1. Does Capital Mobility Finance or Cause a Current Account Imbalance? Antonio H-D Yan Universidad Francisco Marroquin March 22, 2006

2. Two Hot Issues in the International Economics Free capital mobility: a blessing or a curse? –Causes of capital mobility, “ push ” or “ pull ” factor; policy response; sequences and paces of financial liberalization. Persistent current account deficit –Recall the 1994-95 Mexican peso crisis, and the 1997-98 Asian financial crisis: the collapse of the pegged exchange rate regime; inconsistent trinity; selection of exchange rate regime.

3. Motivation Haunted by Asian financial crises, an increased concern about the persistent and growing current account deficit in the USA Are capital inflows to the USA the causes or consequences of the CA deficits?

4. Richard Cooper (2001) “ The U.S. deficit is ‘ financed ’ by net capital inflows only in an ex post accounting sense. In economic terms it is more nearly correct to say that net capital inflows cause the current account deficit. ”

5. William Poole (2001) “ That many commentators have expressed the mistaken view that the capital and financial account ‘ finances ’ the current account. In fact, for the United States, changes in the capital and financial account have been driving changes in the current account for many years. ” “ That many commentators have expressed the mistaken view that the capital and financial account ‘ finances ’ the current account. In fact, for the United States, changes in the capital and financial account have been driving changes in the current account for many years. ”

6. The Purposes of This Paper Show that developed countries and developing countries are different on the causality of the current account and capital mobility One of the differences is whether the financial system is sophisticated enough to absorb the inflowing capitals

7. An Empirical Study “ If you torture the data long enough, Nature will confess. ” Ronald Coase A job interview: Mathematician, Statistician, and Econometrist.

8. Is Persistent Current Account Deficit a Problem? Yes: Corsetti, et al. (1999) and Edwards (2002) for Developing Countries; Obstfeld and Rogoff (2004) and Roubini and Setser (2004) for the USA. No: McKinnon (2001) and Mann (2002), and Bernanke (2005).

9. Determinants of the CA The factors of depth and sophistication of the financial system have a positive effect on the current account for emerging economies, while its effect is not significant for developed countries. (Chinn and Prasad, 2003)

10. How Current Account Imbalance Adjusts? Part of the business cycle for developed countries, Freund (2000). Emerging economies in the 1990s reflect that a postponed current account adjustment plays a central role in dragging down the economy, Edwards (2002).

11. Capital Inflow Overshooting and Volatility There is difference between trade in widgets and dollars (Bhagwati, 1998) absorptive capacity (Bacchante and Wincoop, 2000)

12. BOP Accounting 0 = CA + FA + RES = CA +(FDI +PI +OI)+RES It is an identity and no causality is implied.

13. How FA affects CA? CA = S – I = EX – IM = EX – IM  release liquidity constraint (C up)  real E appreciate, TB deficit  real estate market boom (nontradable demand up)  FDI complements to I  difference between short-run and long-run (policy response) Capital inflow: supply-pushed

14. How CA Affects FA? High profit opportunity induced capital inflow to finance domestic investment, USA CA surplus need to balance BOP, Japan Demand-induced capital inflow

15. Causal Relation: CA and FA It is an empirical question Different causal relation in the current account and financial account between emerging economies and developed countries. Developing countries are much more vulnerable to free capital mobility.

16. Wong and Carranza (1999) Four developing countries: Argentina, Mexico, the Philippines, and Thailand prior to 1989 (CA -> FA) prior to 1989 (CA -> FA) after 1989 (FA -> CA) after 1989 (FA -> CA)

17. Empirical Methodology: Modified Wald Test on Granger Causality Dolado and L ü tkepohl (1996) and Toda and Yamamoda (1995) Modified Wald test

18. The Augmented VAR between CA and FA The null hypothesis of Granger non- causality from FA (CA) to CA (FA) is = 0.

19. The Augmented VAR between CA and FDI, PI, and OI

20. Caveats of the Granger Causality Reverse Causality: X ’ mas and X ’ mas card (be cautious when interprets the results) Omitted variables: here X and GDP

21. Data Developing countries: (1989.1-2003.4) Argentina, Brazil, Indonesia, Mexico, Philippines, South Korea, and Thailand the G-7: (1974.1-2003.4) Canada, France, Germany(1974.1-1989.4), Italy, Japan, UK, and USA. (Kaminsky and Schmukler, 2003) CA, FA (FDI, PI, OI) in GDP ratio;and GDP and real E in growth rate

22. Empirical Results (without controlled variables) CA and FA Table 1a (developing countries) Table 1b (G-7) CA and FDI, PI and OI Table 2a (developing countries) Table 2b (G-7)

23. Empirical Results (with controlled variables) CA and FA Table 3a (developing countries) Table 3b (G-7) CA and FDI, PI and OI Table 4a (developing countries) Table 4b (G-7)

24. Empirical Results (structural break) Tables 5a and 5b – developing countries Tables 5a and 5b – developing countries Tables 6a and 6b – G-7 Tables 6a and 6b – G-7

25. Conclusion (1) For developed countries, capital mobility is demand-induced and financial account functions to finance current account. For emerging economies, capital mobility works like supply-pushed; the financial account causes current account deficit. For emerging economies (South Korea and Thailand), other investment (bank loans) brings to current account deficits.

26. Conclusion (2) Without a sophisticated and sound financial system should not recklessly dismantle their restrictions of capital mobility The pace and sequence of liberalization of the financial account should be heeded also.

27. Extensions Global savings glut: examining the causality between FA with S and I Using panel causality test to include more countries and to have a more general result. (Geweke, 1982 – simultaneous causality) Add the financial deepening variable in the regression