FRBSF Economic Letter
2006-29; October 27, 2006
What Are the Risks to the United States of a Current Account
Reversal?
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The U.S. current account has been in deficit since the beginning
of the 1980s, except for a brief period in 1991, and has grown
to 6.6% of gross domestic product (GDP) in the second quarter
of 2006. The growing deficit has clearly caught the attention
of policymakers and analysts. As Fed Chairman Bernanke put it
in a speech he gave while a Governor of the Federal Reserve Board, "the
current pattern of international capital flows—should it persist—could
prove counterproductive" (Bernanke 2005).
The current account measures the difference between domestic
income and expenditures, and it is the mirror image of the funding
needed to finance this difference. With the deficit in the current
account at historic highs, there is a perceived risk that it
could quickly reverse (become less negative) if, for any reason,
the United States should lose access to the financing that covers
the income-expenditures gap. For example, this could happen as
a result of a reduction in the demand for U.S. assets if foreign
central governments diversified their reserves.
Economic theory does not offer a robust prediction as to how
a current account reversal impacts economic growth, asset prices,
or the exchange rate. Indeed, in the simplest models of open
economies, countries can run very large current account deficits
without much impact at all, as long as they reduce those deficits
eventually by repaying old loans. However, other models predict
that current account reversals can have a negative impact on
economic output, asset prices, and the exchange rate (Mendoza
2006, Obstfeld and Rogoff 2005). Still other models predict that
adjustments leading to strong exports and current account surpluses
can boost income. Given the lack of a theoretical consensus,
this Letter turns to the recent empirical literature to
learn more about the potential risks to the U.S. economy of a
possible current account reversal and about the factors that
are associated with more disruptive corrections.
What can we learn from past adjustments in developing
countries?
When policymakers and economists refer to the possibility of
a disruptive current account correction in the United States,
many are thinking about the experiences of developing countries
during "sudden stops," which are especially disorderly
reversals (Calvo and Reinhart 1999). In the buildup to a sudden
stop, investment and consumption booms typically lead to a rapid
widening of the current account deficit. The sudden stop occurs
when, in a short period of time and usually in response to a
sudden change in economic conditions, a country loses access
to external financing; then imports fall, and the current account
reverses. Some of the most dramatic sudden stop episodes are
the Mexican crises of 1981 and 1994 and the East Asian crisis
of 1997. Calvo and Reinhart find that net private capital flows
to Mexico fell by 12% of GDP between 1981 and 1993 and by 6%
between 1993 and 1994; for South Korea flows fell by 11% of GDP
(1996-1997), and for Thailand by 26% of GDP (1996-1997).
During sudden stop episodes, as foreign financing quickly dries
up, consumption and investment contract, and output quickly slumps.
Calvo, Izquierdo, and Talvi (2006) find that output in Mexico
declined by 4.8% between 1981 and 1983 and by 6.2% between 1994
and 1995, while in South Korea it declined by 6.9% between 1997
and 1998, and in Thailand by 11.7% between 1996 and 1998. During
these reversals, asset prices, such as the value of the exchange
rate and equity prices, also tend to experience large falls,
wiping out wealth. The real exchange depreciation puts great
strain on the domestic banking system. Historically, many countries
going through sudden stops also experience banking crises.
However, not all reversals in developing countries are associated
with output contractions. Milesi-Ferretti and Razin (2000) study
reversals in a sample of 105 low- and middle-income countries
between 1970 and 1996. They find that, for the median country,
the current account deficit shrank dramatically—by 7.4% of GDP
(going from 10.3% to 2.9%). They also find varying consequences
in terms of economic growth after the reversals. For example,
in Uruguay, economic growth fell from 4% between 1979 and 1981
to -7% between 1982 and 1984, while in Malaysia, it increased
from 2.4% (1984-1986) to 8% (1987-1990). Indeed, for over half
the countries that experienced current account adjustments, economic
growth increased rather than decreased.
These authors also study some of the factors associated with
slower output growth after a reversal. One factor is less openness
to trade; in particular, it appears that the more closed the
country, the greater the relative need to reduce investment and
expenditures to close the gap. Another factor is the degree to
which the exchange rate has appreciated; specifically, the greater
the appreciation, the greater the needed depreciation to induce
the transfer of resources into the export sector to boost exports
and reduce the current account deficit.
What can we learn from past adjustments in industrialized
countries?
Some may argue that empirical studies looking at previous current
account adjustments in developing countries may not be directly
relevant in evaluating the risks of a U.S. current account reversal.
