Student: GALINA GHERMAN Supervisor: Professor MOIS Ă ALT Ă R, PhD BUCHAREST, JULY 2007

1. ACADEMY OF ECONOMIC STUDIESDOCTORAL SCHOOL OF FINANCE AND BANKINGDeterminants of current account: an intertemporal approach Dissertation Paper Student: GALINA GHERMAN Supervisor: Professor MOISĂ ALTĂR, PhD BUCHAREST, JULY 2007

2. Contents • Introduction • Literature Review • Theoretical model of the current account: an intertemporal approach • Data analysis and estimation methodology • Results • Concluding remarks • References

3. I. Introduction Main Objectives: • To provide an empirical linkage betweencurrent account deficit and a broad set of economic variablesproposed by theoretical and empirical literature • To study the current account dynamics and derive structural current account position

4. II. Literature Review Thestandard intertemporal current account modelwas proposed by Sachs (1981) and extended by Obstfeld and Rogoff (1995,1996). In accordance with this model, the current account deficit is sustainable if it reflects the expectation of private agents and Ricardian equivalence holds. Campbell and Mankiw (1991)reveal the consumption decision determined by the changes in current and permanent income. Glick and Rogoff (1995)study the impact of global versus country-specific productivity shocks on investment, respectively on current account.

5. II. Literature Review Debelle and Faruqee (1996) make a difference between factors which have an impact in short and long run. Thus the real effective exchange rate, business cycle and term of trade are shown to have a short run effect, while the stage of development and demographics have long run effects. The fiscal balance has a significant impact on current account in short and long run. Milesi-Ferretti and Razin (1996).The paper focuses on the issue that the current account sustainability has to be viewed from different angles: exchange rate policy, structural indicators as the level of openness, the level of savings and investments, financial system weaknesses.

6. II. Literature Review Roubini and Wachtel (1998)reveal the criteria which has to be taken into account in order to assess the sustainability of current account deficit. They argue that a large current account deficit has to be tackled in the context of different variables : weak banking and financial system, large fiscal imbalances, low foreign reserves, increasing foreign debt. Chinn and Prasad (2003)carry out an empirical investigation on determinants of current account. The model is estimated on a sample which includes the industrial and developing countries. They find that the fiscal balance and the initial stocks of net foreign assets are positively correlated with current account, while indicators of openness to international trade are negatively correlated with current account balance.

7. III. Theoretical model of the current account: an intertemporal approach The extended intertemporal current account model was studied byBussiere, Fratzscher and Muller (2004) and Zanghieri (2004). The model includes two stylized facts: • The persistence of current account • The relevance of fiscal balance Assume that in the economyarethree categories of agents: • Private sector, which includes: • Non-Ricardian agents • Ricardian agents • Public sector presented by the Government

8. III. Theoretical model of the current account: an intertemporal approach Private sector: 1. Non-Ricardian agents 2. Ricardian agents Subject to: no-Ponzi game condition

9. III. Theoretical model of the current account: an intertemporal approach Aggregate consumption of private sector: Substituting each terms from the equation, we obtain aggregate consumption of private sector:

10. III. Theoretical model of the current account: an intertemporal approach In accordance with Obstfeld and Rogoff (1995,1996) a country’s current account balance over a period is the change in the value of its net claims on the rest of the world – the changes in its net foreign assets. Where the total net foreign assets position is given by the sum of private and government assets: On the other side, current account corresponds to the sum of net income and the net output minus aggregate consumption:

11. III. Theoretical model of the current account: an intertemporal approach From the formula above, it results: The equation of current account through saving-investment perspective: The dynamic equation of current account:

12. IV. Data analysis and estimation methodologies Our investigation is based on a sample of27 countries: • EU 15 • 10 acceding countries (2004), excluding Malta and Cyprus • Romania and Bulgaria (2007) • Croatia and Turkey Data sources: • Eurostat • World Economic Outlook, provided by IMF • AMECO For all countries we use data from 1995 – 2005.

