Insights on how global current account imbalances might be resolved
In my last post, I recounted the results of several papers presented at a conference held last week at UW Madison. The conference is part of a long term project on current account sustainability in major advanced economies; the conference was sponsored by the University of Wisconsin Center for World Affairs and the Global Economy (along with the Robert M. La Follette School of Public Affairs, the Economics Department, and EU Center)
As I mentioned before, we will be posting a set of proceedings from the conference (including abstracts, discussants’ comments, and general discussion), but in the meantime, I thought it would be interesting to highlight the main points of the papers. About half of the papers can be thought of as focusing on the determinants of current account imbalances, while the other half focus on the manner in which adjustment will take place. In the last post, I recounted the main points of the the first set of papers; today, I’ll cover the remainder. I want to stress that these are the views of the authors, rather than mine (or for that matter, of their respective institutions).
“Three Current Account Balances: A ‘Semi-Structuralist’ Interpretation,” co-authored by Menzie Chinn and Jaewoo Lee:
Three large current account imbalances — one deficit (the United States) and two surpluses (Japan and the Euro area) — are subjected to a minimalist structural interpretation. Though simple, this interpretation enables us to assess how much of each of the imbalances require a real exchange rate adjustment. According to the estimates, a large part of the U.S. current account deficit (nearly 2 percentage points of the 2004 deficit of 5.5 percent of GDP) will undergo an adjustment process that involves real depreciation in its exchange rate. For Japan, a little more than 1 percentage point (of GDP) of the current account surplus is found to require an exchange rate movement (real appreciation) as the surpluses adjust down. For the Euro area, less than half a percentage point of its current account surplus is found to require an adjustment via real appreciation.
“Trade Adjustment and the Composition of Trade,” co-authored by Christopher Erceg, Luca Guerrieri and Christopher Gust:
A striking feature of U.S. trade is that both imports and exports are heavily concentrated in capital goods and consumer durables. However, most open economy general equilibrium models ignore the marked divergence between the composition of trade flows and the sectoral composition of U.S. expenditure, and simply posit import and exports
as depending on an aggregate measure of real activity (such as domestic absorption). In this paper, we use a SDGE model (SIGMA) to show that taking account of the expenditure composition of U.S. trade in an empirically-realistic way yields implications for the
responses of trade to shocks that are markedly different from those of a “standard” framework that abstracts from such compositional differences. Overall, our analysis suggests that investment shocks, originating from either foreign or domestic sources, may serve as
an important catalyst for trade adjustment, while implying a minimal depreciation of the real exchange rate.
“Could Capital Gains Smooth a Current Account Rebalancing?” co-authored by Michele Cavallo and Cedric Tille:
A narrowing of the U.S. current account deficit through exchange
rate movements is likely to entail a substantial depreciation of the dollar, as stressed in the widely-cited contribution by Obstfeld and Rogoff (2005). We assess how the adjustment is affected by the high degree of international financial integration in the world economy. A growing body of research stresses the increasing leverage in international financial positions, with industrialized economies holding substantial and growing financial claims on each other. Exchange rate movements then leads to valuations effects as the currency compositions of a country’s assets and liabilities are not matched. In particular, a dollar depreciation generates valuation gains for the U.S. by boosting the dollar value of the large amount of its foreign-currency denominated assets. We consider an adjustment scenario in which the U.S. net external debt is held constant. The key finding is that while the current account moves into balance, the pace of adjustment is smooth. Intuitively, the valuation gains stemming from the depreciation of the dollar allow the U.S. to finance ongoing, albeit shrinking, current account deficits. We find that the smooth pattern of adjustment is robust to alternative
scenarios, although the ultimate movements in exchange rates are
“The Valuation Channel of External Adjustment,” co-authored by Fabio Ghironi, Jaewoo Lee and Alessandro Rebucci:
Ongoing financial integration across countries has greatly increased two-way foreign asset holdings, enhancing the scope for a “valuation channel” of external adjustment (i.e., the changes in a country’s net foreign asset position due to exchange rate and asset price changes). We examine this channel of adjustment in a dynamic stochastic general equilibrium model with international equity trading. We find that two-way foreign asset holdings are necessary for the emergence of a valuation channel. Its quantitative importance depends on features of the international transmission mechanism such as the size of financial frictions, substitutability across goods, and the persistence of shocks. We also find that the model can replicate key
moments of changes in the U.S. net foreign asset position.
These papers do not in general say much directly about the difficulties that might occur in adjusting to smaller imbalances. The Chinn and Lee paper indicates that over time, about two percentage points of the U.S. current account deficit will disappear, accompanied by dollar depreciation. Over a longer horizon, the current account will tend to stabilize at 3 percent of GDP, if historical correlations persist. The Erceg, Guerrieri and Gust paper does suggest that adjustment to a smaller U.S. current account deficit might be easier if the accelerated growth abroad is based on investment, rather than consumption, expenditures.
One other paper does not directly relate to the adjustment process, but documents the trajectories of net international investment positions, and the degree of international financial integration over time. “The External Wealth of Nations Mark II: Revised and Extended Estimates of Foreign Assets and Liabilities, 1970-2004,” by Philip R. Lane and Gian Maria Milesi-Ferretti:
We construct estimates of external assets and liabilities for 145 countries for the period 1970-2004. We describe our estimation methods and present key features of the data at the country and the global level. We focus on trends in net and gross external positions, and the composition of international portfolios, distinguishing between foreign direct investment, portfolio equity investment, official reserves, and external debt. We document the increasing
importance of equity financing and the improvement in the external position for emerging markets, and the differing pace of financial integration between advanced and developing economies. We also show the existence of a global discrepancy between estimated foreign
assets and liabilities, and identify the asset categories that account for this discrepancy.