essay 2 inter temporal approach to current account dynamics

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Intertemporal Approach to Current Account Dynamics in

Some Asian Economies: Theory and Empirical Evidence

An Essay Assignment (II) for

International Finance (GECO6253)

Submitted to

Prof. Willi Semmler

Department of Economics

New School for Social Research

Submitted by

PhD Students

Prakash Kumar Shrestha Percival Pineda

N00125518 N00402498



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Intertemporal Approach to Current Account Dynamics in

Some Asian Economies: Theory and Empirical Evidence

- by Prakash Shrestha and Percival Pineda

___________________________________________________________________________Abstract

This paper provides an empirical investigation of intertemporal model of current account in two

aspects: determinants of current account and debt sustainability, in eight emerging and

developing Asian countries from a time series perspective for the period 1990-2007. Empirical

results show that intertemporal model alone cannot fully explain the current account dynamics

and debt sustainability issues fully over the time period; other variables need to be added.

General observations reveal that current account deficit in Asian countries are under control

and debt accumulation looks sustainable at least for the medium term.

___________________________________________________________________________

1. Introduction

In an open economy, current account is an important macroeconomic variable that may

convey information about actions and expectations of economic agents. Modern economic theory

views current account imbalances not only as a reflection of goods market development, but also

as an outcome of intertemporal consumption and investment choices (Knight and Scacciavillani,

1998).

Intertemporal model of current account refers that current account is just an outcome of

intertemporal behavior of economic agents. Hence, current account position can reflect

government budgetary situation, and country's investment and saving behavior. According to this

model, a country can make investments through foreign borrowing without curtailing

consumption. A higher investment would lead to a higher growth, so that a country can pay back

what it borrowed in the future. Persistent deficits may, however, have some important effects on

debt accumulation, which can lead to financial crisis as we saw in the previous decades in many

Latin American countries.



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In this context, this paper evaluates implications of the intertemporal model of current

account dynamics in two important aspects: determinants of current account and sustainability of

debt. For this purpose, we use data from eight Asian countries, representing emerging economies

like India, Indonesia, Thailand, and South Korea; and developing countries like Nepal,

Bangladesh, Vietnam, and Pakistan for the period of 1990-20071. We argue that this model

cannot explain the actual dynamics of current account empirically, though this model is

theoretically more intuitive.

This paper proceeds as follows. Section 2 sketches the theory of intertemporal approach

to current account, followed by review of empirical evidence in section 3 and empirical analysis

in section 4. Concluding remarks appear in the last section 5.

2. Theory of Intertemporal Approach to Current Account

Theory of intertemporal approach to current account is primarily based on national

income accounting. In an open economy, national income identity is

Y = C+I+G+(EX-IM).....................................(1),

where Y=GDP, C=Consumption, I=Investment, G=Government expenditure, EX=Export, and

IM=Imports. In an open economy national income, gross national product (GNP) is the sum of

gross domestic product and net factor receipts from abroad (R) (Mark, 2005). Let Q=GNP, we

have

Q =Y+R = C+I+G+(EX-IM)+R, where CA (current account) = (EX-IM+R).

For a close economy: S (saving) = Y-C-G.

For an open economy: Y=C+I+G+CA.

Y-C-G = I+CA S=I+CA S-I = CA..........................(2)

1This is the period of rapid trade liberalization, globalization and capital flows in the world.



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Equation (2) implies that in an open economy, a country can save either by building up its capital

stock or by acquiring foreign wealth, but a closed economy can save only by building up its

capital stock.

Further,

S =Sp+Sg (private saving + government saving)

Sp =Y-T-C = Yd-C; Yd = disposable income

Sg=T-G

Then, S=Sp+Sg=I+CA

Sp=I+CA-Sg = I+CA-(T-G) or I+CA+(G-T) ...........................(3)

(Sp-I)+(T-G) = CA ..........................(4)

Private savings + government savings = current account.

The current account balance reflects the difference between national savings and

domestic investment (public and private). Both saving and investment decisions result from

households and firms' intertemporal optimization behaviors.

To model optimizing behavior, lifetime utility in a 2-period framework is written as V

=U(C1, C2)2. Special case is additive separability as (Obstfeld and Rogoff, 1996).