13. IV. Data analysis and estimation methodologies The dynamic model: The dependent variable: Current account The independent variables: One lag current account Fiscal balance Relative income Relative investment ratio Relative public spending ratio Real effective exchange rate

14. For a R square of 0.11, there is a positive relation between current account and relative income. jfghfhgfh For a R square of 0.41, there is a negative relation between current account and relative investment ratio. IV. Data analysis and estimation methodologies

15. For a R square of 0.005, there is a positive correlation between current account and changes in net output. For a R square of 0.13, there is a positive relation between current account and fiscal balance. IV. Data analysis and estimation methodologies

16. For a R square of 0.12, there is a positive relation between current account and relative public spending ratio. For a R square of 0.008, there is a negative relation between current account and real effective exchange rate. IV. Data analysis and estimation methodologies

17. IV. Data analysis and estimation methodologies We use three estimation strategies: • Least Squares Dummy Variables • Two Stage Least Squares • Generalized Method of Moments

18. V. Results 5.1. Presentation of the short run impact on current account Least Squares Dummy Variables

19. V. Results 5.1. Presentation of the short run impact on current account Two Stage Least Squares

20. V. Results 5.1. Presentation of the short run impact on current account Generalized Method of Moments

21. V. Results 5.2. Analysis of results The lagged current account • positive relation • the coefficient of the lagged current account is 0.66 • the persistence of current account Fiscal balance • positive relation • the immediate impact is 0.086 • the relevance of fiscal balance

22. V. Results 5.2. Analysis of results Changes in net output • positive relation • the coefficient is 0.25 • explanation: 75 % of an increase in net output is consumed, while 25 % is saved, and respectively reflected in current account Relative income • positive relation • the coefficient in the short run is 0.039 • the positive coefficient on relative income indicates that a per capita income below the average EU 15 will be associated with a current account deficit

23. V. Results 5.2. Analysis of results Relative investment • negative relation • the immediate impetus is -0.27 • if investment is above its “permanent level”, an increase in this ratio will induce a current account deficit Relative public spending • we found a positive relation between current account and relative public spending ratio • the immediate impact is 0.06, which is not significant • if public spending ratio is above “permanent level” an increase in this ratio will induce a current account deficit

24. V. Results 5.3. Presentation of results (including REER in the model) Least Squares Dummy Variables

25. V. Results 5.3. Presentation of results (including REER in the model) Two Stage Least Squares

26. Real effective exchange rate negative relation the immediate impact is about -0.016 an appreciation in REER will lead to a loss of competitiveness, and a large current account deficit Generalized Method of Moments V. Results5.3. Presentation of results (including REER in the model)

27. Here we include the variables, which have a long run impact on current account: Fiscal balance – the impact is much larger than in the short run. The coefficient is 0.32. Relative income – in the long run any increases in relative income will lead to an increase in current account by 0.087. Relative investments ratio has a negative effect. The coefficient is about 0.71. Generalized Method of Moments V. Results5.4. Presentation of the long run impact on current account

28. We also found that public spending ratio and real effective exchange rate would have an impact on long run. REER has no such a huge influence neither in the long run. The coefficient is about -0.05. Concerning to public spending ratio, it might have a long run impact. The coefficient is about 0.16. Generalized Method of Moments V. Results5.4. Presentation of the long run impact on current account

29. As we can see from this graph, Romania has an increasingly large current account deficit. Which are the causes of such large current account deficit? V. Results5.5. Structural current account position

30. V. Results The high level of investment ratio is due to: • Favorable climate for foreign investments • High level of capital inflow determined by the accession in EU of Romania • The need of investments in order to restructure different sectors For the saving ratio, from 2002 we find a downward evolution in the context of an increase in consumption.

31. VI. Concluding remarks • The current accountis persistent by including in the model the lagged current account, the coefficient reaching a value of 0.67. • Fiscal balance has a positive effect on current account. Thus in the short run a raise in fiscal balance will cause a raise in current account position. The coefficient in short run is about 0.08. In the long run the influence is much more significant, reaching a value of 0.32. • Changes in net output will lead to an increase in current account through savings. The coefficient on the changes in the net output of around 0.25. This variable is explained as follows: 75 % of an increase in net output is consumed, and just 25 % is saved and reflected in current account.

32. VI. Concluding remarks • An incomebelow the “permanent level” is associated with a current account deficit.In the short run relative income is reflectedby a coefficient of 0.039. In the long run, the influence is larger, reaching a value of 0.087. • The increase inrelative investment ratio will lower the current account deficit. If investment ratio is above the “permanent level”, presented by the average of EU 15, it will lead to a larger current account deficit. In the short run the coefficient is about -0.27, while in long run -0.71.

