Current Account Reversals Research Articles

Inequality and Asset Prices during Sudden Stops

This paper studies the cross-sectional dimension of Fisher’s debt-deflation mechanism that triggers Sudden Stop crises. Analyzing microdata from Mexico, we show that this dimension has macroeconomic implications that operate via opposing effects. We propose a small open economy, asset-pricing model with heterogeneous-agents and aggregate risk to measure the effects of inequality during crises. In contrast to a representative-agent model, heterogeneity generates persistent current account reversals with smaller drops in asset prices and larger drops in consumption driven by the leveraged households. Moreover, in a lower inequality calibration, we find that crises are less severe, as observed in the data.

Persistent external deficits and balance of payments crises

Persistent external deficits are a recurrent phenomena in low and middle income countries. We define a new empirical measure to study balance of payment crises related to the accumulation of persistent external deficits. Using a non-parametric difference-in-differences estimator we estimate a critical value for the accumulated current account deficits associated with a crisis. Countries that have increased their net external indebtedness by an accumulated amount of at least 26%–31% of the GDP in a time span of 3 to 5 years are more vulnerable to suffer a crisis, which includes a consumption fall of 3.1% and a current account reversal of 4.9 percentage points of GDP. These crises are far more severe than an average sudden stop. Thus, our empirical results suggest that fast accumulation of external debt though current account deficits is related to severe crises.

Non-homothetic sudden stops

The expenditure elasticity of the demand for nontradable goods is higher than the one for tradable goods. We extend the small open economy model of Sudden Stops of Bianchi (2011) allowing for non-homothetic preferences to generate this difference. Analytic results for an endowment economy show that, during crises, the non-homotheticity amplifies the decrease in the demand for the nontradable good, triggering a sharper deflation spiral that ultimately leads to a more severe current account reversal. The amplified pecuniary externality calls for more aggressive debt taxes. An extended version of the model with production and permanent productivity shocks shows that non-homothetic preferences can also amplify the credit booms that precede Sudden Stops. The amplification is particularly large when the consumption boom is biased toward nontradable goods. Macroprudential policy shows, not only quantitative, but also qualitative differences in its reaction to shocks under preference non homotheticity.

Monetary unions, external shocks and economic performance: a Latin American perspective

During the last few years there has been a renewed analysis in currency unions as a form of monetary arrangement. This new interest has been largely triggered by the Euro experience. Scholars and policy makers have asked about the optimal number of currencies in the world economy. They have analyzed whether different countries satisfy the traditional “optimal currency area” criteria. These include: (a) the synchronization of the business cycle; (b) the degree of factor mobility; and (c) the extent of trade and financial integration. In this paper I analyze the desirability of a monetary union from a Latin American perspective. First, I review the existing literature on the subject. Second, I use a large data set to analyze the evidence on economic performance in currency union countries. I investigate these countries’ performance on four dimensions: (a) whether countries without a national currency have a lower occurrence of “sudden stop” episodes; (b) whether they have a lower occurrence of “current account reversal” episodes; (c) what is their ability to absorb international terms of trade shocks; and (d) what is their ability to absorb “sudden stops” and “current account reversals” shocks. I find that belonging to a currency union does not lower the probability of facing a sudden stop or a current account reversal. I also find that external shocks are amplified in currency union countries. The degree of amplification is particularly large when compared to flexible exchange rate countries.

Euro area current account imbalances: A tale of two financial liberalizations

This paper explores the extent to financial liberalization in the euro area had a differential impact on members’ current account positions. Theoretically, it builds on an inter-temporal consumption model augmented with household heterogeneity. Low/middle income groups are impatient and constrained, whilst high-income groups are patient and under no constraint. Increased access to international credit in previously financially repressed countries implies a relaxation of collateral constraints specifically for the (low-skilled) low/middle-income group, who differently from high-income agents borrows to finance current consumption. It follows that financial liberalization is associated with deteriorating external positions there where initial levels of financial openness are lowest and the share of the (low-skilled) low/middle-income group with potentially binding collateral constraints largest. The same approach is useful to understand asymmetric current account reversals, which relates to suddenly biting collateral constraints in indebted peripheral countries, where the Great Recession hit disproportionally the low-skilled.

