An assessment of the sustainability of current account imbalances in OECD countries

Transcription

1 An assessment of the sustainability of current account imbalances in OECD countries Mariam Camarero * Department of Economics Jaume I University Josep Lluís Carrion-i-Silvestre Department of Econometrics, Statistics and Spanish Economy University of Barcelona Cecilio Tamarit Department of Applied Economics II University of Valencia In this paper we empirically test the ability of an economy to satisfy its long-run intertemporal budget constraint without a drastic change in private sector behavior or policy shifts. This is a general concept and does not depend on any particular model with the advantage of its easy testability. For this purpose we use panel data stationarity tests that allow for the presence of structural breaks and cross-section dependence. The evidence points towards the stationarity of the current account (i.e., the solvency constraint is met), as well as the stationarity of the net foreign assets. Both, however, evolve for the majority of the countries, around a shifting deterministic component implying, hence, the non sustainability of the external position for most of the countries considered. Keywords: Current account, panel data, structural breaks, cross-section dependence JEL codes: F32, F41, C23 * Corresponding author: Department of Economics, Jaume I University, Campus Riu Sec, E Castellon (Spain). Phone: Fax: camarero@eco.uji.es;

2 1 Introduction Since the beginning of the 1990s, current account (CA) imbalances have been widening considerably in the world economy. Economic globalization has meant an increase in international trade and capital mobility facilitating the financing of larger and more persistent current account imbalances. Among the OECD countries there is a clear trend toward larger imbalances, i.e. by 2007, the current account imbalances, whether surplus or deficit, of the OECD countries were more than twice as large as in However, the trend towards large imbalances is not confined to the OECD countries. These imbalances have been more acute between China and the oil exporter countries, on the one hand, and the US, on the other. Many emerging economies now show larger surpluses in their current accounts, although it may be necessary to distinguish between those who are enjoying a temporary surplus due to a favorable movement in the prices of their exports (as in the recent run-up in commodity prices) and those whose surpluses are the result of the pursuit of a particular development strategy. According to the World Trade Report 2008 (WTO, 2008), emerging East Asia has followed an export-led development strategy which was supported by exchange rate policies that anchored domestic currencies to the US dollar. It has been a successful development strategy resulting in the rapid mobilization and employment of tens of millions of workers. The means to bring this about is the cross-border transfer of goods and services to the centre country in exchange for financing its deficits (Dooley et al., 2007). The flow of savings to developed countries has also been encouraged by the lack of financial and capital market development in emerging Asian economies. The underdeveloped nature of the domestic financial or capital markets has become a bottleneck preventing the effective channeling of domestic savings into worthwhile investment projects at home. But the size of the imbalances has raised the key question of their sustainability and the nature of the adjustment process. Therefore, there has been a renewed interest in the study of the determinants of the dynamic adjustment of external imbalances. In part, larger current account imbalances reflect the impact of greater capital and financial market integration. A current account deficit reflects dissaving by domestic residents, an excess of absorption over income. The fact that it is occurring reflects a willingness by foreigners to finance that excess absorption by accumulating future claims on the earnings of domestic residents. As a consequence, net foreign liabilities have also been growing, generating concern that policy measures may be required if costly and destabilizing shifts in market sentiment are to be avoided. The weight of experts' opinion suggests that these imbalances will ultimately decline although there is no consensus on when or on the manner, whether smoothly or abruptly, in which it would occur (Clarida, 2007). But there seems to be broad agreement that some combination of exchange rate and asset price changes would play a role during the process of adjustment. Studies of past adjustments in 1

3 industrial countries point to the challenges ahead. Larger deficits take longer to adjust and are associated with significantly slower income growth during the current account recovery (Freund and Warnock, 2007). Consumption-driven current account deficits involve significantly larger depreciations than deficits financing investment. Obstfeld and Rogoff (2006) suggest that a large depreciation of the US dollar, something in the order of 30 per cent, could accompany the process. While temporary current account deficits may simply reflect the reallocation of capital to countries where capital is more productive, persistent deficits may be regarded as more serious. Deficits may lead to increased domestic interest rates to attract foreign capital. However, the accumulation of external debt due to persistent deficits will imply increasing interest payments that impose an excess burden on future generations. Now, adjustments to large current account imbalances are complex processes. The speed and economic effects depend on many factors. How much of the adjustment takes place through changes in asset valuation? How much through a reduction in absorption? How much in the form of expenditure switching? It will also matter how much international coordination among financial and central bank authorities takes place to ensure a supportive policy environment. Thus, the discussion above should not be seen as simplifying the challenges that are involved. If one can take a specific example, the soft-landing scenario requires that the acceleration of US export growth be matched by increased demand for US goods from the rest of the world. This would need to be triggered by just the right kinds of movements in exchange rates, asset and goods prices. Mann (2002) considers that sustainability should be viewed both from the domestic and international finance point of view. A sustainable current account is one that does not trigger feedback effects on domestic variables (investment and savings) or does not lead to significant international portfolio reallocations leading to changes in interest rates. We can distinguish three approaches in the theoretical literature that analyzes the current account balance. First, the conventional nonoptimizing models, that comprises the Keynesian and monetary views, generally using reduced-form solutions and examining aggregated macroeconomic aspects. Although these models à la Mundell-Fleming-Dornbusch provide a useful policy framework, the main drawback is that they are not based on microeconomic foundations and optimizing behavior of the economic agents. A second approach is the micro-founded intertemporal optimizing models developed in the 1980's that use the intertemporal budget constraint. The major advantage of these models is that they deal with current and capital account behavior simultaneously through direct and portfolio investment flows across border along with trade in goods and services. The use of these models has facilitated the analysis of the sustainability of current account deficits. The intertemporal models developed until the late 1980's generally assumed perfectly flexible domestic prices and ignored the shortterm price rigidities in product and factor markets. Finally, a third theoretical approach is the extension of the intertemporal models developed during the 1990's that introduced nominal rigidities and market imperfections into the dynamic general equilibrium models, being the Obstfeld-Rogoff Redux model the major 2