Rather, it may be more to the point to consider the evidence
of current account adjustment in developed economies. Croke,
Kamin, and Leduc (2005) study 23 episodes of current account
adjustments in industrialized countries. They find that current
account adjustments were associated with modest decreases in
economic activity about two-thirds of the time. They then split
the sample to study the differences between the seven episodes
where output growth increased the most (they call these "expansion
episodes") and the seven episodes where output growth decreased
the most ("contraction episodes"). For contraction
episodes, they find that output growth turns slightly negative
about one year after the current account reversal. However, they
do not find that the slowdown was associated with large currency
depreciations, rapid increases in interest rates, or asset price
collapses. In the expansion episodes, typically large currency
depreciations occurred without an asset price collapse. This
latter finding is significantly different from the sudden stop
episodes in developing countries, where large currency depreciations
are associated with economic slowdowns and asset price collapses.
It is natural to ask whether a larger initial current account
deficit leads to more economic disruption after a reversal occurs.
If it does, then the growing U.S. current account deficit increases
the risk a reversal will be disruptive. Freund and Warnock (2005),
using a data set similar to that of Croke, Kamin, and Leduc,
find that larger initial current account deficits lead to larger
output declines when the deficit reverses. However, they also
find that a 1 percentage point increase in the deficit is associated
with only a 0.15 percentage point decrease in annual growth for
three years. If the United States were forced to halve its current
account deficit, which stood at 6.6% of GDP in the second quarter
of 2006, the results of the study would suggest that the current
account adjustment may be associated with a modest reduction
in GDP growth—0.5 percentage points over the next three years.
Possible global effects of a U.S. current account
reversal
U.S. GDP alone represents about one-third of world output and
takes the lion's share—more than half—of worldwide capital
flows. Thus, when one considers the potential risks to the United
States from a current account reversal, one must also consider
any second round effects arising from its impact on other countries.
For instance, if the U.S. economy were to slow down significantly,
reducing its demand for imports, it would negatively affect many
of its trading partners. If these economies were to slow down
as a result, then demand for U.S. products may also drop, making
the current account adjustment harder to achieve.
If the dollar significantly depreciated at the same time as
the current account reversed, it also would have worldwide financial
implications. Many foreign banks, particularly in developing
countries, are vulnerable to rapid currency changes because of
currency mismatches in their balance sheets: a big depreciation
would result in significant capital losses for foreign banks
that hold a large fraction of their reserves in dollars. For
developing countries, this would be particularly problematic
because they use these reserves as a buffer to protect against
and prevent financial crises. These countries would observe a
drop in U.S. demand for their goods and a fall in the value of
their reserves concurrently, making them more vulnerable to financial
and currency crises.
Conclusions
There have been many instances of disruptive current account
adjustments, particularly in developing countries. However, there
is little evidence that current account adjustments, in general,
lead to lower GDP growth. Some of the most disruptive current
account adjustments have occurred in developing countries that
experience sudden stops. However, on average, adjustments have
coincided with either small increases in output growth (in developing
countries) or very moderate reductions in growth (in industrialized
countries). From the experience of industrialized countries we
learn that the larger the deficit, the faster and the greater
the associated fall in output.
Based on the historical evidence, the likelihood of a rapid
and disruptive current account adjustment in the United States
remains low. However, the downside risk cannot be ruled out.
In particular, the large size of the U.S. economy makes these
risks more substantial if a slowdown in the United States were
to lead to a worldwide economic downturn or to an international
financial disruption.
Diego Valderrama
Economist
References
[URLs accessed October 2006.]
Bernanke, Ben S. 2005. "The Global Savings Glut and the
U.S. Current Account Deficit." Remarks at the Sandridge
Lecture, Virginia Association of Economics, Richmond, VA, on
March 10.
Calvo, Guillermo A., and Carmen Reinhart. 1999. "When
Capital Inflows Come to a Sudden Stop: Consequences and Policy
Options." Mimeo, University of Maryland.
Calvo, Guillermo A., Alejandro Izquierdo, and Ernesto Talvi.
2006. "Phoenix Miracles in Emerging Markets: Recovering
without Credit from Systemic Financial Crises." NBER Working
Paper 12101 (March).
Croke, Hilary, Steven B. Kamin, and Sylvain Leduc. 2005. "Financial
Market Developments and Economic Activity during Current Account
Adjustments in Industrial Countries." Board of Governors,
International Finance Discussion Paper 2005-827.
Freund, Caroline, and Frank Warnock. 2005. "Current Account
Deficits in Industrial Countries: The Bigger They Are, the Harder
They Fall?" NBER Working Paper 11823.
Mendoza, Enrique G. 2006. "Endogenous
Sudden Stops in a Business Cycle Model with Collateral Constraint:
A Fisherian
Deflation of Tobin's Q." Mimeo, University of Maryland
(August 13).
Milesi-Ferretti, Gian Maria, and Assaf Razin. 2000. "Current
Account Reversals and Currency Crises: Empirical Regularities." In Currency
Crises, ed. Paul Krugman, pp. 285-326. Chicago, IL: University
of Chicago Press.
Obstfeld, Maurice, and Kenneth Rogoff. 2005. "The Unsustainable
U.S. Current Account Position Revisited." Mimeo, University
of California, Berkeley (November 30).
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