A Fisherian approach to financial crises: Lessons from the Sudden Stops literature

Sudden Stops are financial crises defined by a large, sudden current-account reversal. They occur in both advanced and emerging economies and result in deep recessions, collapsing asset prices, and real exchange-rate depreciations. They are preceded by economic expansions, current-account deficits, credit booms, and appreciated asset prices and real exchange rates. Fisherian models (i.e. models with credit constraints linked to market prices) explain these stylized facts as an outcome of Irving Fisher's debt-deflation mechanism. On the normative side, these models feature a pecuniary externality that provides a foundation for macroprudential policy (MPP). We review the stylized facts of Sudden Stops, the evidence on MPP use and effectiveness, and the findings of the literature on Fisherian models. Quantitatively, Fisherian amplification is strong and optimal MPP reduces sharply the size and frequency of crises, but it is also complex and potentially time-inconsistent, and simple MPP rules are less effective. We also provide a new MPP analysis incorporating investment. Using a constant debt-tax policy, we construct a crisis probability-output frontier showing that there is a tradeoff between financial stability and long-run output (i.e., reducing the probability of crises reduces long-run output).

Household heterogeneity and the transmission of foreign shocks

We study the role of heterogeneity in the transmission of foreign shocks. We build a Heterogeneous-Agent New-Keynesian Small Open Model Economy (HANKSOME) that experiences a current account reversal. Households' portfolio composition and the extent of foreign currency borrowing are key determinants of the magnitude of the contraction in consumption associated with a sudden stop in capital inflows. The contraction is more severe when households are leveraged and owe debt in foreign currency. In this setting, the revaluation of foreign debt causes a larger contraction in aggregate consumption when debt and leverage are concentrated among poorer households. Closing the output gap via an exchange-rate devaluation may therefore be detrimental to household welfare due to the heterogeneous impact of the foreign debt revaluation. Our HANKSOME framework can rationalize the observed “fear of floating” in emerging market economies, even in the absence of contractionary devaluations.

Non-Homothetic Sudden Stops

Financial crises preceded by nontradable consumption booms are characterized by sharper real exchange rate depreciation and deeper economic contractions. We show that a small open economy model of Sudden Stops under non-homothetic preferences can rationalize the danger of credit-fueled nontradable booms. Nontradable goods are more income-elastic than tradable goods. Thus, when a credit boom leads to a Sudden Stop, the demand for nontradable goods contracts violently and proportionately more than under homothetic preferences, causing a larger depreciation that further decreases the collateral value amplifying the current account reversal by 24%. The amplified pecuniary externality calls for 15% more aggressive debt taxes and increases the welfare gains from simple rules.

A Fisherian Approach to Financial Crises: Lessons from the Sudden Stops Literature

Sudden Stops are financial crises defined by a large, sudden current-account reversal. They occur in both advanced and emerging economies and result in deep recessions, collapsing asset prices, and real exchange-rate depreciations. They are preceded by economic expansions, current-account deficits, credit booms, and appreciated asset prices and real exchange rates. Fisherian models (i.e. models with credit constraints linked to market prices) explain these stylized facts as an outcome of Irving Fisher's debt-deflation mechanism. On the normative side, these models feature a pecuniary externality that provides a foundation for macroprudential policy (MPP). We review the stylized facts of Sudden Stops, the evidence on MPP use and effectiveness, and the findings of the literature on Fisherian models. Quantitatively, Fisherian amplification is strong and optimal MPP reduces sharply the size and frequency of crises, but it is also complex and potentially time-inconsistent, and simple MPP rules are less effective. We also provide a new MPP analysis incorporating investment. Using a constant debt-tax policy, we construct a crisis probability-output frontier showing that there is a tradeoff between financial stability and long-run output (i.e., reducing the probability of crises reduces long-run output). Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Trend shocks and sudden stops

Sudden Stops are characterized by large output drops, current account reversals and real exchange rate depreciation followed by a slow recovery, a pattern that has proven to be hard to capture with standard open economy models. This paper extends the standard models with endogenous collateral constraints to include permanent income (trend) shocks and studies the optimal policy design in this setting. We find that shocks to the trend play an important role in generating a Sudden Stop followed by a slow recovery, a result that is also supported by the data. With trend and transitory shocks, optimal capital control policy is procyclical, although less so than under transitory shocks only.