4 milestone in the intertemporal approach to open-economy macroeconomics. These models provide a sound micro-theoretical framework, although they lack a matching empirical validation of the theoretical propositions. The empirical content in some of the models remains restricted to only calibrated simulations. The policy formulations at the central banks, government organizations, International Monetary Fund and the World Bank require an empirically tractable and econometrically estimable model to verify the theoretical propositions. More recently, some studies have extended the modern portfolio optimization theory to the current account and suggest that the marginal unit of wealth arising from a positive productivity shock is allocated according to the existing portfolio choices, and that changes in saving lead to changes in current account proportional to the share of foreign assets in total assets. Kraay and Ventura (2003) suggest that, in the long run, countries invest a marginal unit of saving in domestic and foreign assets in the same proportions as in their initial portfolios. In the short run, countries invest a marginal unit of saving mostly in foreign assets, and only gradually do they rebalance their portfolio back to its original composition. Countries not only try to smooth consumption, but also domestic investment, and they use foreign assets as a buffer stock. Lane and Milesi-Ferretti (2001, 2002) have examined the relationship between current account and changes in net foreign asset position at market value, and showed that the correlation between them is low or even negative. Lane and Milesi-Ferretti (2004) suggest that currency fluctuations influence the rates of return on inherited stocks of foreign assets and liabilities, in addition to operating through the traditional trade adjustment channel. The large gross cross-holdings of foreign assets and liabilities suggest that the valuation channel of exchange rate adjustment has grown in importance, relative to the traditional trade balance channel. More recently, Gourinchas and Rey (2007) have decomposed the external adjustment into a financial (valuation) channel and a trade (net export) channel and show that the deteriorations in net exports or net foreign asset position of a country have to be matched either by future net export growth (trade adjustment channel) or by future increases in the returns of net foreign asset portfolio (financial adjustment channel). The valuation channel is important in the medium-term and the net export channel is important in a long-time horizon. The aim of this research is to test for sustainability following the framework defined in Milessi-Ferretti and Razin (1996) and Taylor (2002). According to this stream of the literature, it is possible to define two key concepts regarding the stochastic properties of the current account. First, the current account is said to be solvent if it is I(0) stationary. Second, the current account is sustainable if the economy is able to satisfy its long-run intertemporal budget constraint without a drastic change in private sector behavior or policy shifts. This is a more general concept and does not depend on any particular model. At the same time this concept of sustainability is a sufficient condition for other concepts to hold, with the advantage of its easy 3

5 testability. According to Trehan and Walsh (1991), current account stationarity is a sufficient condition for the intertemporal budget constraint to hold. To this aim we first test for stationarity of two variables: the Current Account (CA) to GDP ratio and the Net Foreign Assets (NFA) position to GDP ratio. The first variable is representative of the traditional flow approach to the intertemporal budget constraint, while the second, provided that we use the stocks build by Lane and Milesi-Ferretti (2007), that consider the valuation effects in the financial markets, is already a methodological improvement compared to previous empirical work. Finally, as a second step we analyze a key relationship for the long run stability of the unified approach model of the current account adjustment as defined in Gourinchas and Rey (2007). For this purpose we use a panel data unit root test that allows for the presence of structural breaks and cross-section dependence. From an econometric point of view the contribution of this paper is twofold. First, we test for the presence of structural breaks affecting the CA time series, considering as a particular case the situation with no structural breaks. Once the presence of structural breaks has been investigated, then individual stationarity test statistics are computed. Second, such individual tests can be pooled to define panel data based test statistics, which permit an assessment of the CA stochastic properties using more powerful statistical tools. The statistical inference is conducted taking into account the presence of cross-section dependence through the computation of the bootstrap distribution and the use of approximate common factor models. As for the third variable analyzed, that is, the relationships between CA and NFA we first, use the Bai and Perron (1988) methodology in order to ascertain the possible structural breaks in the relationship on a country by country basis. It is worth mentioning that the application of the Bai-Perron methodology to estimate the number and position of the structural breaks requires the variables under analysis to be stationary in variance, which is consistent with the null hypothesis and previous findings of the univariate analysis of the two ratios. Secondly, we analyze the relationship between both variables accounting for possible co-breaking relations in a dynamic heterogeneous panel setting. The remainder of the paper is organized as follows. Section 2 develops the present global imbalances situation in the economic relations at the world level, describing the main stylized facts. Section 3 displays a revision of the previous empirical literature, emphasizing the main issues related to the relationship between increasing economic integration and the external imbalances. In Section 4 we discuss the theoretical framework that guides our empirical investigation on the mechanisms of international financial adjustment. Section 5 presents our econometric methodology and describes the construction of our annual database for the OECD countries. The empirical results are presented in Section 6 and, finally, Section 7 concludes. 4