)()( 21 C uC uV ..................... (5)

where 0<<1, .0)(",0)(' t t C uC u Then, life time budget constraint without government and

investment is

r

Y Y

r

C C

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21

21 .....................................(6),

where r is world interest rate, Y is national income.

The first order condition is )(')1()(' 21 C ur C u ,......................(7)

2Drawn from Obstfeld and Rogoff (1996).



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which is called intertemporal Euler Equation. Then, ))(1( 1122 C Y r Y C . In this case,

foreign asset accumulation view of current account implies CAt as

t t t t t t t C Br Y B BCA 1 .................................(8)

Introducing government with balanced budget each period, the budget constraint becomes

r

GY GY

r

C C

11

2211

21 ........................................(9)

Then,t t t t t t t t GC Br Y B BCA 1.......................................(10)

With investment, saving can flow into capital as well as foreign assets. Since

t t t K K I 1 , the change in total domestic wealth (national saving) is

t t t t t t t t t GC Br Y K BK B

)(11 ..................................(11)

Rearranging terms, current account becomes

t t t t t t t t t I GC Br Y B BCA 1 ,.............................(12)

where t t t t t t GC Br Y S , so that t t t I SCA . Hence, current account is fundamentally an

intertemporal phenomenon.

Intertemporal budget constraint when there is both government spending and investment

assuming B1=0 and B3=0, then from (12), we get 11112 I GC Y B for period 1 and

222222 I GC rBY B for period 2. Then, intertemporal budget constraint is

r

GY GY

r

I C I C

11

2211

2211 ............................(13)

On the production side, output is produced using physical capital and labor as

),( t t t LK F Y . But, assuming constant labor supply, the production function is

),(

LK F Y t t and there is diminishing marginal return to capital. Agents can invest in future

capital stock by reducing current consumption as t t t C Y I in autarky. But, in an open

economy, a country can borrow from abroad.



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Optimal production is characterized by r K

F

2

and optimal consumption is

characterized by )(')1()(' 21 C ur C u . The former implies identical returns on physical

investment and on bonds, and the latter implies equality of marginal cost of savings (LHS) and

marginal gains from saving.

Two periods model can be extended into infinite horizon model. In infinite horizon, the

representative individual maximizes

t s

s

t s

t C uU )( ........................(14)

subject to

ssssssss G I C K F ArB B B )(1 ............................(15)

For every period st, two condition must hold as

)(')1()(' 1 ss C ur C u ............................(16)

r K F A ss )(' 11 .........................................(17)

For No-Ponzi scheme and no unrequited gift to foreigners, the following transversality condition

should also hold.

01

1lim 1

T t

T

T B

r ...........................(18)

In a general form, neglecting stochastic effects and assuming that interest rate (r) is

constant, the intertemporal budget constraint in continuous time can be written as (Semmler et.al,

2007)

0

)0( dt Se B t

rt or 0)(lim

t Be rt

t ..................................(19),

where B(0) is initial debt at time zero, St is the primary surplus ( t t t t G I C Y ), B(t) is

debt at time 't'. A country can go bankrupt if



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3. Review of Empirical Evidence

According to the intertemporal approach, the current account deficit is the outcome of forward-

looking dynamic saving and investment decisions. Accordingly, Calderon et al. (2000) examine the

empirical links between current account deficits and a broad set of economic variables in 44

developing countries for the period 1966-1995. They found that current account deficits in

developing countries are moderately persistent. A rise in domestic output growth generates a

larger current account deficit, while increases in savings rates have a positive effect on the

current account. Moreover, the real exchange rate appreciation and shocks on terms of trade

deteriorate the current account balance. But higher growth rates in industrial economies and

higher international interest rates reduce the current account deficit in developing economies

Chinn and Prasad (2003) provides an empirical investigation of the medium-term

determinants of current accounts for a large sample of both industrial and developing countries,

utilizing an approach that highlights macroeconomic determinants of longer-term saving and

investment balances. They found that government budget balance, initial net foreign asset

positions and, for developing countries, indicators of financial deepening are positively

correlated with current account balances.

A recent study by Calderon et al. (2007) in 30 African countries and other 34 developing

countries also uncover the possible factors affecting current account for the period of 1975-1995.

