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Article Excerpt
Abstract
We demonstrate that a different causal relationship exists between the current and financial accounts in developed and developing countries. Using the Granger causality test, we clearly determine that the financial account is by and large responsible for the current account in developing countries; instead of financing the current account, the financial account thrusts the current account into an imbalance. In developed countries, however, the current account leads the way, and the financial account, as its name indicates, serves to finance a current account imbalance. This represents a forewarning that countries, which lack a sophisticated financial system to channel funds to proper locations, should not recklessly liberalize capital mobility. (JEL F32)
Introduction
Whether free capital mobility merits economic growth, particularly in developing countries, has become a topic of great interest and one with far-reaching implications since the currency crisis that wrought havoc for many Asian economies during the late-1990s. (1) Free capital mobility enables developing countries to access the international pool of financial capital, thereby, facilitating their own investment opportunities. From the perspective of an intertemporal model, capital flowing either in or out finances the gap between domestic investments and savings. In that the current account serves as a buffer stock, and its deficit should not be any cause for concern. (2)
The currency crisis of the late 1990s shows that a persistent current account deficit is like a flashing red light preceding a pending currency crisis. In an unsound banking system, an instant influx of foreign capital is typically channeled into unproductive sectors or may even lead to a consumption spree. The end result is that the current account deteriorates owing to an overvalued domestic currency, and this is particularly so when a pegged rate regime has been adopted. Once a current account imbalance becomes unsustainable, the public envisages that the government is postponing or even ignoring the necessary adjustment, and then a currency crisis is triggered by a speculative attack. (3)
Studies on various currency crises have generally focused on the interaction between current account deficits and overvalued currencies. Although a causal link is found between a current account balance and inflowing capital, very few studies on the causal relationship between the current account and financial account have been conducted. One exception, however, is the study of four developing countries (Argentina, Mexico, the Philippines, and Thailand) by Wong and Carranza [1999], which provides evidence that prior to 1989, when capital mobility was highly restricted, there was the current account that Granger-caused the financial account, while the trend was reversed from around 1989 to 1994 when capital mobility was liberalized. Indeed, this mirrors what occurred during the Asian financial crisis when inflowing capital served to force the current accounts of crisis-affected countries into deficits.
In discussions on the relationship between the current account and financial account, differences of opinion vis-a-vis developed countries have surfaced. Evaluating the persistent U.S. current account deficit, Cooper [2001] and Poole [2001] claim that the deficit is caused by the financial account, resembling the scenario which occurred in developing countries during the 1997-98 Asian currency crises. (4) Such a view is justified in light of the 1997-98 Asian currency crises. Apparently, it is not odd to reason in this way after witnessing the 1997-98 Asian currency crises. Pakko [1999], however, expresses an opposing view by arguing that the U.S. current account deficit is attributable to its immense investment opportunities and that its absorption of other countries' savings testifies to its own strong economy. Thus, capital inflow into the U.S. is considered demand-induced. Therefore, contrary to that witnessed in developing countries, the current account of the U.S. represents a leading force, whereby, the financial account serves to finance the current account.
Whether the financial account causes the current account or vice-versa remains a moot point. In this paper, we try to determine that capital mobility mostly serves to finance the current account in developed countries, but that this is not the case in developing countries. Using the Granger causality test, we find that, after capital mobility is liberalized, the financial account Granger-causes the current account in developing countries, but that the reverse is true in developed countries. For developing countries, it is more likely that capital mobility propels the current account to an imbalance, which might well result from the absence of a sophisticated financial system to channel the funds to a proper location in developing countries. (5)
The paper is organized as follows. The next section explains the causal relationship between the current account and financial account and shows the testing strategy. The following section presents the empirical results, while the last section concludes.
Causal Relationship Between the Current Account and Financial Account
BOP Accounting and the Causality
A balance of payment (BOP) accounting can be expressed as follows:
CA + FA + RES = 0. (1)
This equation simply states that the sum of the current account (CA), the financial account (FA), and the official settlements account (RES) must equal zero. (6) Given that RES is zero, countries with a CA deficit (surplus) must have an FA surplus (deficit), or net capital inflow (outflow) to ensure the BOP accounting is balanced. (7) Equation (1), however, is an accounting identity, and it is possible that FA balances CA, or vice versa. Clearly, economic theory is required to expound upon the causal relationship between the current account and financial account.
Using panel data of 58 developing countries for the period 1978-95, Bosworth and Collins [1999] find that inflowing capital contributes to increasing domestic investment. Indeed, technology and management transfer from foreign countries are conductive to domestic investment. In addition, with inflowing capital, the borrowing constraint is released, consumption increases, and national savings decrease. Both increasing investment and decreasing national savings reduce the current account, as exemplified in the case of the crisis-affected Asian countries. On the other hand, capital inflow could well be prompted by domestic demand. For example, the high profit opportunity in the U.S. during the 1990s induced capital inflow to finance domestic investment. Bear in mind, however, that a country with a current account surplus is also required to balance its BOP transactions by buying foreign assets either through the private sector or the central bank, much like that which took place in Japan in the 1980s. Cases from the U.S. and Japan indicate that the current account could lead the financial account in...
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