6 2 Some stylized facts about the current account Prior to the empirical analysis developed in the next sections we will study the stylized facts associated with the current account and the external position of the developed countries. The first stylized fact that emerges is the intense degree of financial globalization that has occurred during the last decade, despite the financial crises and the reversal in global stock markets values in During the last decade, the amount of financial wealth has increased steady in the world. The intensity of the process can be understood if we compare Figures 1 and Figures 2 and 3. Figure 1 shows the sum of exports and imports as a percentage of GDP for the Euro area countries, the UK, the US and Japan. Trade openness has increased steadily during the period considered. Even if the US and Japan are less open than the UK or the EMU countries, all of them have doubled, approximately, their level. This is in sharp contrast with Figures 2 and 3, where financial integration is measured as the sum of foreign assets and liabilities as a percentage of GDP, as proposed by Lane and Milesi-Ferretti (2008). We have presented this index selecting the countries according to criteria linked to their size and characteristics. The Southern and peripheral European countries (Spain, Ireland, Italy, Greece, and Portugal) are shown in the left graph of Figure 2. With the exception of Ireland (an outlier in comparison with the rest, due to its exceptionally high level), these countries have increased their financial integration around nine or ten times. The evolution is different in the graph on the right: larger Anglo-Saxon countries, such as the US, Canada, Australia and New Zealand, are four or five times more financially integrated than at the beginning of the seventies. The exception is the UK in this case, a major financial center, especially after the advent of the euro. The behavior of the countries depicted in Figure 3 turns out to be similar to the other European countries mentioned above: financial integration has augmented around ten times. Thus, even if international trade has increased substantially, on the financial side international capital flows have expanded even more rapidly, and the financial linkages, as well as the real ones, have tightened across countries. A second stylized fact is that this process has caused important external imbalances in the current account. Figures 4 and 5 show the current account balance as a percentage of GDP for the same country groups as above 1. In Figure 4, on the left graph, the peripheral Southern European countries have experienced significant deficits. The most dangerous positions, with deficits above 10% of GDP, are those of Portugal and Spain (and to a lesser extent, Greece); however, Italy and Ireland also worsened their balance after According to Blanchard (2007), these very large deficits in rich countries reflect mostly private saving and investment decisions. The question is why these countries have been able to experience such 1 Caballero et al. (2008) divide the world into four groups: the United States (and similar economies such as Australia and the United Kingdom); the Euro Zone; Japan; and the rest of the world. This classification also emerges from our stylized facts analysis. 5

7 deficits without having suffered a reversal and, therefore, an adjustment. A possible explanation is that in a monetary union, the broad external balance of the European economy hides significant differences in external positions across individual European countries. Some of them, such as the Southern peripheral European countries are converging towards the core EMU countries. The external constraint that individual countries may face is not longer working in a monetary union. However, according to Lane and Milesi-Ferretti (2007), the exposures across Europe are very heterogeneous (differences in trade patterns, financial exposures, and net external positions) so that the process of adjustment may constitute an asymmetric shock. This implies bilateral real exchange rate adjustments between creditor and debtor countries as members of the Euro area. This heterogeneity can be observed in Figure 5: with the exception of France, after the euro, the core euro-area countries and the Nordic economies maintained a surplus in their current account balance. Therefore, some members of the EMU may experience significant and probably painful adjustments in their external position when the credit conditions become tighter. However, it should be emphasized that the EMU countries are not the only ones to have been affected, in recent years, by external imbalances. The case of the US has been discussed abundantly due to its magnitude and the persistence of the creditor position. Other OECD countries, such as New Zealand and Australia are also experiencing similar imbalances. An alternative, although complementary, approach to the nature and dimension of external imbalances can be gathered by looking at the net foreign assets (NFA hereafter) position of this same group of countries. Figures 6 and 7 show quite clearly another stylized fact: the preeminence or the persistence of the net debtor positions among the developed countries. The only exceptions are Japan, Norway (the only oil exporting country in the sample), and a group of core EMU members (Germany, France and Belgium). The negative values of the NFA position (sometimes reaching 50% of GDP or even 75% as in Spain) reflect the cumulated effect of persistent current account deficits and therefore, the imbalance between foreign assets and liabilities. Many rich countries have benefited from the high degree of international financial globalization and have been able to finance their growing current account imbalances through foreign capital entries. However, the deterioration of the NFA position has been severe in many cases and calls for painful adjustments. 3 Brief empirical literature review As the current account represents the rate at which a country accumulates or decumulates foreign assets, one approach to judging whether an external balance of a given size is a problem or not is to see whether it is consistent with the assumption that all external debts will ultimately be repaid. This is the notion of intertemporal solvency. This concept, however, is a relatively weak criterion as far as giving warning of an emerging problem. The reason is that solvency requires 6