Household Heterogeneity and the Transmission of Foreign Shocks

We study the role of heterogeneity in the transmission of foreign shocks. We build a Heterogeneous-Agent New-Keynesian Small Open Model Economy (HANKSOME) that experiences a current account reversal. Households' portfolio composition and the extent of foreign currency borrowing are key determinants of the magnitude of the contraction in consumption associated with a sudden stop in capital inflows. The contraction is more severe when households are leveraged and owe debt in foreign currency. In this setting, the revaluation of foreign debt causes a larger contraction in aggregate consumption when debt and leverage are concentrated among poorer households. Closing the output gap via an exchange-rate devaluation may therefore be detrimental to household welfare due to the heterogeneous impact of the foreign debt revaluation. Our HANKSOME framework can rationalize the observed fear of floating in emerging market economies, even in the absence of contractionary devaluations.

When do fixed exchange rates work? Evidence from the Gold Standard

Current account reversals under the Gold Standard (1880–1913) – a fixed exchange rate regime – were accompanied by few, if any, output losses. To understand why, we build and estimate an open economy model of the Gold Standard, which allows us to quantitatively assess the importance of three channels of external adjustment: flexible prices, international migration, and monetary policy. Our first finding is that flexible prices were the most influential channel through which output was stabilized, whereas migration and monetary policy mattered little. Our second finding is that price flexibility was predicated on large primary sectors. Their flexibly priced products dominated the export booms that stabilized output during major external adjustments.

Adjustment to small, large, and sunspot shocks in open economies with stock collateral constraints

This paper characterizes analytically the adjustment of an open economy with a stock collateral constraint to fundamental and nonfundamental shocks. In the model, external borrowing is limited by the value of physical capital. Three results are established: (1) Adjustment to external shocks is nonlinear. In response to small negative output shocks, the economy adjusts as prescribed by the intertemporal approach to the current account, with increases in debt, deficits in the trade and current account balances, and no significant movement in the price of collateral. By contrast, in response to large negative output shocks the economy experiences a sudden stop with debt deleveraging, trade and current account reversals, and a Fisherian deflation of asset prices. (2) Generically, weak fundamentals (low output and high external debt) give rise to multiple equilibria. (3) In this case, the economy is prone to self-fulfilling sudden stops driven by downward revisions of expectations about the value of collateral.

Euro area macroeconomic imbalances and their asymmetric reversal: the link between financial integration and income inequality

This paper explores the impact of the Economic and Monetary Union (EMU) and the ensuing financial integration on Euro Area (EA) macroeconomic imbalances. It is found that EMU caused an exceptional deterioration of current account positions in relatively unequal EA countries more than in the others. The explanation provided is that the large increase in money supply following the abolition of capital controls in 1990, of exchange rate risks in 1999 and the parallel softening of domestic credit market regulation throughout the 1990s that lead to downwards interest rate convergence had the effect of relaxing collateral constraints specifically for lower-income households, whose share is found to rise with levels of income inequality. Optimistic expectations about future income led to over-borrowing by these groups. Consequently, current account reversal was asymmetric because the crisis forced indebted lower-income (unskilled) households to abruptly reduce consumption, as they were the first to be pulled out of the labour market and hardly had financial buffers. The hypothesis is tested using a difference-in-difference approach to panel data.

