Current Account Reversals in Industrial Countries: does the Exchange Rate Regime Matter?

• DOI: http://doi.org/10.1002/ijfe.1535
• Author: Christian Saborowski,Cosimo Pancaro
• Published date: 01 April 2016
• Date: 01 April 2016

INTERNATIONAL JOURNAL OF FINANCE AND ECONOMICS

Int. J. Fin. Econ.21: 107–130 (2016)

Published online 21 December 2015 in Wiley Online Library

(wileyonlinelibrary.com). DOI: 10.1002/ijfe.1535

CURRENT ACCOUNT REVERSALS IN INDUSTRIAL COUNTRIES: DOES

THE EXCHANGE RATE REGIME MATTER?

COSIMO PANCAROa;; andCHRISTIAN SABOROWSKIb

aEuropean Central Bank, Kaiserstrasse 29, D-60311 Frankfurtam Main, Germany

bInternational Monetary Fund, 700 19th Street, N.W.,Washington DC 20431, USA

ABSTRACT

This paper studies current account reversals in industrial countries across different exchange rate regimes. There are two major

findings which have important implications for industrial economies with external imbalances: first, triggers of current account

reversals differ between exchange rate regimes.While the current account deficit and the output gap are significant predictors of

reversals across all regimes, reserve coverage,credit booms, openness to trade and the US short term interest rate determine the

likelihood of reversals only under more rigid regimes.Conversely, the real exchange rate affects the probability of experiencing a

reversal only under flexible arrangements. Second, current account reversalsin advanced economies do not have an independent

effect on growth. This result holds not only for industrial economies in general but also for countries with fixed exchange rate

regimes in particular. Copyright © 2015 John Wiley& Sons, Ltd

Received 1 August 2013; Revised 13 August 2015; Accepted 9 September 2015

JEL CODE: F32; F41

KEY WORDS: Current account; reversals; exchange rate regime

1. INTRODUCTION

The years preceding the global crisis saw large and persistent current account imbalances, which peaked at some

3% of the global gross domestic product (GDP) in 2006 (IMF, 2012a). Commentators focused primarily on the

US deficit, but many other advanced economies including Australia, Greece, Ireland, New Zealand, Portugal and

Spain recorded large and persistent external deficits at that time. After the outbreak of the financial crisis, several

world economies experienced sizable current account corrections, yet the intense debate among academics and

policy-makers about the nature and the sustainability of global current account imbalances continues (Feldstein,

2008; Obstfeld, 2012; Serven and Nguyen, 2010).1While external positions can often be explained by economic

fundamentals such as demographics or expectations of productivity growth, the pronounced imbalances recorded

prior to the crisis reflected at least in part structural distortions such as unsustainable expansionary fiscal policies

and asset booms in major advanced economies. The perceived sustainability of these deficits determines whether

and how long they can be maintained and financed. Indeed, a current account deficit investors that are no longer

willing to finance will be forced to reverse partly or fully, often within a short period of time (Blanchard and Milesi

Ferretti, 2010; IMF, 2012a).

Sharp external adjustments that lead to a sustained current account improvement are commonly referred to

as current account reversals. Reversals have been analysed intensively in the literature, typically with a focus on

the channels through which they are achieved as well as on the question whether they have implications for real

economic performance. However, one aspect that has received only limited attention in the literature is the rela-

tionship between current account reversals and exchange rate regimes, an aspect that is especially timely with

Correspondence to: Cosimo Pancaro, European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany.

E-mail: Cosimo.Pancaro@ecb.int

We are solely responsible for anyerrors that remain in this paper. The findings, views and interpretations expressed in this paper are those of

the authors and should not be attributed to the ECB or IMF, ortheir Executive Boards, or their management.

Copyright © 2015 John Wiley & Sons, Ltd

108 C. PANCAROAND C. SABOROWSKI

regard to the existing external imbalances within the Euro area. To our knowledge, only Edwards (2004a,b),

De Haan et al. (2008), Gosh et al. (2010), Chinn and Wei (2013) and Lane and Milesi-Ferretti (2012) have dealt

with this important topic.2The present paper contributes to this strand of the literature by presenting a system-

atic analysis of current account reversals across different de-facto exchange rate regimes. In particular, it examines

whether current account reversals in industrial economies follow different patterns depending on the exchange rate

regime in place. Moreover, it identifies triggers of reversals and examines the link between reversals and growth

across different exchange rate regimes.