8 only that, in the very long run, all debts be repaid. Since this is equivalent to saying that large trade deficits today will be offset by equally (in present value terms) large trade surpluses in some future period, a country can remain technically solvent even while running large external deficits as long as policies are adjusted as needed in the future to bring about the required surpluses that enable debts to be repaid. Therefore, it can be argued that intertemporal solvency imposes too few restrictions on the evolution of the current account and external debt over the medium term to be of much operational value in telling us when a country's external position warrants attention from policy makers. A more demanding criterion is sustainability. This concept adds on to the notion of solvency the idea that policies remain constant for the indefinite future. Thus, an external position is sustainable if, under the assumption that policies do not change, the country does not violate its intertemporal solvency constraint. The problem with the sustainability concept is that what matters for the current account are people's expectations of future policies rather than the policies themselves. These expectations are notoriously difficult to observe and measure, which makes the sustainability concept difficult to apply operationally. Economists do not agree on a precise definition of a sustainable current account. In general, sustainability refers to a stable state in which a current account deficit generates no economic forces of its own to change its trajectory. In this research, a country's current account deficit is defined as unsustainable when it triggers a sharp hike in domestic interest rates, a rapid depreciation or some other abrupt domestic or global economic disruption. Using this definition, a sustainable current account is one that changes in an orderly fashion through market forces without causing jarring movements in other economic variables, such as the exchange rate. The traditional Keynesian approach to the current account put the emphasis on international price competitiveness and relative demand in explaining current account movements. However, the intertemporal approach that appeared from the beginning of the 1980's has emphasized the role of forward-looking expectations in explaining current account patterns. The current account of a country is treated as a reflection of consumption and investment decisions that span over long-term horizons. Thus, the standard intertemporal model of the current account considers the current account from the saving-investment perspective and features an infinitely lived representative agent who smooths consumption over time by lending or borrowing abroad. As the global integration of the financial markets increased from mid 70's, there was a rapid expansion of two-way capital flows and gross external asset and liability positions that contributed to the creation and sustainability of current account imbalances. Therefore, the intertemporal approach became a more appropriate framework to analyze the dynamics of the current account. The intertemporal approach to the current account stresses that, since the current account is the difference between national saving and investment, external deficits 7

9 or surpluses result from intertemporal investment and consumption decisions by firms, households and the government. 2 Thus, when international markets provide limited insurance opportunities, borrowing and lending enables economic agents to smooth consumption through intertemporal trade, enhancing economic efficiency. The empirical applications of this approach evolved along two main lines of research. The first strand of the literature applied the present value test, as developed by Campbell and Shiller (1987). Under some simplifying assumptions and using a methodology developed by these authors in a different context, one can estimate the current account series that would have been optimal from a consumption smoothing perspective. The standard model implication is that the current account balance equals the present value of expected future declines in net output (output less investment and government spending). The intertemporal approach to the current account was first popularized by Sachs (1981) and considers net accumulation of foreign assets as a way for domestic residents to smooth consumption intertemporally in the face of idiosyncratic income shocks. Namely, in response to positive temporary shocks to net output, domestic households can increase both current and future consumption by lending internationally, either directly or through financial institutions. Conversely, in response to permanent shocks that raise net output in the long-run by more than in the short run, domestic households can optimally smooth consumption by borrowing in the international financial markets. To the extent that the permanent increase in net output is driven by shocks to productivity, borrowing in international financial markets allow the domestic economy to sustain higher rates of domestic investment without cutting current consumption. For more that two decades, these basic propositions have been tested using variants of the present-value model originally conceived by Campbell (1987) and Campbell and Shiller (1987) with mixed results. Starting with Ahmed (1986) and Sheffrin and Woo (1990), economists have compared actual current account data with this optimal benchmark leading to the general result that while the modelpredicted current account is positively correlated with the actual series, the latter is substantially more volatile, what implies a statistical rejection of the model. Although the positive correlation means that consumption-smoothing plays a role in the dynamics of the current account, the finding of excess current account volatility has been used to reject the proposition of limited international capital mobility, as stated by Feldstein and Horioka. The present value framework was then extended in several directions in more recent papers. These studies have tried to generate extra predicted volatility through real exchange rates and interest rates variability (Bergin and Sheffrin, 2000), by incorporating consumption habits (Gruber, 2004) or by adding an exogenous world real interest rate shock (Nason and Rogers, 2006). The extent to which the model performance is driven by the empirical failure of the 2 See Obstfeld and Rogoff (1995, 1996) for a survey of the literature. 8

10 auxiliary assumptions commonly adopted to make the model testable is unclear but has been claimed as the main reason for that. In addition, present-value tests do not distinguish between temporary or permanent shocks driving the dynamics of a country's net foreign liabilities. The second strand of the literature has applied standard econometric techniques to establish if there is a long-term relationship between the current account and macroeconomic fundamentals i.e. relative GDP per capita, the demographic structure or fiscal policy. 3 Recent literature addressing these issues has used DSGE models with non conclusive results. 4 Moreover, due to the lack of a precise definition, no universally accepted measure of sustainability exists. Many economists gauge sustainability by examining the value of a country's external obligations. In this context, two commonly used measures are the ratio of the country's current account deficit to GDP and the ratio of the country's net international debt to GDP. Insight into the causes of the deficit can be gained by looking at how the deficit is financed. Examining the ratio of net international debt to GDP provides an alternative method for assessing the sustainability of a country's current account deficit. Net international debt is the accumulation over time of current account deficits. If an economy runs a current account deficit consistently, net international debt may become so great that foreign investors lose confidence in the economy's ability to service its debt or, worse yet, repay the principal. Once this happens, interests rates must rise or the borrowing country's currency must depreciate to enable the country to continue financing its deficit. In this case, the current account deficit has generated economic forces of its own to change its trajectory, and the current account deficit and the associated debt have become unsustainable. In balance of payments terminology, net capital inflow is the financial counterpart of the current account deficit. Thus, current account positions which appear justified from such perspective can only materialize subject to the constraints implied by international capital flows. In other words, a country that is solvent may nevertheless not be able to finance a particular current account deficit if investors are not willing to provide the required funds, i.e. if the country is liquidity constrained. However, recent empirical literature trying to test for this approach still relies only on flows to assess the dynamics of the adjustment process. 5 3 See, for example, Debelle and Faruquee (1996), Chinn and Prasad (2003) or Bussiere et al. (2004). 4 See, for instance, Blanchard and Giavazzi (2002), Fagan and Gaspar (2007) or Bems and Schellekens (2007). 5 For example, Bussière et al. (2004) extend the standard intertemporal model by introducing habit formation and non-ricardian consumers to account for current account behavior in the OECD and in EU acceding countries. Similarly, Zanghieri (2004) extends this analysis by projecting the future level of debt using the forecasts of current account minus FDI flows. Depending on the assumed share of FDI in the current account deficit, CEECs' debt will be stabilized (high share of FDI) or will continue to grow (low share of FDI). 9

