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

1
 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.

2
 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)

1
This is the period of rapid trade liberalization, globalization and capital flows in the world.
3
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).

V  u (C1 )  u (C 2 ) ..................... (5)

where 0<<1, u' (Ct )  0, u" (Ct )  0. Then, life time budget constraint without government and

investment is

C2 Y
C1   Y1  2 .....................................(6),
1 r 1 r

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

The first order condition is u ' (C1 )  (1  r ) u ' (C 2 ) ,......................(7)

2
Drawn from Obstfeld and Rogoff (1996).
4
which is called intertemporal Euler Equation. Then, C 2  Y2  (1  r )(Y1  C1 ) . In this case,

foreign asset accumulation view of current account implies CAt as

CAt  Bt 1  Bt  Yt  rt Bt  Ct .................................(8)

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

C2 Y  G2
C1   Y1  G1  2 ........................................(9)
1 r 1 r
Then, CAt  Bt 1  Bt  Yt  rt Bt  Ct  Gt .......................................(10)

With investment, saving can flow into capital as well as foreign assets. Since
I t  K t 1  K t , the change in total domestic wealth (national saving) is

Bt 1  K t 1  ( Bt  K t )  Yt  rt Bt  Ct  Gt ..................................(11)
Rearranging terms, current account becomes
CAt  Bt 1  Bt  Yt  rt Bt  Ct  Gt  I t ,.............................(12)

where S t  Yt  rt Bt  Ct  Gt , so that CAt  S t  I t . 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 B2  Y1  C1  G1  I 1 for period 1 and

 B2  Y2  rB2  C 2  G2  I 2 for period 2. Then, intertemporal budget constraint is

C2  I 2 Y  G2
C1  I 1   Y1  G1  2 ............................(13)
1 r 1 r

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

Yt  F ( K t , Lt ) . But, assuming constant labor supply, the production function is


Yt  F ( K t , L) and there is diminishing marginal return to capital. Agents can invest in future

capital stock by reducing current consumption as I t  Yt  Ct in autarky. But, in an open

economy, a country can borrow from abroad.

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 F
Optimal production is characterized by  r and optimal consumption is
K 2

characterized by u ' (C1 )  (1  r ) u ' (C 2 ) . 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


U t    s t u (C s ) ........................(14)
s t

subject to

Bs 1  Bs  rBs  As F ( K s )  Cs  I s  Gs ............................(15)
For every period st, two condition must hold as
u' (Cs )  (1  r )u' (Cs 1 ) ............................(16)

As 1 F ' ( K s 1 )  r .........................................(17)

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

should also hold.

T
 1 
lim
T  1  r
 Bt T 1  0 ...........................(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)


B(0)   e  rt S t dt or lim e  rt B(t )  0 ..................................(19),
t 
0

where B(0) is initial debt at time zero, St is the primary surplus ( Yt  Ct  I t  Gt ), B(t) is

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

6
 
B(0)   e  rt S t dt ...................................(20)
0

Hence, the current account is an intertemporal phenomenon. This is the basic insight

underlying the intertemporal approach to current account. Strategy of the intertemporal approach

is to focus on saving and investment behavior as determinants of current account. Assuming the

behavior of private saving and private investment is stable over time, some argue that

government's fiscal deficit is related to current account deficit i.e. twin deficit3. The effect of

budget deficit on current account, thus, depends on reaction of private savings; there would be no

effect on current account if an increase in private saving compensates a decrease in the public

saving (Ricardian equivalence). But, a decrease in public saving not compensated by a rise in

private savings would generate current account deficit.

In this way, current account acts as an intertemporal trade allowing for higher investment

and a more favorable consumption path and thus enhances growth and welfare. Economic agents

in an open economy context make optimal decisions on consumption and investment

expenditure, and the trade account closes the gap between gross domestic production and

spending (Semmler, 2008). This theory has a number of implications, mainly (i) possibility of

twin deficit: budget deficit and current account deficit, and (ii) a higher economic growth drives

current account deficit or in another words today‘s current account reflects expectations about

future growth rates. But a question can arise on the sustainability of current account deficit,

because there should not be a persistent current account deficit in the long term i.e. non-

explosiveness of the debt of a country (Semmler, 2006).

3
The Mundel Flemming approach argues that an increase in budget deficit induces an upward pressure on interest
rates that, in turn, will trigger capital inflows and an appreciation of exchange rates, ultimately leading to an increase
in CAD (Kouassi et.al, 2004, p504).
7
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;

8
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.

