Academy of Economic Studies Doctoral School of Finance and Banking

1. Academy of Economic StudiesDoctoral School of Finance and Banking Determinants of Current Account for Central and Eastern European Countries MSc Student: Anca Apӑteanu Coordinator: Professor Moisӑ Altӑr Bucharest, July 2008

2. Contents • Introduction • Literature Review • Theoretical Model • Empirical Research • Conclusions

3. Introduction Objectives: • Investigate the determinants of current account deficits for the newest EU members • Answer the question whether the deficits run by these countries are caused by the catching up processes they experience • Address the issue of sustainability

4. Obstfeld and Rogoff (1996) developed the intertemporal approach, according to which the current account balance is the outcome of forward looking dynamic saving and investment decisions; Calderòn, Chong and Loayza (1999) focused on developing countries and distinguish between transitory and permanent components of current account deficits. They found that current account deficit is moderately persistent and there exists a negative relation between output growth rate and current account; Literature Review

5. Literature Review • Chinn and Prasad (2000) view current account balance as the outcome of variations in structural and macroeconomic determinants that influence the saving-investment balance. The main findings are that current accounts are positively correlated with fiscal balances and initial stock of net foreign assets, but negatively correlated with the degree of openness; • Bussière, Fratzsher and Müller (2004) provide a study on 21 OECD countries and all EU acceding countries. The results show that current account balances are highly persistent and that fiscal balance has significant positive effects on current account;

6. Literature Review • Aristovnik (2005) examines the dynamics and current account sustainability of selected transition economies and concludes that generally deficits higher than 5% GDP pose external sustainability problems.

7. The Model In line with the work of Chinn and Prasadwe link the intertemporal approach with the stage of development hypothesis. The starting point is the identity of current account with the difference of domestic saving and investment: CA= SP+ SG-I (1) Equation 1 is divided by GDP for comparability purposes. Private saving is a function of different variables: SP/Y=f((Y/N)/(Y*/N*); REER, SG/Y, If/Y)(2)

8. The Model SP/Y=α0+α1(PCI-PCI*)+α2REER+ α3SG/I+ α4If/Y+ε (3) Substituting into equation (1) we obtain the regression to be estimated: CA/Y=SP/Y=α0+α1(PCI-PCI*)+α2REER+(1+ α3)SG/I+(α4-1)If/Y(4) The variables: • Relative per capita income – real per capita income Y/N in relation to the real per capita income of the reference country Y*/N*. Anticipating real convergence and higher income in the future, consumers in developing economies take on debt in order to smooth their long term consumption. Therefore we expect a positive relation between relative per capita income and current account balance.

9. The Model • Real effective exchange rate – tends to rise while the catching up process takes place, so the expected sign is expected to be the same as the one of the relative income. However, it has opposite effects depending whether it is expected or unforeseen, permanent or transitory. So the effect of real effective exchange rate can only be determined empirically. • Fiscal balance – affects private savings. In case of Ricardian equivalence a rise in government debt is fully compensated by additional private savings. We expect a positive relation between fiscal balance and current account. • Fixed investment – correlates with savings especially when access to capital market is restricted, however they can be considered linked reasons known in the literature as “home bias”

10. Data and Estimation Methodology • Our investigation is based on panel of 10 countries : Bulgaria,Czech Republic, Estonia, Latvia, Lithuania, Hungary, Poland, Romania, Slovakia and Slovenia. • We have used quarterly data series from 1998:1 to 2007:4 • Data sources: Eurostat IMF National Bank of Romania • We have used EGLS (Estimated Generalised Least Square) for the panel of 10 countries and TSLS and GMM for Romania

11. Results

12. Results • Lagged current account coefficient: • 0.49 shows the substantial persistence of the current account dynamics • The coefficient is in line with the findings of Chinn and Prasad (2003) and Bussière, Fratzsher and Müller (2004) • Can be rationalized by habit formation behavior of private agent • Relative Income: • 0.02 indicates that a per capita income below average will be associated with a current account deficit • It can be explained by the “stage of development hypothesis” • Investment ratio: • -0.21 denotes that and increase in this ratio by one percent will lower the current account by 0.21 percent. • Can also be linked to the stage of development hypothesis, as the income level of developing economies moves closer to that of EU, the need for investment is likely to diminish.

13. Results • Fiscal Balance: • The coefficient is 0.13 which means that 13 percent of unit change in fiscal balance is reflected in the current account • Confirms the twin-deficits hypothesis • Confirms that there is no complete Ricardian off-set of changes in the way the public expenditure is financed. • Real Effective Exchange Rate: • The REER is not significant in the estimated equation

14. Results In the second equation we introduced two variable related to the financial system. According to Edwards (1995) they can be used to explain the saving ratio. NRIR represents the real interest rate for deposits. It should, ceteris paribus, have a positive effect on current account. M2GDP measure the development of the financial system. Its influence can only be determined empirically because it opens up both saving and investment opportunities.

15. Results • Real Deposit Rate: • The coefficient is 0.0025 which shows a positive relation with the current account. However the influence is very small • Money to GDP: • The coefficient is 0.012 is compliant with the economic literature

16. Results for Romania • The only significant factors are Investment, M2GDP and deposit rate • The continuous increase of the deficit is caused by a series of structural factor influence. • Romania exports low technological products and imports products of high technological level.

17. Conclusions • Current account deficits in developing countries are mainly caused by the stage of development. Developing countries face the need of importing technology and investment. • Consumption smoothing can also be a factor explaining high deficits in the early stage of development. • Although the current account position does not require structural changes, it is not risk free. It can pose a problem in case of set-backs in the course of a country’s development.