11 From a theoretical perspective, the above flow approaches have a major drawback, as they ignore valuation effects of stocks of foreign assets and liabilities and assume that the current level of net foreign assets (NFA) is sustainable. Although this mechanism could help to a gradual rebalancing, these benefits could turn into a problem if policies are not consistent with a credible medium-term policy framework aimed at external and internal balances, as expectations may not be well anchored. In this case, investor preferences may quickly change and the fallout from disruptive financial market turbulence would likely be more elevated than it had been otherwise. Moreover, a country running persistent current account deficits might be at the same time improving its NFA position if capital gains on its foreign assets exceed those on its foreign liabilities (Lane and Milesi-Ferretti, 2006). Additionally, if the country is located away from its equilibrium level of NFA, the current account deficit can be sustained precisely because the economy is adjusting to a higher level of long-term liabilities. Edwards (2001) shows that this adjustment process can lead to quite substantial current account deficits. In our view, a stock approach can cope successfully with this problem. Stocks are also less volatile and can provide long term relationships that are easier to estimate. The stock approach has recently been used by several authors thanks to the development of an external wealth database by Lane and Milesi-Ferretti (2006). They use their own estimates of external positions to study the determinants of NFA in developing and industrial countries and they find that public debt, GDP per capita and a set of demographic variables give a good account of the patterns of external holdings (Lane and Milesi-Ferretti, 2001). Calderon et al. (2000) use a dataset constructed by Kraay et al. (2005) to test a portfolio model on a set of developing and industrial countries. Gourinchas and Rey (2007) use monthly data and an intertemporal budget constraint view to measure external imbalances in the United States. External imbalances should be especially disruptive in developing markets. IMF (2005) uses a methodology close to Gourinchas and Rey (2007) to show the different roles played by valuation effects in emerging and industrial countries. The idea behind this is that valuation effects are destabilizing in developing countries because of liability dollarization (see for example Obstfeld, 2004). The more an economy is dollarized, the worse will be a reaction of its net foreign assets position to depreciation. And since the reaction of the exchange rate to excess external liabilities will be to depreciate, a dollarized indebted country should become even more indebted, unless it runs substantial trade surpluses. On the other hand, if these surpluses are not accompanied by a surge in productivity, it should take place thanks to a shift in demand from tradables to nontradables, and this is possible only through further real exchange rate depreciation. This mechanism initiates a vicious circle that badly affects firms' balance sheets and their capacity to invest, thus leading to an output collapse. Indeed, IMF (2005) finds that valuation effects play a stabilizing role in industrial countries but not in developing countries. Although stock imbalance measures proved useful at predicting future flows (see Lane and Milesi-Ferretti, 2001, IMF, 2005 and Gourinchas and Rey, 2007), no attempt has been made at using them to predict the particular phenomenon of sudden stops in capital flows, which can be 10

12 defined as a sharp, disruptive reversal in the current account. The mean reversion property of current account has several implications for international macroeconomics. First, a stationary current account is consistent with sustainability of the external debts. In this case, there is no incentive for the government to make drastic policy changes and default on its international debts in the near future. Second, stationarity of the current account validates the modern intertemporal model as, theoretically, the model combines the assumptions of perfect capital mobility and consumption smoothing behavior to postulate that the current account acts as a buffer to smoothing consumption in the event of shocks. From an empirical point of view, the stationarity and sustainability of OECD current account balances has been the focus of many researchers over a number of years. 6 The literature on the sustainability of the current account examines the question within two alternative frameworks. On the one hand, a time series perspective is employed where researchers investigate either the long-run relationship between exports and imports or the stationarity of the external debt process (see Chortareas et al., 2004). 7 With the exception of Liu and Tanner (1996), who consider the impact of structural breaks, the above mentioned studies generally find that current accounts are nonstationary for OECD countries. Tests that rely on linear approximations are likely to be imprecise on short samples when the observed current account is persistent, as it typically is. A persistent current account does not necessarily mean a nonstationary one. A stationary current account will be considered persistent if its process of mean reversion is slow. The small sample problems can occur even if the current account is stationary but persistent. Therefore, panel data can improve the information in relatively short sample databases. On the other hand, panel unit root techniques have been employed since unit root tests applied to single series suffer from low power. In recent years a number of alternative procedures have been proposed to test for the presence of unit roots in panels that combine the information from the time series dimension with that from the cross-section dimension. Studies that employ panel data methods include Wu (2000), Wu et al (2001), Holmes (2006) using Im, Pesaran and Shin (2003) test (IPS) and cointegration tests. However, due to the heterogeneous nature of the alternative hypothesis in their test, one needs to be careful when interpreting the results, because the null hypothesis that there is a unit root in each cross section may be rejected when only a fraction of the series in the panel is stationary. Moreover, the hypothesis that the current account balances or the debt series 6 See, inter alia, Trehan and Walsh (1991), Otto (1992), Wickens and Uctum (1993), Liu and Tanner (1996), Wu (2000), Wu et al. (2001), Holmes (2006) and Holmes et al. (2007). 7 The strand of this empirical literature using single equation unit root tests usually rejects the mean reverting behavior of the current account. See, among others, Husted (1992), Ghosh (1995), or Bergin and Sheffrin (2000). 11