As they mentioned, a stylized characterization of the region includes deficits in the current

account that have been very large in recent years, dismal rates of growth, strong reliance on

foreign aid, low public and private savings, concentration of exports on single primary products,

and large distortions in the economy (p191). By employing the generalized method of moments

(GMM) estimator for dynamic models of panel data, they found that there is not as much

persistence in current account deficits in African as in the full sample of developing countries;



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unlike in the full sample of developing countries, domestic output growth is positively linked

with current account deficits, possibly as a result of differences in income elasticity.

Macroeconomic uncertainty, openness, and balance of payments controls are not statistically

significant, but a depreciation of the currency reduces the current account deficit, at least in the

short run in African countries.

Moreover, empirical studies on twin deficits debate have generally failed to provide a

consensus view. Enders and Lee (1990) and Alse and Oskooee(1992) show that there is no

systematic association between current account and budget deficit. Biswas et al. (1992) have also

examined the empirical relation between current account deficit and budget deficit. Using US

annual data over the 1950-1988 period, they find a bi-directional causal relation between actual

budget deficit and net exports. Further, using international data from a sample of twenty

developed and developing countries, Kouassi et al. (2004) find evidence of causality

(unidirectional or bi-directional) between the twin deficits for some developing countries.

However, the results for developed countries are less persuasive.

Present value tests as shown in equation (19) run by Sheffrin and Woo (1990) in four

countries (Belgium, Canada, Denmark and the United Kingdom ) for the period 1955-1985 led to

mixed results. More recently, Bergin and Sheffrin (2000) have applied the procedure described

above, allowing for a variable real interest rate and exchange rates. Allowing for interest rate and

exchange rate fluctuations yielded much better results.

Using the concept of excessive current account deficit, Adebeji (2001) used the

intertemporal model of the current account and macroeconomic indicators to examine the size

and sustainability of Nigerian current account deficits over the 1960-1997 period and found that

current account deficits accompanied by macroeconomic instability and structural weaknesses

can degenerate into an external debt crisis.



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Finally, a study by Cassimon et al. (2008) shows that there is no one-size-fits-all model to

analyze current account balance sustainability. They argue that the complexities of factors

affecting debt sustainability, especially in low-income countries, cannot be captured in a single

indicator that could be applied indiscriminately to all countries, and therefore debt sustainability

models used in industrial countries cannot be used in low-income countries. In the recent study,

Rossini and Zanghieri (2009) argue that current account deficit financed by net inflow of equity

capital does not change the external debt (ED) so that emerging economies can sustain larger

current account imbalances.

In this way, the empirical literature has focused mainly on cross-country analysis pooling

the diverse countries together. In contrast, this study analyzes the current account situation of

countries drawn from one region in a time series perspective.

4. Empirical Analysis

For empirical analysis, eight Asian countries are considered and data are obtained from

Asian Development Bank's Key Indicators of Asian Countries for the time period of 1990-2007.

Data are analyzed in two aspects: determinants of current account and debt

sustainability .

4.1 Determinants of Current Account

As per the intertemporal model, determinants of current account could be budget deficit

and higher investment leading to higher growth. Instead of cross sectional panel data approach,

the determinants of current account balance in each selected countries are examined in this paper

from a time series perspective. Before doing some regression analysis, chart 1 shows the

graphical exposition of relationship between current account balance and budget balance in the



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selected Asian countries between 1990 and 2007, and chart 2 depicts the relationship between

economic growth and current account balance.

There is no any unique pattern of relationship between budget deficit and current account

deficit (chart 1). India has experienced both deficit most of the time except in a few years of

the 2000s; budget deficit remained comparatively higher than that of current account deficit. In

Indonesia, Thailand, South Korea and Vietnam, these two deficits moved in quite opposite

direction. After the East Asian Crisis in 1998, these countries witnessed significant current

account surplus with budget deficit. On the other hand, after long time of current account

deficit, South Asian countries Nepal, Bangladesh, and Pakistan witnessed current account

surplus with the turn of twenty-first century4. Although, the first two countries still have

current account surplus, it turned into a deficit again in Pakistan in 2005. According to the

intertemporal model of current account, a developing country should not generally have a current

account surplus.

Table 1 exhibits the correlation between budget balance and current account balance in

these countries. Out of eight, correlation between budget balance and current account

balance is negative in five countries. Only in Nepal and Pakistan, these twin balance

correlates positively to each other; in Vietnam, there is very weak relationship between

these two balances.

