External adjustment and trading partners’ exchange rate regimes

Abstract

Large and persistent current account deficits or surpluses have generated a dispute about the effects of exchange rate regimes on current account adjustment. The previous studies focus on the role of a country's regime in correcting its current account imbalances. However, assessing the overall impact of an exchange rate regime requires consideration of the effects of both the home country's regime and its trading partners’ regimes. Thus, this paper estimates the effect of trading partners’ regimes on the speed of the home country's current account adjustment, using a mean-reversion current account model and data of 80 countries from 1980 to 2010. The results show that when a country trades more with countries under non-free-floating regimes, its current account adjustment as a whole becomes slower than under free-floating. The adjustment speed, however, does not increase monotonically with the flexibility of the partners’ regimes. There is also an asymmetry in the adjustment, that is, less flexible regimes decelerate the adjustment of a partner in deficit of the current account. These findings are robust even when using other exchange rate regime classifications or employing different samples.