13 adjust to long-run equilibrium in a continuous fashion is troublesome when we suspect that in many cases discontinuities may be present in the mean-reversion process. We can identify several sources of breaks rooted in policy or institutional investors' behavior. The presence of high government debt may have repeatedly induced abrupt corrective actions requiring sudden adjustments. More specifically, the fiscal health of the government tends to affect international investors' perception of expected profitability and the investment climate in the country. This perception, in turn, may trigger abrupt reversals in capital flows and imbalances in the current account (i. e. the EMS crisis in the early 1990s). Another channel that may lead to discontinuities in the series is the level of a country's indebtedness, which reflects the willingness of foreign lenders to hold domestic assets. Investors may be unwilling to lend beyond a level of foreign debt they consider normal and withdraw large amounts of funds, creating majors imbalances in the balance of payments. 4 Theoretical framework 4.1 The classical flow equilibrium approach: sustainability of the current account and the intertemporal budget constraint According to Taylor (2002) sustainability of the current account can be defined as the ability of an economy to satisfy its long-run intertemporal budget constraint without a drastic change in private sector behavior or policy shifts. It views the current account as the equilibrium outcome of forward-looking saving and investment decisions taken by rational individuals and driven by expectations of productivity growth, government expending, interest rates and other factors. This view emphasizes the role of the current account as a buffer against transitory shocks in productivity or demand in order to smooth the intertemporally-optimal consumption path. As we previously claimed, this is a rather general concept and does not depend on any particular model, with the advantage of its easy testability. According to Trehan and Walsh (1991), current account stationarity is a sufficient condition for the intertemporal budget constraint to hold. Consider a stochastic model with zero growth. The one period budget constraint is, (1) where and are consumption, investment, government consumption, net stock of debt and income respectively. is the world interest rate. Rearranging (1) and from national accounts identities we have that, (2) where is the net exports. Iterating (2) forward and assuming that the expected value, with being the information set available in, we get 12

14 (3) Equation (3) simply states that international agents are able to lend to an economy if they expect that the present value of the future stream of next exports surpluses equals the current stock of foreign debt. Hence, the sustainability hypothesis, or long run budget constraint implies that: (4) This transversality condition means that the present value of the expected stock of debt when t tends to infinity must equal zero, that is, a no-ponzi game condition. Following Trehan and Walsh (1991), given that the current account, a sufficient condition for (4) to hold is that the current account is an I(0) stationary process. In the more realistic case of an economy with a positive rate of growth of output, we have that the sustainability condition holds if the ratio is I(0) stationary. This means that sustainability is possible with current account deficits as far as they do not grow faster than output in expected value. An obvious test of sustainability is hence a unit root test on. This is what most of the literature has previously used as a test of sustainability. However, note that we are dealing here with expected values of future events. Changes in the agents' perceptions about risk, portfolio allocation decisions, future policy changes, transaction costs in international financial flows, among others, can lead to changes in the dynamics of current account mean reversion and, hence, equilibrium values of the current account. As previously mentioned, Taylor (2002) sees the speed of convergence towards equilibrium as a summary statistic of the degree of capital mobility. This is because it reflects how agents are prepared to allow for periods of current account deficits (surpluses) above the perceived equilibrium value. If, given the international financial environment, agent's perceptions about, for instance, the relative risk of US denominated assets changes due to large observed current account deficits, the speed of mean reversion and the mean of the current account itself would also change. That is, changes in the current account affecting the agent's perception can trigger adjustment dynamics leading to discontinuities in the time series. In this sense, it may be the case that tests that do not consider the existence of breaks are misspecified and reach wrong conclusions about the sustainability of the current account or arrive at too simplistic descriptions of the current account dynamics. Moreover, the special nature of the financial markets, characterized by contagion effects may give rise to sudden stops or even reversals in the asset holdings leading again to breaks in the time series and to the existence of cross-section dependence. This fact may again lead to misleading conclusions. In this research we overcome these two problems through a new panel unit root test that considers the existence of multiple breaks and cross-section dependence. 13

