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CHAPTER THREE
REVIEW OF RELATED LITERATURE
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balance. This is because, in a stationary economy, the ―long-run‖ current account balance is expected to be zero. This idea relates to solvency7, which implies that an economy’s trade deficit today necessarily implies a need for a trade surplus in the future.
Solvency requires that the present value of the sum of the current and future trade balances is zero. This solvency condition can be extended in two ways. The first relates to when an economy begins with a net stock of foreign debt. It is expected that the present value of the future trade surpluses is at least as great as the initial net external debt (Vinals et al., 1986).
The second suggests that, if the real interest rate is negative8, the present value of foreign exchange earnings is effectively infinite, and the external constraint evaporates (Cohen, 1985). Thus, a country is solvent no matter how large its initial foreign debt is.
In an ideal economy, the path of the current account and foreign debt levels would be privately and socially optimal. Authorities would not care about the need for ―maintaining external balance,‖ ―improving the current account,‖ ―increasing international competitiveness,‖ or ―avoiding the external leakages of domestic expansion.‖ However, in the real world, assumptions of an ideal economic break down. This gives authorities several reasons to be concerned about the short-run behaviour of the current account balance. The need for the concern of the authorities is further sustained by the following arguments:
i. Divergence between Private and Social Costs: Harberger (1985) stressed that an externality has imposed on the country as a whole and on future borrowers by the marginal borrowers (see Cooper and Sachs, 1985; Gersovitz, 1985).
ii. Sticky Wages and Prices: A worsening of the current account is often interpreted as a leakage in demand that boosts the foreign economy and slows down the domestic economy when output is demand-determined (see Salop and Spitäller, 1980).
iii. Future Flexibility: Of the many paths which satisfy long-run solvency, those that are excessively profligate today imply severe constraints in the future, which may be wiser to avoid (see Cooper and Sachs, 1985).
7Solvency deals with the ability of a country to generate sufficient net export surpluses (inclusive of services) in the future in order to repay the existing foreign liabilities.
8 Or, more generally, if the growth rate of foreign currency earnings exceeds the real interest rate.
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iv. Impact on the Current Account on Financial Markets: The current account balance evolution affects market sentiments and the capital account in the short-run.
For fixed exchange rate regimes, prevention of the current account balance from speculative attack through a suitable policy, such as regulating short-term capital outflow, is essential (see Rogoff, 1985; Giavazzi and Giovannini, 1986). Under a flexible exchange rate, the exchange rate adjustment follows a deterioration of the current account balance which is likely to have adverse effects on resource allocation.
v. Protectionism: This may emerge after a period of current account deficit (Dooley et al., 2007).
In the literature, there are some concepts that also help to further appreciate the extent of surpluses or deficits. These include solvency, sustainability and excessiveness. Solvency relates to the ability of a country to generate sufficient revenues in the future to repay the existing liabilities. In terms of current account, solvency deals with the ability of a country to generate sufficient net export surpluses (inclusion of services) in the future to repay the existing foreign liabilities. In terms of fiscal policy, solvency will infer the ability of a country to generate sufficient revenue in the future to repay the existing liabilities.
Solvency criterion has come under severe criticism because of its inherent weakness (Milesi-Ferretti and Razin, 1996). The first argument relates to its inability to distinguish between the willingness and the ability to pay and lend. The second argument ensues from the uncertainty in predicting the ability of a country to generate sufficient future revenue to repay the current debt obligations. Although from theoretical view, a country may be able to pay its current debt but in reality, the lender may not be willing to continue lending, given the possibility of debt default (see Adedeji et al., 2005).
Sustainability addresses if the current debt position is sustainable under the current policy position without significant policy shift, otherwise crisis supervene. Affirmative response to the above implies sustainability of the imbalance. This makes sustainability more stringent than solvency. Excessiveness on the other hand expresses the deviation of the actual balance from the optimal or benchmark. The deviation between the optimal and
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actual can be used to look into how close a given path of current imbalances may be to unsustainability (see Adedeji et al., 2005).
3.2.2: Theories of Current Account Balance Determinations
Various approaches have been adopted to analyse the behaviour of the current account balance. These include traditional models and the modern/dynamic model of the current account balance. The dynamic model of the current account balance, otherwise called the inter-temporal model is based on the consumption smoothing hypothesis. This approach is further explained in section 3.4.
On the other hand, Traditional approaches to the current account balance9 do not specify the process governing the formation of expectations and, thus, neglect the inter-temporal framework. This implies that they are static in nature. Using traditional approaches to modelling the current account balance, Khan and Knight (1983), Pastor (1989), and Adedeji et al. (2005) identified real effective exchange rate, world real interest rate, domestic budget balance as a ratio of GDP, real output in the industrial countries, and terms of trade as determinants of the current account balance expressed as a percentage of GDP.
Their results suggest that these variables affect the current account balance.
The three traditional approaches to current account modelling that are identified in the literature are the elasticity, absorption, and monetary approaches. The elasticity approach emphasises the trade balance component of the current account balance, thus, relative international prices are the central determinants of the current account balance10. The absorption approach examines the income effect of the responses of imports and exports to a reduction in the value of a country’s currency (see Meade, 1951; Alexander, 1952). It attempts to eliminate external imbalance through adjustment in absorption of goods and services. The absorption approach also focuses on the income effects of the same policy as postulated by the elasticity approach. However, it ties current consumption to current income, which makes it a static analysis. The monetary approach can be traced to the pioneering works of Polak (1957), Frankel and Johnson (1976), and IMF (1977). This approach views the balance of the payment determination as a monetary phenomenon, thus,
9 See Hooper and Marquez (1995) and Mwau and Handa (1995) for further details on the traditional approaches to modelling the current account.
10 See Adedeji et al (2005) for more explanation on the traditional approaches to the current account balance.
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disequilibrium in the money markets will be associated with balance of payments disequilibrium. The testable implication of this approach is that a government that engages in continuous money supply expansion experiences a reduction in the level of official reserves.
The modern model of the current account balance is based on the inter-temporal framework. The current account balance (surplus or deficit) is seen as the outcome of forward-looking, dynamic savings and investment decisions driven by expectations of productivity growth, government spending, interest rates, and several other factors. Within this framework, the role of the current account balance as a buffer against transitory shocks in productivity or demand is stressed (Sachs, 1981; Obstfeld and Rogoff, 1995 and Ghosh, 1995, among many others).
The inter-temporal model can be used to examine the excessiveness of persistent deficits.
The model implies that unanticipated temporary declines in output in a small open economy will produce deterioration in the current account balance. The early test of inter- temporal current account models is based on the notion that the current account balance depends on deviations of output, government spending, and investment from their permanent levels when the subjective discount factor equals the world market interest rate.
Their major focus was to examine the relative impact on the current account balance of temporary and permanent changes in government expenditures. Another test focuses on the implications of the present-value model that links today’s current account balance to the expected future changes in the economy’s net output. This implies that unanticipated temporary fall in output in a small open economy will produce deterioration in the current account balance (see Campbell and Shiller, 1987; Sheffrin and Woo, 1990; Milbourne and Otto, 1992; Otto, 1992).
One of the distinguishing features of this approach is that it assumes zero for the permanent change in a variable, which implies that the model is restricted to testing the temporary change in the current account balance determinant. Another relates to its use of consistent treatment of the data time series properties.
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Some of the economic determinants of the current account balances identified in the literature include fiscal policy11, real exchange rate12, terms of trade fluctuations13, capital controls; Global productivity shocks14, among many others.