Effective Exchange Rates, Current Accounts and Global Imbalances

• Published date: 01 August 2017
• Author: Robert Czudaj,Joscha Beckmann
• DOI: http://doi.org/10.1111/roie.12272
• Date: 01 August 2017

Effective Exchange Rates, Current Accounts and

Global Imbalances

Joscha Beckmann and Robert Czudaj*

Abstract

This study analyzes the dynamics between real effective exchange rates and current accounts from a novel

perspective. We start by dissecting long-run and time-varying short-run dynamics as well as causalities

between both variables. Following this, we extend our framework by including short-term interest rates.

Finally, we examine common exchange rate and current account dynamics across countries based on com-

mon factors. Our results show that a real appreciation coincides with a worsening of the current account in

most cases. The adjustment pattern is time varying but suggests thatthe causality mainly runs from effective

exchange rates to current accounts. However, an extension of our framework based on monthly data shows

that trade balance adjustment is observed less frequently, suggestingthat valuation effects play an important

role for the relationship between current accounts and exchange rates. From a global point of view, cross-

country trends that drive exchange rates and current accounts also share similar dynamics over the long

run, which is an importantfinding in the context of global imbalances.

1. Introduction

Current account imbalances are a key feature of the current international monetary

system and have triggered controversial discussions among policymakers and econo-

mists in recent times. This is true not only for the origins and consequences but also

for any potential mechanisms to reverse sustainable current account deficit or sur-

pluses. Even the importance of the exchange rate as possibly the most intuitive adjust-

ment tool is still subject to controversy.

1

For instance, the idea that a flexible exchange

rate regime generally facilitates current account adjustment has yet to be convincingly

demonstrated (Chinn and Wei, 2013). A re-acquisition aimed at generating an impact

of exchange rate changes on the current account via trade effects is an exporters’

producer-currency pricing strategy (Campa and Goldberg, 2005). However, such a

pass-through is frequently found to be incomplete owing to local-currency pricing and

heterogeneity across sector firms and exporters (Berman et al., 2012; Brun-Aguerre

et al., 2012; Auer and Schoenle, 2016). Against this background, the overall empirical

link between exchange rates and current accounts is far from unambiguous.

* Beckmann: Macroeconomics, Department of Economics, University of Duisburg-Essen, D-45117,

Essen, Germany. Tel: 149-201-183-3215. Fax: 149-201-183-4181. E-mail: joscha.beckmann@uni-due.de.

Also affiliated to Ruhr University of Bochum, Germany and Kiel Institute for the World Economy,

Germany. Czudaj: Chemnitz University of Technology, Germany. Also affiliated to Department of

Economics, University of Duisburg-Essen, Germany and FOM Hochschule f€

ur Oekonomie &

Management, University of Applied Sciences, Essen, Germany. Thanks for valuable comments are due

to two anonymous reviewers and the associate editor Raphael Auer as well as Takuma Kunieda, Joshua

Aizenman, Yin-Wong Cheung, Soyoung Kim, Pietro Cova, Jeffrey Sheen, Davide Romelli and the par-

ticipants of the EEA-ESEM 2014 at Toulouse School of Economics, the annual meeting of the German

Economic Association at University of Hamburg, the “International Conference on Pacific Rim Econo-

mies and the Evolution of the International Monetary Architecture” at City University of Hong Kong,

as well as the INFINITI Conference on International Finance at Monash University Prato Centre, Italy.

Robert Czudaj also gratefully acknowledges the support of MERCUR through project An-2014-0004.

V

C2016 John Wiley & Sons Ltd

Review of International Economics, 25(3), 500–533, 2017

DOI:10.1111/roie.12272

This paper offers a comprehensive and novel analysis of the relationship between

effective exchange rates and current accounts. We undertake several steps to clarify

the issue of causality, both for a broad number of single countries and from a global

perspective. More precisely, we make three key contributions: first, we dissect long-

run and short-run relationships between real effective exchange rates and current

accounts for eleven major economies. In doing so, we make use of monthly and quar-

terly data for both the current account relative to gross domestic product (GDP) and

the real trade balance. This procedure provides an implicit robustness check for our

results and a direct evaluation of the impact of exchange rate changes via the trade

channel.

