External Debts and Current Account Adjustments

Abstract

We empirically investigate the effect of net external debt positions on the size of medium-term current account balances. We utilize an approach where net external debt positions dampen the widening of the current account balances. In a simple accounting framework, we find supportive evidence of the adjustment role of the net external debt positions on the current account balances. Our findings show that net external debt holdings affect current account imbalances through their effect on private consumption. Government expenditure and Domestic Investment, on the other hand, are not negatively affected by net external debt holdings. We show that, on average, developing countries in the sample would have run 2.703 percentage point wider current account deficit in the absence of the negative impact of net external debts. Net external debt positions, therefore, reduce the dispersions of current account imbalances, thus, increase the correlation of investment and saving ratios.