As the intertemporal model suggests, a higher economic growth can drive up current

account deficit. A country can increase investment more than domestic saving by borrowing

from abroad, thereby increasing economic growth and it can repay its loans in future. Hence,

economic growth and current account deficit tend to move together. However, as illustrated in

4It may be due to rising remittance inflows instead of improvement in trade balance.



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chart 2, there is no any unique pattern of relation between the GDP growth and current account

deficit as envisioned in the intertemporal theory of current account. Chart 1: Budget Balance and Current Account Balance in 8 Asian Countries.

India

-10.0

-5.0

0.0

5.0

1 9 9 0

1 9 9 2

1 9 9 4

1 9 9 6

1 9 9 8

2 0 0 0

2 0 0 2

2 0 0 4

2 0 0 6

BB CAB

Indonesia

-5.0

0.0

5.0

10.0

1 9 9 0

1 9 9 2

1 9 9 4

1 9 9 6

1 9 9 8

2 0 0 0

2 0 0 2

2 0 0 4

2 0 0 6

BB CAB

Thailand

-10.0

0.0

10.0

20.0

1 9 9 0

1 9 9 2

1 9 9 4

1 9 9 6

1 9 9 8

2 0 0 0

2 0 0 2

2 0 0 4

2 0 0 6

BB CAB

South Korea

-5.0

0.0

5.0

10.0

15.0

1 9 9 0

1 9 9 2

1 9 9 4

1 9 9 6

1 9 9 8

2 0 0 0

2 0 0 2

2 0 0 4

2 0 0 6

BB CAB



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Table 1: Correlation between Budget Balance and Current Account Balance

Country Correlation Coefficient

India -0.11

Indonesia -0.75

Thailand -0.86

South Korea -0.36

Nepal 0.79

Bangladesh -0.05

Vietnam 0.003

Pakistan 0.73Source: Calculated from data obtained from Asian Development Bank

Chart 2: Economic Growth and Current Account Balance in 8 Asian Countries

India

-5.0

0.0

5.0

10.0

15.0

1 9 9 0

1 9 9 2

1 9 9 4

1 9 9 6

1 9 9 8

2 0 0 0

2 0 0 2

2 0 0 4

2 0 0 6

GDP rowth CA

Indonesia

-15.0

-10.0

-5.0

0.0

5.0

10.0

15.0

1 9 9 0

1 9 9 2

1 9 9 4

1 9 9 6

1 9 9 8

2 0 0 0

2 0 0 2

2 0 0 4

2 0 0 6

GDP growth CAB

Thail and

-20.0

-10.0

0.0

10.0

20.0

1

9 9 0

1

9 9 2

1

9 9 4

1

9 9 6

1

9 9 8

2

0 0 0

2

0 0 2

2

0 0 4

2

0 0 6

GDP growth CAB

South Korea

-9.0-6.0

-3.0

0.0

3.0

6.0

9.0

12.0

15.0

1

9 9 0

1

9 9 2

1

9 9 4

1

9 9 6

1

9 9 8

2

0 0 0

2

0 0 2

2

0 0 4

2

0 0 6

GDP growth CAB

Nepal

-12.0-9.0-6.0-3.00.03.06.09.0

12.0

1 9 9 0

1 9 9 2

1 9 9 4

1 9 9 6

1 9 9 8

2 0 0 0

2 0 0 2

2 0 0 4

2 0 0 6

GDP growth CAB

Bangladesh

-6.0

-3.0

0.0

3.0

6.0

9.0

1 9 9 0

1 9 9 2

1 9 9 4

1 9 9 6

1 9 9 8

2 0 0 0

2 0 0 2

2 0 0 4

2 0 0 6

GDP growth CAB



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The following equation is estimated to identify the determinants of current account, as

identified by the intertemporal model.

t t

t t t GDP

ED

GDPgrowthGDP

BD

GDP

CA

3210 ......................(21)

where CA=current account balance, BD=budget balance, ED=External debt, and t is an error

term. Expected values of coefficient at priori as per the theory of intertemporal approach of

current account are 1 >0, 2> 0, 3> 0.