33. VI. Concluding remarks • Relative public spendingratiohas a positive effect on current account deficit. From our estimation, we found a positive relation between relative public spending and current account. If public spending ratio is above the “permanent level”, an increase in this variable will lead to an increase in current account by a coefficient of 0.06. • An appreciation ofreal effective exchange rate will lead to a loss of competitiveness inducing a larger current account deficit. The coefficient of this variable is -0.016

34. References • Abel, A.B. (1990), „Asset prices under habit formation and catching up with the Joneses”, American Economic Review Vol.80, No.2, 38-42 • Alvarez-Cuadraro, F., G. Monteiro, and S.J. Turnovsky „Habit formation, catching up with the Joneses, and Economic growth”, University of Washington • Baum, C.F., M.E.Schaffer, and S.Stillman (2003), „Instrumental variables and GMM: estimation and testing”, Boston College, Department of Economics, Working paper No.545 • Bussiere, M., G.Chortareas, and R.L.Driver (2002), „Current accounts, net foreign assets and the implications of cyclical factors”, The Bank of England’s Working Paper Series • Bussiere, M., M. Fratzscher, and G.J.Muller (2004), „Current account dynamics in OECD and EU acceding countries – an intertemporal approach”, Working Paper Series No.311 ECB • Campbell, J.Y. and N.G. Mankiw (1991), „The response of consumption to income. A cross-country investigation”, European Economic Review 35

35. References • Campbell, J.Y. and J.H. Cochrane (1999), „By force of habit: a consumption-based explanation of aggregate stock market behavior”, NBER Working Paper Series • Chinn, M. and E.S. Prasad (2000), „Medium-term detreminants of current accounts in industrial and developing countries: an empirical exploration”, NBER Working Paper Series • Debelle, G. and H. Faruqee (1996), „What determines the current account?A Cross-Sectional and Panel approach”, IMF Working Paper, Research Department • Glick, R. and K.Rogoff (1992), „Global versus country-specific productivity shocks and the current account”, NBER Working Paper Series • Gruber, J.W. (2002), „Productivity Shocks, habits, and the current account”, International Finance Discussion Papers, Board of Governors of the Federal Reserve System • Herrmann, S. and A.Jochem (2005), „Determinants of current account developments in the central and east European EU member states – consequences for the enlargement of the euro area”, Deutsche Bundesbank, Discussion, Paper Series 1:Economic Studies No.32/2005

36. References • Konya, L. (2001), „Panel Data Unit Root Tests with an Application”, School of Applied Economics Victoria University, Melbourne • Levin, A., C.F. Lin, and C.S.J. Chu (2001), „Unit root tests in panel data: asymptotic and finite-sample properties”, Journal of Econometrics 108, 1-24 • Copaciu, M. and I.Racaru (2006), „Echilibrul extern al României – abordări calitative şi cantitative”, Banca Naţională a României • Milesi-Ferretti, G.M. and A.Razin, (1996a), „Current account sustainability”, International Finance section, Department of Economics, Princeton University, New Jersey • (1996b), „Sustainability of persistent current account deficit”, NBER Working Paper Series • (1998), „Current account reversals and currency crises”, NBER conference • Obstfeld, M., K. Rogoff, (1995), „The intertemporal approach to the current account”, NBER Working Paper Series • (1996), „Foundation of International Macroeconomics ”, MIT Press, Cambridge M.A.

37. References • Roubini, N. and P.Wachtel (1998), „Current account sustainability in transition economies”, NBER Working Paper Series • Sachs, J.D., R.N.Cooper, and S.Fischer, (1981), „The current account and macroeconomic adjustment in the 1970s”, Brookings Papers on Economic Activity Vol. 1982, No.1, 201-282 • Sheffrin S.M. and W.T.Woo (1990), „Present value tests of an intertemporal model of the current account”, Journal of International Economics 29 (1990), 237-253 • Wooldridge J.M.(2001), „Econometric Analysis of Cross-Section and Panel Data”, MIT • Zanghieri, P. (2004), „Current account dynamics in new EU members: sustainability and policy issues”, CEPII (Centre d’Etudes Prospectives et d’Informations Internationales)

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