DISSERTATION PAPER

1. DISSERTATION PAPER Current Account and its Determinants in Central and Eastern Europe Student: Monica Tanu Professor: Moisa Altar

2. Objective • to provide an empirical investigation of the medium-term determinants of current account for a sample of Central and East European countries; • are used cross-section and panel regression techniques; • my approach iews current account as the outcome of variations in structural and macroeconomic determinants that influence the saving-investment balance; • the data set covers a heterogeneous group of Central and East European countries over a relative medium time span (1990 - 1999).

3. Review of the literature • intertemporal approach to current account - private saving and investment decisions result from forward-looking calculation based on expectations; • the current account balance behaves as a buffer against transitory shocks in productivity and demand; • shocks may be: • country-specific or global (origin) • transitory or permanent (persistence) • I take into account how the nature of economic changes impact on the current account - • overtime changes within a country • the evolution of the world economy • structural differences across countries

4. Savings, Investment and the Current Account • GNP t = Y t + r t B t • Y t = C t + G t + I t + NX t • CA t = NX t + r t B t = GNP t – ( C t + G t +I t) • CA t = S t - I t • CA t = ( B t+1 + K t+1 – B t – K t ) – I t = B t+1 – B t

5. Savings, Investment and the Current Account • viewing the current account as net exports or as the difference between savings and investment is equivalent from an accounting perspective; • movements in interest rate, exchange rates, prices and income will ensure that the decision to export and import and to save and to invest, made at microeconomic level will match in the aggregate; • defining the current account as the difference between savings and investment is more appropriate when trying to explain enduring patterns in international capital flow.

6. Current account sustainability • the current account balance is an important and intriguing measure of macroeconomic performance for economies in transition; • it is often difficult to distinguish between current account deficits that are the consequence of growth inducing capital inflows and current account deficits that result in debt accumulation that cannot be sustained; • most of transition economies experienced large current account deficits due to decline in output and financing by official international assistance and borrowing.

7. Criteria for assessing sustainability • a non-increasing foreign debt to GDP ratio; • the country’s willingness to pay and the creditors willingness to lend; • no external sector crises occurs (in a situation where current macroeconomic conditions continue and are no changes in macroeconomic policy) • exchange rate crises • foreign debt crises • “close attention should be paid to any current account deficit in excess of 5% of GDP, particularly if it is financed in a way that could lead to rapid reversals” (Lawrence Summers)

8. Sources of current account deficit • a fall in savings or an increase in investment • running a current account deficit involves borrowing from abroad which is less dangerous if it is financing new investment rather than consumption • large current account deficits may be more sustainable if economic growth is higher • a current account imbalance can be due to a fall in • private savings • public savings (higher budget deficits)

9. CA in economic policymaking • the essence of the policymaker’s problem is to determine a sustainable set of economic policies: • reasonable economic growth performance • price stability • a sustainable fiscal position • low unemployment • a sustainable current account position

10. CA in economic policymaking

11. Econometric methodology • I use an panel of 140 annual observations from 5 Central and East European countries • main sources are World Bank - World Development Indicators 2001 - and IMF- International Financial Statistics • I work with time series and cross-country data • I identify and differentiate within-country and cross-country effects • the model considers inertial properties in the current account deficit by allowing for an independent effect from its lagged value

12. Econometric methodology 1. Cross-country effects • country-specific factors are not controlled for • y i t = β 1 y i t-1 + β 2 X i t + ε i t 2. Within-country effects • this model allow me to de-emphasize the cross-sectional variance in favor of its time-series counterpart • akin to the fixed-effects estimator • y i t = β 1 y i t-1 + β 2 X i t + η i + ε i t

13. Econometric methodology Methods of estimation: • Seemingly Unrelated Regression: • residuals are cross-section heteroskedastic • residuals are contemporaneously correlated • Cross section weights • residuals are cross-section heteroskedastic • Pooled least squares

14. Exogenous variables Persistence • CA lagged 1 period Internal Condition • Domestic Output Growth Rate (annual %) • Savings (as % of GDP) • Investment (as % of GDP) • Financial Deepening (M2/GDP) External Condition • Openess (as % of GDP) • Net Foreign Assets (as % of GDP) • Real Effective Exchange Rate (in logs)

15. Exogenous variables Evolution of the World Economy • Industrialized Output Growth Rate (annual %) • World Real Interest Rate Additional Financial Variables • Youth dependency ratio • Old dependency ratio • Foreign Direct Investment (as % of GDP) • Relative GDP per capita • External debt (as % of GDP)

16. Cross-country effects Persistence • the coefficient is positive and significant (0.27) • moderate persistence of transitory shocks Domestic output growth rate • the coefficient is negative and significant (-0.12) • GDP implications on savings and investment

17. Cross-country effects Savings and Investment • both have significant coefficient across all considered estimators ( 0.74 and -0.57) Financial Deepening • a potentially important determinant of savings • proxied by the ratio of M2 to GDP • a positive effect on the current account, but it is not significant (0.007)

18. Cross-country effects Openness • the degree of openness - make a country attractive to foreign capital • more open economies generate foreign exchange earnings through exports - a better ability to service external debt • negative relationship with the current account (-0.008) Net Foreign Assets • countries that have run current account deficits - countries with better access to capital markets - are favored by international investors for a variety of reasons • negative relationship (-0.03)

19. Cross-country effects Real Effective Exchange Rate • significant positive relationship (-0.015) • I study the delayed effects of REER on the current account • the net effect (adding the coefficients on contemporaneous and lagged REER) is similar to the coefficient of the REER in the core specification

20. Cross-country effects Output Growth Rate of Industrialized Country • positive and significant coefficient (1.17) • an increase in growth rate ->a rise in the demand for the exports and increase capital flow between industrialized countries International Real Interest Rate • positive coefficient (0.15) • net debtor countries widen their demand for intl capital in response to interest rate reductions.

21. Cross-country effects Age dependency ratio • positive coefficient (0.16 - Youth, 0.22 - Old) • national savings is not the channel through which dependency ratio affect current account positions. Foreign Direct Investment • negative and significant coefficient (-0.06) • higher rates of capital accumulation and growth • facilitate the transfer of managerial and technological knowhow

22. Cross-country effects Relative GDP per capita • negative and significant coefficient (-0.03) • doesn’t sustained the stage of development hypothesis External debt • positive coefficient (0.01) • countries with larger external debt tend to have smaller current account deficits because of rhe external financing constraints.