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An assertion among many academic and applied economists is that flexible exchange rate regimes facilitate current account adjustment. Indeed, this view is so widespread that policy recommendations aimed at reducing global current account imbalances typically focus on reform of exchange rate regimes in emerging market economies. But recent empirical evidence casts doubt on this idea (Chinn and Wei 2013). In this chapter we explore the role of domestic financial repression/liberalization as an alternative determinant of current account adjustment. Previous work focused on the relationship between domestic financial liberalization and savings decisions in the closed economy (see Bayoumi 1993b; Bayoumi and Koujianou 1989; Japelli and Pagano 1994; Bandiera et al. 2000, among others). But the impact of financial liberalization on the relationship between domestic shocks and the current account is not well understood. This chapter aims to fill that gap. We first examine the effect of financial repression, modeled in the form of liquidity constraints, in the standard intertemporal model of the current account. This theory suggests that the size impact of log-level/difference net output shocks on, as well as the persistence response of, the current account varies with the degree of financial repression. These predictions are tested with a panel VAR model, where the coefficients are allowed to vary with the degree of financial repression, capital account openness, the exchange rate regime, trade openness, and financial development. To provide a credible test of our proposed hypothesis, we introduce a Bayesian approach to estimate this type of interacted panel VAR model, which allows for both dynamic heterogeneity (Pesaran and Smith 1995) and cross-sectional dependence (Pesaran 2006), two important econometric issues that most previous applied work in development and international economics has not addressed.
The extent to which financial repression/liberalization amplifies or dampens the impact of domestic shocks on the current account is an important issue for both academic economists and policymakers. For instance, Borio and Disyatat (2011) claim that the international monetary and financial system suffers from excessive ‘elasticity’ (the authors trace this idea back to as early as Jevons 1875), defined as “the degree to which extent monetary and financial regimes constrain the credit creation process, and external funding more generally”. They hypothesize that an increase in the elasticity of the financial system over time, as a result of financial liberalization for instance, led to greater domestic and external imbalances. Indeed, the data suggest that the increase in the absolute size of current account imbalances (Fig. 8.1) and their persistence (Fig. 8.2) emerged against the backdrop of financial liberalization in both OECD and emerging market countries (Fig. 8.3; we define persistence as the AR(1) coefficient from an autoregressive panel data model, estimated with country fixed effects, of the current account to GDP ratio), providing informal support for the ‘excess elasticity’ hypothesis. To our knowledge, however, no previous work has rigorously tested if, and to what extent, the size of the current account response depends upon the degree of financial repression/liberalization. In this chapter, we take a step towards filling this gap. In particular, we provide the first empirical evidence that, for a given set of net output shocks, the current account response is larger and more persistent in a country with a low, than in one with a high, degree of financial repression.
In the first part of this chapter, we derive robust identification restrictions and theoretical predictions from the intertemporal model of the current account (Sachs 1981). Recent work has shown that this approach can explain current account movements well, as long as either external habit formation (Bussiere et al. 2006), internal habit formation (Gruber 2004)
Fig. 8.1 Size of current account imbalances (in percent of world GDP). Source: IMF WEO
Fig. 8.2 Financial deregulation index. Source: Abiad et al. (2010)
Fig. 8.3 Current account/GDP persistence over time. Source: IMF WEO and staff calculations
or a stochastic world real interest rate (Bergin and Sheffrin 2000) is introduced to match the persistence of the current account typically observed in the data. We show that our identification restrictions are robust to any of these assumptions. Following previous theoretical and empirical work on long-run economic growth, savings, and consumption, we also introduce a liquidity constraint into this model and interpret it as a reflection of the degree of financial repression. This simple theory predicts that a given net output shock will have a larger and more persistent effect on the current account balance if agents are less liquidity constrained (the economy is less financially repressed). The underlying intuition is simple: the current account reflects agents’ savings decisions in response to net output shocks. In a repressed (liberalized) financial system, few (many) agents have access to borrowing and saving and the current account will therefore show a smaller (greater) reaction to domestic shocks.
In the second part of the chapter, we take our theory to the data. The theoretical model implies a VAR data-generating process that consists of real per capita net output growth and the current account to net output ratio. These theoretical VAR coefficients, that is the effect of a net output shock on the current account balance, depend on the degree of liquidity constraints/financial repression. We therefore allow the structural VAR coefficients of our empirical model to vary with the degree of financial repression and capital account openness, an independent determinant of liquidity constraints (Lewis 1997). To avoid omitted variable bias, we also introduce trade openness, the exchange rate regime and financial development as additional determinants of the VAR coefficients. Previous work on annual data estimates, such as interacted panel VAR models (see, for instance, Broda 2004; Raddatz 2007; or Towbin and Weber 2013) by pooling the data. If this assumption is violated, the estimated coefficients will suffer from dynamic heterogeneity bias. Given the predictions on the persistence response of the current account, our empirical model needs to address this problem to provide a credible test of the theory. A separate issue is the maintained assumption of cross-sectional independence in previous work, meaning that shocks should not spill over across countries for the inference to be valid (Pesaran 2006). Since our aim is to identify shocks of domestic origin, our empirical model needs also to account for this second potential source of econometric bias. We propose a Bayesian approach that addresses both of these issues and use this novel method to estimate our model on an unbalanced panel of annual data across 79 countries over the period 1973-2005. We use the de jure financial liberalization indices provided in Abiad et al. (2010) to proxy for financial liberalization/repression. Our underlying theory also provides robust identification restrictions which naturally translate into sign restrictions of the type first introduced in Canova and De Nicolo (2002), Faust and Rogers (2003) and Uhlig (2005). We use these restrictions to identify a log-level and log-difference net output shock and compare the associated current account to net output impulse response under regimes of low and high financial repression. Our results confirm that the impact of either a log-level or log-difference net output shock on the current account differs across low- and high-repression regimes in a statistically significant way. The response of the current account is approximately 80 percent larger, as well as more persistent, in the average financially liberalized country than in the average financially repressed country. This implies that the degree of financial repression/liberalization is an important determinant of current account adjustment. To our knowledge, this insight is not part of the current monetary and financial reform debate, but it could have potentially important implications for the adjustment of global imbalances.
This chapter contributes to the existing literature in a number of ways. We provide the first empirical investigation of the interaction between financial repression and the current account, expanding upon existing empirical work that examines the relationship between financial liberalization and savings decisions in the closed economy (see Bayoumi 1993b; Bayoumi and Koujianou 1989; Jappelli and Pagano 1994; Bandiera et al. 2000, among others). Second, we work with a broad sample of countries for the standards of previous papers that study the effect of domestic financial liberalization on savings decisions, being the first to apply the sign restriction methodology to test the predictions of this type of model. Finally, we propose a new econometric method to estimate interacted panel VAR models that addresses two important sources of econometric bias which previous empirical work in development economics has ignored. From a policy perspective, this chapter highlights the i nterconnection between two hotly debated issues following the global financial crisis of 2008: global imbalances and financial regulation. These issues are generally treated separately in policy circles but this chapter shows that changes in the regulatory landscape may affect the nature of global imbalances going forwards.
The rest of this chapter proceeds as follows. Section 8.2 lays out the theoretical model and derives theoretically robust identification restrictions and predictions. Section 8.3 discusses the empirical specification and the data used. Section 8.4 presents the results and Sect. 8.5 summarises and concludes, highlighting the policy implications of the chapter.