15 Although the saving-investment equilibrium approach does provide an analytical basis for the evaluation of external positions, its almost exclusive concern with flows limits its ability to assess the viability and adequacy of external indebtedness, a stock problem by nature. 4.2 The stock approach: the arithmetic of intertemporal solvency (Net international debt to GDP ratio) The arithmetic of solvency starts from the notion that an economy is intertemporally solvent if its (net) foreign indebtedness is no larger than the present discounted value of the stream of its future non-interest surpluses. The practical difficulty with this approach is that in principle any level of external debt is consistent with solvency provided that sufficient trade surpluses are generated in the indefinite future (Milesi-Ferretti and Razin, 1996). Thus, to make this approach operational, researchers typically assume that the economy targets a given debt-to-gdp ratio, and consider the particular case in which current policy would remained unchanged into the indefinite future (Corsetti and Roubini, 1991). The arithmetic of solvency is primarily concerned with the question of whether net external liabilities grow less rapidly than their (marginal) rate of return so that the present discounted value of net liabilities converges to some finite quantity. In practical terms, the arithmetic of solvency examines whether the net debt/gdp ratio grows more or less rapidly than the difference between the real interest rate and the economy's growth rate. Following Chortareas et al (2004) let us start with a stylized version of the nominal balance of payments identity defined in domestic currency: (5) where is the net foreign assets position, stands for trade balance, are domestic (foreign) assets held by foreigners (domestic residents), are the nominal rates of return on domestic (foreign) assets, and is the domestic price of the foreign exchange rate. Deflating by nominal GDP, and regrouping terms, the former identity can be rewritten as: (6) where is the primary current account deficit, is net foreign indebtedness, is net exports, and = is the growthadjusted real return on net foreign debt. Further, = and = all other lower case letters denote variables as a ratio to nominal GDP. If (6) is deflated by a price index, and are real foreign debt and current account, and is the real interest rate. Assuming solving (6) forward, and imposing the no-ponzi game condition, the Intertemporal Budget Constraint (IBC) is: (7) 14

16 with If this conditions holds, current and future discounted primary current account surpluses are sufficient to pay off initial indebtedness. The traditional sustainability approach tests for the stationarity on In the present exercise we take account of the valuation effects of stocks of foreign assets and liabilities using the new External Wealth of Nations Mark II (EWN II) database provided by Milesi-Ferretti and Lane (2007). According to them the size of countries' external portfolios is now such that fluctuations in exchange rates and asset prices cause very significant reallocations of wealth across countries, playing the exchange rate a dual role influencing both net capital flows and net capital gains on external holdings. 4.3 The unified approach of Gourinchas and Rey (2007): foreign debt and the current account In this subsection we summarize the model developed by Gourinchas and Rey (2007). This model follows an intertemporal approach and is based on two elements: an intertemporal budget constraint and a long run stability condition. They start from a country's intertemporal budget constraint and derive two implications. The first one is a link between the net foreign asset position and the future dynamics of the current account. If total returns on NFA are expected to be constant, today's net foreign liabilities must be offset by future trade surpluses (the so called trade channel ). However, in the presence of stochastic asset returns, the expected capital gains and losses on gross external positions constitute a complementary adjustment tool called the valuation channel. The external constraint implies that today's imbalances must predict either future changes in the trade balance (flow adjustment), future movements in the returns of the NFA portfolio (changes in the stock of foreign assets), or both. In the short and medium term, most of the adjustment goes through asset returns, whereas at longer horizons it occurs via the trade balance. The value of assets owned by domestic residents held abroad minus the value of domestic liabilities to the rest of the world is called the national net foreign asset position. If its net foreign asset position is positive, the country is a net creditor to the rest of the world. Conversely, if NFA is negative then the country is a net debtor, because its outstanding liabilities to the rest of the world exceed its claims on the rest of the world. All nations are subject to a budget constraint that requires that the value of gross domestic expenditure, (GDE) or absorption, plus the change in the stock of foreign assets owned by domestic residents equals the value of gross domestic product (GDP) plus the change in the stock of domestic debt owed to foreigners. Combining this relationship with the definition of the current account, it follows that the change in the net foreign asset position is the same as the balance on the current account. (8) 15

17 Substituting in the definition of the net export balance foreign asset position, this simplifies to: and net which says that the change in the net foreign asset position is the sum of net exports, net foreign income, and unilateral transfers or the balance on the current account. Therefore, if the current account is in deficit, the change in the net foreign asset position is negative, indicating that the increase in foreign debt was greater than the increase in foreign assets over the year. A negative change in the net foreign asset position is referred to as a net capital inflow, since more capital flowed into the country through additions to the level of foreign debt than flowed out through purchases of foreign assets. Future current account and net foreign asset positions are related to the present current account and net foreign asset positions through future net foreign income flows 8. The extent of these flows is influenced by the rates of return on foreign assets and foreign debt. Net foreign income is essentially the difference between interest earned on foreign assets and interest paid on foreign liabilities: (10) where is the rate of interest residents earn on their foreign assets and is the rate of interest that the country pays on its foreign liabilities. Theoretical analyses typically assume that there is no differential between the interest rate on foreign assets and debt, and that the interest rate on foreign debt exceeds the growth rate of nominal GDP, which suggests that the economy must shift to a net export surplus to maintain its current negative net foreign asset position. In textbook examples there is no distinction between and, because they assume there is only one traded asset. However, this assumption is far from reality 9, so it is important to allow for differences between and : (11) Substituting expression (11) into (9) above, it follows that: Dividing through by the level of GDP and imposing the foreign debt sustainability condition that the ratio of NFA to GDP be constant at, we find that the critical (9) (12) 8 See Lane and Milesi-Ferretti (2002) and Gourinchas and Rey (2007) for a more complete discussion of the longer term relationship between the U.S. net exports deficit and revaluations of the U.S. net foreign asset position. 9 The experience is inconsistent with standard theoretical assumptions in many countries, like the U.S.. First, the return the U.S. earns on its private foreign assets exceeds the rate it pays on its private foreign debt. Second, on average, rates of return on most classes of U.S. foreign debt have been roughly equal to the growth rate of nominal GDP. 16