Probabilidad de corrección súbita de cuenta corriente para costa rica: un enfoque de análisis de supervivencia

Mediante un modelo de análisis de supervivencia con datos de panel, se realiza un análisis exploratorio para la estimación de la probabilidad de correcciones súbitas en la cuenta corriente costarricense. Los resultados obtenidos muestran que la probabilidad de reversión de cuenta corriente disminuye cuando: i) se incrementa el crecimiento real para los siguientes cinco años; ii) mejora la situación externa de países considerados similares; iii) aumenta la tasa de dependencia económica; iv) el porcentaje del PIB mundial con el que se han ratificado acuerdos comerciales se incrementa; v) la acumulación de reservas monetarias se acelera; y vi) el marco institucional se vuelve más democrático. Por otra parte, una mayor productividad total de los factores en los cinco años siguientes incrementa la probabilidad de reversión de cuenta corriente. El efecto del control de capitales sobre la probabilidad mostró un comportamiento ambiguo. El análisis se realiza para 116 países con datos anuales de 1981 a 2012.

Income Inequality and Macroeconomic Imbalances Under EMU

This paper explains the build-up and reversal of euro area macroeconomic imbalances by considering the interaction between the underlying income distribution in each country and EMU-induced financial liberalization. The argument is that the sharp increase in money supply since the early 1990s had the effect of relaxing collateral constraints for illiquid lower-income groups, whilst having no specific impact on other households. The former started over-borrowing against optimistic expectations about their future income. It follows that unequal countries such as Greece, Ireland, Italy, Portugal and Spain - where the share of lower-income groups is relatively high - had greater private debt burdens and worse external positions than equal countries. Consequently, current account reversal was asymmetric because the crisis forced these indebted households to abruptly reduce consumption not least because they were the first to be pulled out of the labour market and hardly had financial buffers. The hypothesis is tested using a difference-in-difference approach to panel data.

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

AbstractThis 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 reversals in 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.

Sudden stops and current account reversals: the euro area experience

Abstract The paper analyzes the impact of massive capital flows and possible sudden stops on current account reversals. The aim of this paper is to consider the relationship between sudden stops and current account reversals in the eurozone and to explain the possibility of a balance-of-payment crisis within a monetary union. Peripheral eurozone countries experienced significant private-capital inflows from the core countries, followed by unambiguously massive outflows. Due to this, peripheral countries ran sustained current account deficits while core countries ran surpluses. At the end we analyze the evolution of current-account balances in the non-euro area EU countries and the peripheral euro-area countries, and we find out that current account deficits could be maintained over a longer period of time in the peripheral euro-area countries.

The Adjustment of Current Account (Im-)Balances in Africa

Large current account imbalances are perceived to be a macroeconomic risk. Consequently a reversal (especially of a deficit) is often regarded as good in itself, and is frequently pursued as a policy objective or as part of reform programme. This perception is surprising in light of the intertemporal approach to the balance of payments, where international borrowing and lending - and therefore current account imbalances - result from rational economic decisions with a time dimension. But the theory does not settle the matter. Hence, this paper investigates the actual experience of current account reversals in Africa, the region where current account imbalances have been the largest (relative to GDP) in recent decades. We identify periods of current account reversal (both deficits and surpluses) and identify the associated development in real GDP growth, the real effective exchange rate, inflation, investment and aid inflows, both prior to and following the reversal. These results are compared with a control group. The results do not suggest that these reversals have been associated with either disruptive business cycle episodes or other macroeconomic risks in the sample group.

Sudden Stops and Current Account Reversals: Potential Macroeconomic Consequences for South Africa

AbstractSouth Africa is one of the emerging market countries that have received a relatively large amount of foreign capital since the mid‐2000s. In South Africa's case, these inflows were partly used to build the country's foreign exchange reserves, but more particularly to finance continued large current account deficits. During the course of the past two years, however, adverse domestic political developments, combined with the potential negative impacts of the unwinding of quantitative easing policies and the normalising of monetary policy in the United States on emerging markets in general, has raised the spectre of a sharp slowdown in foreign capital flows to South Africa and an associated reversal of the current deficit. This paper explores the potential impact of such a development on macroeconomic conditions in South Africa. The analysis consists of macroeconometric model‐based alternative scenarios backed up by both the international evidence on the impact of such events and South Africa's own history.