been driving changes in the current account for many yearscurrent account for many years.” .”

The Purposes of This PaperThe Purposes of This PaperShow that developed countries and Show that developed countries and developing countries are different on developing countries are different on the causality of the current account the causality of the current account and capital mobilityand capital mobility

One of the differences is whether One of the differences is whether the financial system is sophisticated the financial system is sophisticated enough to absorb the inflowing enough to absorb the inflowing capitalscapitals

An Empirical StudyAn Empirical Study

““If you torture the data long enough, NIf you torture the data long enough, Nature will confess.” Ronald Coaseature will confess.” Ronald Coase

A job interview: Mathematician, StatisticA job interview: Mathematician, Statistician, and Econometrist.ian, and Econometrist.

Is Persistent Current Account Is Persistent Current Account Deficit a Problem?Deficit a Problem?

Yes: Corsetti, et al. (1999) and Edwards (2002) fYes: Corsetti, et al. (1999) and Edwards (2002) for Developing Countries; Obstfeld and Rogoff or Developing Countries; Obstfeld and Rogoff (2004) and Roubini and Setser (2004) for the U(2004) and Roubini and Setser (2004) for the USA.SA.

No: McKinnon (2001) and Mann (2002), and BerNo: McKinnon (2001) and Mann (2002), and Bernanke (2005).nanke (2005).

Determinants of the CADeterminants of the CA

The factors of depth and The factors of depth and sophistication of the financial system sophistication of the financial system have a positive effect on the current have a positive effect on the current account for emerging economies, account for emerging economies, while its effect is not significant for while its effect is not significant for developed countries. (Chinn and developed countries. (Chinn and Prasad, 2003) Prasad, 2003)

How Current Account Imbalance How Current Account Imbalance Adjusts?Adjusts?

Part of the business cycle for Part of the business cycle for developed countries, Freund (2000). developed countries, Freund (2000).

Emerging economies in the 1990s Emerging economies in the 1990s reflect that a postponed current reflect that a postponed current account adjustment plays a central account adjustment plays a central role in dragging down the economy, role in dragging down the economy, Edwards (2002). Edwards (2002).

Capital Inflow Overshooting and Capital Inflow Overshooting and VolatilityVolatility

There is difference between trade in widThere is difference between trade in widgets and dollars (Bhagwati, 1998)gets and dollars (Bhagwati, 1998)

absorptive capacity (Bacchante and Winabsorptive capacity (Bacchante and Wincoop, 2000)coop, 2000)

BOP AccountingBOP Accounting

0 = CA + FA + RES0 = CA + FA + RES

= CA +(FDI +PI +OI)+RES= CA +(FDI +PI +OI)+RES

It is an identity and no causality It is an identity and no causality is implied.is implied.

How FA affects CA?How FA affects CA?CA = S – ICA = S – I = EX – IM= EX – IM

release liquidity constraint (C up) release liquidity constraint (C up) real E appreciate, TB deficitreal E appreciate, TB deficit real estate market boom (nontradable demand up)real estate market boom (nontradable demand up) FDI complements to IFDI complements to I difference between short-run and long-run (policy resdifference between short-run and long-run (policy res

ponse)ponse)

Capital inflow: supply-pushedCapital inflow: supply-pushed

How CA Affects FA?How CA Affects FA?

High profit opportunity induced High profit opportunity induced capital inflow to finance domestic capital inflow to finance domestic investment, USAinvestment, USA

CA surplus need to balance BOP, CA surplus need to balance BOP, Japan Japan

Demand-induced capital inflowDemand-induced capital inflow

Causal Relation: CA and FACausal Relation: CA and FAIt is an empirical questionIt is an empirical question

Different causal relation in the Different causal relation in the current account and financial current account and financial account between emerging account between emerging economies and developed countries.economies and developed countries.

Developing countries are much more Developing countries are much more vulnerable to free capital mobility. vulnerable to free capital mobility.

Wong and Carranza (1999)Wong and Carranza (1999)

Four developing countries: Argentina, Four developing countries: Argentina, Mexico, the Philippines, and ThailandMexico, the Philippines, and Thailand

prior to 1989 (CA -> FA) prior to 1989 (CA -> FA)

after 1989 (FA -> CA)after 1989 (FA -> CA)

Empirical Methodology: Modified Empirical Methodology: Modified Wald Test on Granger CausalityWald Test on Granger Causality

Dolado and Lütkepohl (1996) and Toda aDolado and Lütkepohl (1996) and Toda and Yamamoda (1995) nd Yamamoda (1995)

Modified Wald test Modified Wald test

The Augmented VARThe Augmented VAR between CA and FAbetween CA and FA

The null hypothesis of Granger non-The null hypothesis of Granger non-causality from causality from FAFA ( (CACA) to ) to CACA ( (FAFA) is ) is = 0. = 0.