The study of Milesi-Ferretti and Razin (2000) is one of the first among a growing number of studies that explic-

itly analyses the triggers and patterns of current account reversals. The authors use a large panel of developing

countries to identify determinants of current account reversals. The evidence suggests that the current account bal-

ance itself, a country’s openness to trade, its terms of trade and reserve coverage as well as growth in industrial

economies and US interest rates are drivers of current account reversals in developing economies. Moreover, con-

ducting a before-after analysis, they do not find any evidence of a systematic relationship between current account

corrections and economic performance.

Freund (2005) was the first to systematically examine current account reversals in industrial economies.

Studying the patterns of macroeconomic variables during reversal episodes, she finds that reversals in industrial

economies are generally accompanied by a depreciation of the real exchange rate, a decline in GDP growth,

investment and imports, and a rise in exports. The current account deficit takes between 3 and 4 years to resolve.

Moreover, Freund (2005) shows that a larger current account deficit and weakening growth are significant predic-

tors of reversals. However, she does not condition the triggers of reversals directly on the exchange rate regime in

place. The work of De Haan et al. (2008) is the only study we are aware of that does take the role of exchange rate

regimes into account when analysing triggers of current account reversals in advanced economies. The authors find

that, under a peg and a moving band, a deeper current account deficit has less predictive power of current account

reversals than under a crawling peg. Conversely, a larger output gap has a lower predictive power under a moving

band than under a crawling peg. The authors do not, however, systematically distinguish groups of countries with

different exchange rate regimes as we do in this paper.

Croke et al. (2006) study the link between current account reversals and economic growth in industrial

economies. Their work tests the so-called ‘disorderly correction hypothesis’, which claims that current account

reversals lead to a disruptiveadjustment process that translates into a decline in growth. While some current account

reversals indeed coincide with growth declines, the authors do not find any supportive evidence for a causal link

between the reversal itself and the fall in growth.

Debelle and Galati (2007) come to the same conclusion.3However, the inability of these studies to identify a

link between reversals and growth may be due to the fact that they do not distinguish countries with fixed from

those with more flexible exchange rate regimes.

Indeed, Friedman (1953) already pointed out that flexible exchange rates allow a more orderly adjustment pro-

cess by functioning as external shock absorbers, that is, by providing a device for continuous adjustment and

guaranteeing full autonomy to domestic policy in the achievement of its targets. However, Chinn and Wei (2013)

study the relationship between the exchange rate regimes and the speed of current account adjustment and do not

find any evidence supporting the hypothesis that the current account reversion to its long run equilibrium is faster

under flexible exchange rate regimes. This result suggests that current account imbalances are not more persistent

under fixed exchange rates. Indeed, in principle, fixing the nominal exchange rate does not necessarily limit the

ability of the real exchange rate to adjust, given sufficient flexibility in prices and costs. However, in practice, both

prices and wages are relatively sticky compared with the nominal exchange rate. Thus, a fixedexchange rate regime

may imply that most of the adjustment burden has to be borne by changes in economic activity, potentially lead-

ing to a more pronounced slowdown. Indeed, Edwards (2004a,b) find in a sample of mainly developing economies

that current account reversals lead to lower GDP growth only under hard pegged and intermediate exchange rate

systems.

The analysis in the present paper focuses precisely on distinguishing rigid exchange rate regimes from those

that are more flexible when identifying triggers of reversals and when analysing the link between reversals and

growth. The paper proceeds as follows: we initially identify 43 episodes of current account reversalsin 22 industrial

economies between 1970 and 2007. The episodes are then grouped by exchange rate regime using the de-facto

Copyright © 2015 John Wiley & Sons, Ltd Int. J. Fin. Econ.21: 107–130 (2016)

DOI: 10.1002/ijfe