Lessons from Recent Crises: What Are the Causes and Consequences of Sharp Falls in Current Account Deficits?

• Pages: 62-63

Page 62

Persistent current account deficits need to be reversed to stabilize the ratio of external liabilities to GDP.

The collapse of the Mexican peso at the end of 1994 and, more recently, the balance of payments crises in Thailand, Korea, and Indonesia have shown the dangers of sudden changes in the direction of international capital flows after a period of large current account deficits. Such changes can force governments to adopt costly contractionary adjustment measures to reduce external imbalances and meet external obligations. Indeed, external crises often feature large depreciations followed by a reduction in current account deficits-that is, reversals in current account imbalances. What triggers such reversals, and what factors explain their cost? Are persistent current account deficits likely to end up in a crisis, or can they be reversed without large output costs? In a new study, Sharp Reductions in Current

Account Deficits: An Empirical Analysis, Gian Maria Milesi-Ferretti of the IMF's Research Department and Assaf Razin of Tel Aviv University examine these issues, basing their analysis on the experience of 86 low- and middle-income countries during 1971-92.

External Sustainability and Reversals

Persistent current account deficits need eventually to be reversed in order to stabilize or reduce the ratio of external liabilities to GDP. This, in turn, requires a trade surplus, assuming that the country's real interest rate exceeds its economic growth rate. As such, the larger the external liabilities, the greater the necessary reversal will be. From the standpoint of interest rates, a reversal can, on the one hand, be thought of as lowering the risk premium on external debt, thereby reducing the actual size of the necessary turnaround in the trade balance. On the other hand, the need for a turnaround may also arise because of an increase in world interest rates, in which case the interest differential would raise the size of the necessary reversal.

A sharp reduction in a country's external deficits may result from a change in macroeconomic policy- for example, the introduction of a stabilization plan- or it can be forced upon a country by external developments, such as a sudden capital outflow. A country's ability to sustain prolonged imbalances...