t

dm

iitiit

dm

iiit

dm

iiit

dm

iit VGDPXCAFACA 1

11

11

11

111

maxmaxmaxmax

t

dm

iitiit

dm

iiit

dm

iiit

dm

iit VGDPXCAFAFA 2

12

12

12

122

maxmaxmaxmax

The Augmented VARThe Augmented VAR between CA and FDI, PI, and OIbetween CA and FDI, PI, and OI

t

dm

iitiit

dm

iiit

dm

iiit

dm

i

Ji

OIPIFDIJt VGDPXCAJCA 1

11

11

11

11

,,1

maxmaxmaxmax

t

dm

iitiit

dm

iiit

dm

iiit

dm

i

Ji

OIPIFDIJt VGDPXCAJFDI 2

12

12

12

12

,,2

maxmaxmaxmax

t

dm

iitiit

dm

iiit

dm

iiit

dm

i

Ji

OIPIFDIJt VGDPXCAJPI 3

13

13

13

13

,,3

maxmaxmaxmax

t

dm

iitiit

dm

iiit

dm

iiit

dm

i

Ji

OIPIFDIJt VGDPXCAJOI 4

14

14

14

14

,,4

maxmaxmaxmax

Caveats of the Granger CausalityCaveats of the Granger Causality

Reverse Causality: X’mas and X’mas cReverse Causality: X’mas and X’mas card (be cautious when interprets the resard (be cautious when interprets the results)ults)

Omitted variables: here X and GDPOmitted variables: here X and GDP

DataDataDeveloping countries: (1989.1-2003.4)Developing countries: (1989.1-2003.4)Argentina, Brazil, Indonesia, Mexico, PhilippinArgentina, Brazil, Indonesia, Mexico, Philippines, South Korea, and Thailand es, South Korea, and Thailand

the G-7: (1974.1-2003.4)the G-7: (1974.1-2003.4)Canada, France, Germany(1974.1-1989.4), Italy,Canada, France, Germany(1974.1-1989.4), Italy, Japan, UK, and USA. (Kaminsky and Schmukle Japan, UK, and USA. (Kaminsky and Schmukler, 2003)r, 2003)

CA, FA (FDI, PI, OI) in GDP ratio;CA, FA (FDI, PI, OI) in GDP ratio; and GDP and and GDP and real E in growth ratereal E in growth rate

Empirical Results (without Empirical Results (without controlled variables)controlled variables)

CA and FACA and FATable 1a (developing countries)Table 1a (developing countries)Table 1b (G-7)Table 1b (G-7)

CA and FDI, PI and OICA and FDI, PI and OITable 2a (developing countries)Table 2a (developing countries)Table 2b (G-7)Table 2b (G-7)

Empirical Results (with controEmpirical Results (with controlled variables)lled variables)

CA and FACA and FATable 3a (developing countries)Table 3a (developing countries)Table 3b (G-7)Table 3b (G-7)

CA and FDI, PI and OICA and FDI, PI and OITable 4a (developing countries)Table 4a (developing countries)Table 4b (G-7)Table 4b (G-7)

Empirical Results (structural Empirical Results (structural break)break)

Tables 5a and 5b – developing countriesTables 5a and 5b – developing countries

Tables 6a and 6b – G-7Tables 6a and 6b – G-7

Conclusion (1)Conclusion (1)For developed countries, capital mobility is For developed countries, capital mobility is demand-induced and financial account demand-induced and financial account functions to finance current account.functions to finance current account.

For emerging economies, capital mobility For emerging economies, capital mobility works like supply-pushed; the financial works like supply-pushed; the financial account causes current account deficit.account causes current account deficit.

For emerging economies (South Korea and For emerging economies (South Korea and Thailand), other investment (bank loans) Thailand), other investment (bank loans) brings to current account deficits.brings to current account deficits.

Conclusion (2)Conclusion (2)

Without a sophisticated and sound finanWithout a sophisticated and sound financial system should not recklessly dismancial system should not recklessly dismantle their restrictions of capital mobilitytle their restrictions of capital mobility

The pace and sequence of liberalization The pace and sequence of liberalization of the financial account should be heedeof the financial account should be heeded also. d also.

ExtensionsExtensionsGlobal savings glut: examining the Global savings glut: examining the causality between FA with S and Icausality between FA with S and I

Using panel causality test to include more Using panel causality test to include more countries and to have a more general countries and to have a more general result. (Geweke, 1982 – simultaneous result. (Geweke, 1982 – simultaneous causality)causality)

Add the financial deepening variable in the Add the financial deepening variable in the regressionregression