18 net exports to GDP ratio, at the current gross foreign asset to GDP ratio and typical unilateral transfer to GDP ratio is: (13) where g is the growth rate of nominal GDP. According to Kouparitsas (2005) when economists want to assess sustainability of the current account, they begin by calculating the net exports to GDP ratio that would be required to maintain the current net foreign assets to GDP ratio,. He refers to this as the critical net exports to GDP ratio,. Net exports to GDP ratios above will increase the nation's net foreign assets to GDP ratio above, while net exports to GDP ratios below will decrease it. For reasons explained below, negative net foreign asset positions are typically associated with a positive. Another way of stating this is that a country must give up a fraction of all future GDP equal to to maintain its current negative net foreign asset position. A country's current net foreign asset position is considered unsustainable if the associated is a relatively large fraction of GDP. Similarly, a current account deficit is considered unsustainable if it maintains or leads to an unsustainable net foreign asset position. According to this analysis, depends not only on, which is weighted by the difference between the growth rate of nominal GDP and the interest rate on foreign debt, but also the current ratio of domestic gross foreign assets to GDP,, which is weighted by the difference between the interest rates on foreign debt and foreign assets, and the typical ratio of unilateral transfers to GDP, A by-product of this analysis is the current account to GDP ratio,, that would be required to maintain. only depends on, which is weighted by the growth rate of nominal GDP. Through a similar analysis, one can show that the critical current account to GDP ratio is: (14) Moreover, many statistic databases do not take into account the unrealized capital gains from both changes in local currency prices and exchange rate adjustments and this mechanism can be of increasing importance in a financially integrated world. 10 Although the theoretical relation (14) should hold between the current account and the net foreign assets, Gourinchas and Rey (2007) argue that they use trade balance instead of the current account to avoid possible discrepancies in the 10 See Lane and Milesi-Ferretti, (2001) and Tille (2003) for detailed discussion of the size and history of valuation effects for the U.S. and other nations. 17

19 valuation of capital gains 11. Consequently, they consider the accumulation identity for net foreign assets between and : (15) where are the net exports (difference between exports, and imports, and are net foreign assets (difference between gross foreign assets, and gross foreign liabilities, measured in the domestic currency). According to equation (15), the net foreign position would increase with net exports and with the total return on the net foreign asset portfolio (see equation (2) above) Next, the model is log-linearized. The following assumptions should hold: Assumption 1: (a) The ratios,, and are stationary, where represents total household wealth. (b) The steady state values of the ratios, denoted,, and respectively, satisfy and. Assumption 2: The growth rate of household wealth with steady state value. Assumption 3: The return to the net foreign asset portfolio with a steady state value that satisfies. is stationary is stationary Concerning Assumption 1, this is not particularly restrictive. The first part of the assumption would be verified in any model where exports, imports, external assets, liabilities and household wealth grow at the same rate along a balanced growth path. This will be the case in a wide variety of models, as long as assets and liabilities are not perfect substitutes. The second part of the assumption guarantees that some ratios are well defined. Assumption 2 is also an implication of the existence of a well-defined balanced growth path. Assumption 3 has an intuitive interpretation in this context: manipulating equation (15) if Assumption 3 holds, the steady state ratio of net exports to net foreign assets is stationary with an unconditional mean that satisfies: (16) where implies that the real growth rate of wealth is lower than the rate of return of the net foreign asset portfolio. Therefore, countries with steady state 11 However, in order to ease the comparison between the three theoretical approaches that we present in this research, in the empirical application we substitute by in equation (15). 18

20 creditor positions should run trade deficits, whereas countries with steady state debtor positions should run trade surpluses. Lane and Milessi-Ferretti (2002) point out that the correlation between the change in the net foreign asset position at market value and the current account is low or even negative. They also note that rates of return on the net foreign asset position and the trade balance tend to commove negatively, suggesting that wealth transfers affect net exports. Moreover, Lane and Milesi-Ferretti (2004) show exchange rate effects on rates of return of foreign assets and liabilities. 5 Econometric methodology and results In this section we describe the testing strategy we use to address the theoretical issues described above. The empirical application is based on a panel database that consists of 20 OECD countries, both European and from the rest of the world. The sample covers the period , and the data has been obtained from the World Bank and the new External Wealth of Nations Mark II (EWN II) database provided by Milesi-Ferretti and Lane (2007a). The two variables of interest are the current account balance as a percentage of GDP ( ), and the net foreign assets stock also as a percentage of GDP ( ). We first test, using panel methods, both for the sustainability of the current account and the solvency of the net foreign assets position of our group of countries. Then, following what we call the unified approach by Gourinchas and Rey (2007), we study the stability and the sign of the relationship linking the two variables. Concerning the two first hypotheses, we have applied panel data based test statistics following a two-step testing strategy that addresses the problems related to the issues of multiple structural breaks and cross-section dependence. 12 First, we have tested for the sustainability of the current account and for the external solvency by allowing for multiple structural changes in a panel setting that, to the best of our knowledge, has not been applied yet in this literature. Previous evidence has revealed that there might be some events that affect the current account and the net foreign asset position in a permanent way. It is well known that non accounting for structural breaks biases both unit root and stationarity tests towards concluding in favor of non-stationarity in variance. 13 Thus, this feature should be of special interest in our case, since this type of variables may be affected by major events such as currency crises or economic integration 12 We have applied as well classical panel unit root and stationarity tests without structural breaks finding mixed results. These results are available upon request from the authors. 13 See Perron (1989) for univariate statistics, or Carrion-i-Silvestre, del Barrio and López-Bazo (2001) for panel data statistics. 19