Table 2 reports the regression results of the equation (21). The positive association

between current account deficit and budget deficit is statistically significant only in Nepal

and Pakistan. In many countries, that coefficient is found not only insignificant but also in

reverse sign, questioning the validity of model. With respect to economic growth, except

Bangladesh and Pakistan, statistical relation is found negative contrary to the expectation

of the theory. The coefficient 2 is found significant only in Nepal and Vietnam. Such a

negative relationship between economic growth and current account deficit could be due to

higher exports associated with higher economic growth and impact of remittance inflows

on current account.

Table 2: Determinants of Current Account

Dependent Variables: current account to GDP ratio (1990-2006)(t-statistic in parenthesis)

Country 0 BD/GDP GDP growth rate ED/GDP R2 DW

India -0.49(-0.17)

-0.34(-0.90)

-0.07(-0.42)

-0.05(-0.81)

0.31 1.46 0.25

Indonesia 0.97

(0.24)

-0.79

(-1.68)

-0.11

(-0.48)

0.01

(0.28)

0.82 1.58 0.78

Thailand 1.96

(0.41)

-2.10*

(-3.73)

-0.18

(-0.57)

-0.01

(-0.15)

0.74 1.70

SouthKorea

-2.76

(-0.69)

-0.61

(-1.50)

-0.29

(-1.53)

0.23

(1.76)

0.71 1.58 0.40

Nepal 7.08

(1.38)1.30*(4.37)

-0.84*(-2.44)

-0.003

(-0.02)

0.74 1.26

Bangladesh -4.33

(-0.83)

-0.04

(-0.14)

0.39

(0.82)

0.03

(0.40)

0.05 1.35

Vietnam 11.5** 0.006 -1.71 -0.01 0.42 1.36



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(2.00) (0.01) (-2.58)* (-1.56)

Pakistan -3.66

(-0.73)1.56*

(5.0)

0.24

(0.77)

0.19**

(1.82)

0.68 1.35

* Significant at 5 % level of significance

** Significant at 10% level of significance

is the coefficient of serial correlation

If we look at R2, the explanatory power of the estimating equation widely varies from

country to country, 0.05 in Bangladesh to 0.82 in Indonesia. Serial correlation occurs in a few

countries and it was corrected by AR(1) process in E-views.

4 .2 Matter of Debt Sustainability

As regards the debt sustainability, the intertemporal model of current account implies that

debt accumulation through current account deficit must be repaid at some point of time i.e. the

present value of debt converge to zero as shown in equation (19), otherwise as equation (20)

implies, a country can go bankrupt through debt accumulation. Empirical test of these equations

of debt sustainability is not practically feasible. An economy with growing output can run

perpetual current account deficits (Obstfeld and Rogoff, 1996, 67). Hence, one alternative test is

to check whether debt to income ratio remains stationary. If the series is stationary (B/Y=

constant(C)), the intertemporal budget constraint is fulfilled for dynamically efficient economies.

As shown in Semmler et al.(2007), equation (19) becomes 0)(lim )(

0

t BeCY

t r g

t , where g is the

growth rate. The condition g<r characterizes a dynamically efficient economy. Another test as

suggested by Bohn (1998) is to test whether the primary deficit to GDP ratio is positive function

of the debt to GDP ratio. If this is hold, debt is sustainable. For this, one can test the following

equation

t

t

t

t Y

t B

Y

S

)(

)(.................................(22)

>0 guarantees that intertemporal budget constraint of the country holds. Equation (22) has been

estimated by applying OLS in the sampled countries in this paper.



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Obstfeld, M and Rogoff, K. 1996. Foundations of International Macroeconomics. The MIT

Press, Cambridge.

Rossini, G. and Zanghieri, P. 2009. "Current account composition and sustainability of external

debt". Applied Economics, 41-5, p677.

Semmler, W. 2006. Asset Prices, Booms and Recessions. Springer, New York.

Semmler, W. 2008. Lecture Notes on International Finance, Unpublished Manuscript, New

School for Social Research.

Semmler, W., Greiner, A., Diallo, B., Rezai, A., and Rajaram, A. 2007. "Fiscal Policy, PublicExpenditure and Growth: Theory and Empirics", Policy Research Working Paper 4405, The

World Bank.

Sheffrin, S.M. & Woo, W.T., 1990. "Present Value Tests of an Intertemporal Model Of TheCurrent Account,", Journal of International Economics, 29(3-4), 237-253.

essay 2 inter temporal approach to current account dynamics

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