Determinants of Current Account Imbalances in Emerging Asian Economies: MG-subset Model Approach

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CHAPTER 1: INTRODUCTION

Haunted by the financial crises of the 1990s in emerging market economies (henceforth EMEs), there is increased concern that the U.S. might suffer a precipitous dollar depreciation together with a disorderly correction of its economy. This speculation is not groundless inasmuch as a persistent current account deficit has been perceived as being one of the leading indicators of the EME currency crises of the 1990s.With the unprecedented growing current account deficits of the U.S. since the 1980s, it is hard to shrug off a possible devastating consequence, as warned by Obstfeld and Rogoff (2004) and Roubini and Setser (2004). However, there is no shortage of arguments claiming that the U.S. is different and unique. As posited by McKinnon (2001) and Mann (2002), in view of the international dollar standard, the U.S. will not fall prey to sudden capital jitters like the EMEs. Nevertheless, Bernake (2005) claims that the global savings glut is the cause of the U.S. current account deficit. As foreign investors seek out secure and profitable investments, the U.S. serves as a relatively reliable destination. Accordingly, the fears of there being an unsustainable current account deficit in the U.S. are overstated, particularly in the present era of globalization.

With regard to adjusting an external imbalance, developed countries and developing countries are indeed different. Freund (2000) finds that the current account adjustments of developed countries are closely related to the business cycle. When an economy experiences a recession, the demand for foreign goods decreases and the current account improves. However, the current account deteriorates when the economy experiences an expansion. For developed countries, current account adjustments are more likely to be of only minor importance to the business cycle. By contrast, the experiences of the EME currency crises of the 1990s indicate that a postponed current account adjustment plays a central role in dragging down the economy. A persistent current account deficit piles up net foreign debt and poses non-sustainability in the external balance. The ensuing reversal of the current account is usually accompanied by economic malaise.

Chinn and Prasad (2003) also find that the factors that determine current accounts differ between developed and developing countries. One of the interesting findings is that the factors of the depth and sophistication of the financial system have a positive effect on the current account for developing countries, while the effect is not significant for developed countries. This implies that with a mature financial system to channel funds in developed countries, a current account imbalance should be neutral to capital mobility. On the contrary, with an immature financial system like those the EMEs have, unbridled capital inflows can adversely affect the current account balance.

Bacchetta and Wincoop (2000) show that, once capital movements are liberalized, there is the phenomenon of overshooting and a high volatility of inflowing capital in developing countries. This might be because their financial systems are not sufficiently sophisticated to absorb the sudden and enormous inflows of capital. Financial crises involving the EMEs in the 1990s attest to the fact that with inflowing capital, ...