2

Our second contribution stems from the consideration of time-varying short-run

dynamics, which are related to disequilibria from the underlying long-run relation-

ships. Such a framework has turned out to be useful for examining exchange rate

dynamics since it allows for the existence of a stable relationship between current

accounts and exchange rates while causality is allowed to change over time (Sarno

et al., 2004; Sarno and Valente, 2006). The degree and character of the current account

or trade balance adjustment allows an evaluation of the exchange rate channel for the

correction of global imbalances. Leaving the country dimension, our third contribution

stems from focusing on the question of whether effective exchange rates and current

accounts or trade balances share similar dynamics across countries. This issue has not

been explicitly considered in previous studies although it is important when it comes

to (global) policy recommendations regarding global imbalances and the role of the

exchange rate. Similar to the country level, we also examine long-run and time-

varying short-run dynamics for our global factor model. As will be shown our results

indicate that a real effective depreciation coincides with a worsening of the current

account relative to GDP for most economies under observation. We also find that the

effects are significantly weaker for the trade balance in most cases, suggesting that the

trade channel is not able to explain completely the result obtained.

When discussing the links between exchange rates and current accounts, a distinc-

tion between positive understanding and normative evaluation is necessary (Interna-

tional Monetary Fund (IMF), 2013). In this paper, we are neither interested in

calculating a “fair” exchange rate, which is designed to “correct” global imbalances

nor are we aiming at providing a general answer to the question of whether effective

exchange rates should adjust or not. Conducting a positive rather than a normative

approach, our key questions are: if, to what extent and during which times current

accounts (relative to the GDP) and/or trade balances have been linked to effective

exchange rates in the past. Our paper is therefore in line with several studies focusing

on the relationship between exchange rates and current accounts from different per-

spectives (Lee and Chinn, 2006; Chinn and Lee, 2009; Chinn and Wei, 2013;

Shibamoto and Kitano, 2012). We suggest an error correction model with Markovian

shifts to model the relationship between current accounts and exchange rates as a key

difference to the existing empirical literature, which is notably silent regarding nonli-

nearities in this relationship although previous studies have provided broad evidence

in favor of nonlinear exchange rate dynamics.

The remainder of this paper is organized as follows. The following section discusses

the motivation for our analysis from several perspectives: after a brief recap of the the-

oretical background, we categorize and summarize previous empirical findings and jus-

tify our own empirical approach. Section 3 provides our dataset, a detailed description

of our empirical approach and a discussion of our findings. In the empirical part of the

paper we start with an analysis of the relationship between current accounts and

EXCHANGE RATES AND GLOBAL IMBALANCES 501

V

C2016 John Wiley & Sons Ltd

exchange rates for eleven major economies. To this end, we apply a Markov-switching

vector error correction model (MS-VECM), which is well suited for this purpose, con-

sidering that the relationship between effective exchange rates and current accounts is

potentially time varying and not necessarily clear cut. After testing for the long-run

relationship, a consideration of a time-varying adjustment mechanism allows us to

look at time-varying causality patterns. As a next step, we analyze the common

exchange rate and current account dynamics on a global level based on common fac-

tors derived from a principal component analysis (PCA). We then turn to the relation-

ship between those common factors according to our MS-VECM. As an extension and

robustness check, we then re-run our analysis for a broader model at a monthly fre-

quency including industrial production and short-term interest rates. This step also

contains a study of long-run impacts of shocks between the variables and therefore

allows for a direct assessment of the trade channel for exchange rate effects. Figure 1

presents an overview of our modeling cycle.

3

Finally, we discuss the implications of

our results for the reduction of global imbalances through changes in exchange rates.

Section 4 concludes.

2. Effective Exchange Rates and the Current Account: Background,

Previous Studies and Methodological Issues

Background and Previous Studies

This section starts with a brief reconsideration of theoretical and empirical linkages

between effective exchange rates and current accounts. Our empirical framework

allows for the possibility that causalities in terms of (time-varying) adjustment to long-

run disequilibria go into both directions. We therefore elaborate on both possibilities

and also include studies that deal with the role of exchange rate adjustment for restor-

ing global imbalances.

To explain a potential causality running from effective exchange rates

4

to current

accounts, consider the following simplified model equation introduced by Milesi-

Ferretti (2008). The current account is expressed as the sum of trade balance tb

t

,net

exports of services nse

t

, net receipts from interest, dividends and profits nir

t

and net

unilateral receipts nur

t

cat5tbt1nset1nirt1nurt:(1)

If we disregard net exports of services and net unilateral receipts, the current account

can be written as the sum of trade balance and net investment income, which is driven

by the interest rate differential between interest on domestic assets aand loans l

(Milesi-Ferretti, 2008).

5

cat5tbt1ira

tat212irl

tlt21:(2)

The change in the net foreign asset position Dbtis given by the sum of the current

account ca

t

, the capital gain or loss on the net foreign asset position kg

t

,capital

account transfers and measurement errors v

t

Dbt5bt2b1215cat1kgt1vt:(3)

Based on these definitions, an impact of the exchange rate on the evolution of the

current account and the net foreign asset position can work through a trade

502 Joscha Beckmann and Robert Czudaj

V

C2016 John Wiley & Sons Ltd