9
 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

10
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

4
It may be due to rising remittance inflows instead of improvement in trade balance.
11
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 Indonesia

5.0
10.0
0.0
5.0
90

92

94

96

98

00

02

04

06
-5.0
19

19

19

19

19

20

20

20

20 0.0
-10.0

90

92

94

96

98

00

02

04

06
BB CAB -5.0

19

19

19

19

19

20

20

20

20
BB CAB

Thailand South Korea

15.0
20.0
10.0
10.0 5.0
0.0
0.0
-5.0
90

92

94

96

98

00

02

04

06
19

19

19

19

19

20

20

20

20
90

92

94

96

98

00

02

04

06

-10.0 BB CAB
19

19

19

19

19

20

20

20

20

BB CAB

12
 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 0.73
Source: Calculated from data obtained from Asian Development Bank
Chart 2: Economic Growth and Current Account Balance in 8 Asian Countries

Indone sia
India 15.0
15.0 10.0
10.0 5.0
5.0 0.0
0.0 -5.0
90

92

94

96

98

00

02

04

06
-10.0
19

19

19

19

19

20

20

20

20
-5.0
90

92

94

96

98

00

02

04

06

-15.0
19

19

19

19

19

20

20

20

20

GDP growth CAB GDP growth CAB

Thailand South Korea

15.0
12.0
20.0 9.0
10.0 6.0
3.0
0.0 0.0
-10.0 -3.0
90

92

94

96

98

00

02

04

06

90

92

94

96

98

00

02

04

06
19

19

19

19

19

20

20

20

20

19

19

19

19

19

20

20

20

20
-20.0 -6.0
GDP growth CAB -9.0 GDP growth CAB

Ne pal Banglade sh

12.0 9.0
9.0
6.0 6.0
3.0
0.0 3.0
-3.0
-6.0 0.0
90

92

94

96

98

00

02

04

06

-9.0
1990
1992
1994
1996
1998
2000
2002
2004
2006

-3.0
19

19

19

19

19

20

20

20

20

-12.0
GDP growth CAB -6.0 GDP growth CAB

13
 The following equation is estimated to identify the determinants of current account, as

identified by the intertemporal model.

 CA   BD   ED 
    0  1     2 GDPgrowth t   3     t ......................(21)
 GDP  t  GDP  t  GDP  t
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 -0.34 -0.07 -0.05 0.31 1.46 0.25
(-0.17) (-0.90) (-0.42) (-0.81)
Indonesia 0.97 -0.79 -0.11 0.01 0.82 1.58 0.78
(0.24) (-1.68) (-0.48) (0.28)
Thailand 1.96 -2.10* -0.18 -0.01 0.74 1.70
(0.41) (-3.73) (-0.57) (-0.15)
South -2.76 -0.61 -0.29 0.23 0.71 1.58 0.40
Korea (-0.69) (-1.50) (-1.53) (1.76)
Nepal 7.08 1.30* -0.84* -0.003 0.74 1.26
(1.38) (4.37) (-2.44) (-0.02)
Bangladesh -4.33 -0.04 0.39 0.03 0.05 1.35
(-0.83) (-0.14) (0.82) (0.40)
Vietnam 11.5** 0.006 -1.71 -0.01 0.42 1.36
14
 (2.00) (0.01) (-2.58)* (-1.56)
Pakistan -3.66 1.56* 0.24 0.19** 0.68 1.35
(-0.73) (5.0) (0.77) (1.82)
* 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 limCY0 e ( g r )t B(t )  0 , where g is the
t 

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

St B(t )
    t .................................(22)
Yt Y (t )

>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.

15
 Table 3 reports the estimation of equation (22). Only, Thailand, South Korea and

Nepal have passed the debt sustainability criteria prescribed by the equation (22). However,

declining trend of external debt to GDP ratio in the sampled countries shows that repayment of

debt would not be a problem.

Table 3 : Debt Sustainability

Dependent Variables: St to GDP ratio
(t-statistics in parenthesis)
Country India Indonesia Thailand South Nepal Banglad Vietnam Pakistan
Korea esh
 -1.20 5.78* 1.07 -3.44* -16.8* -5.20** -3.48 -10.77
(-1.12) (2.33) (0.05) (-2.54) (-5.04) (-2.05) (-1.74) (-1.44)
B(t)/Y(t) 0.06 -0.01 0.20** 0.23* 0.17* 0.01 -0.004 0.22
(1.36) (-0.41) (2.04) (4.17) (2.59) (0.20) (-0.18) (1.28)
R2 0.11 0.01 0.84 0.52 0.31 0.22 0.39 0.29
DW 1.32 1.23 1.34 1.02 1.52 1.34 1.18 1.62
* Significant at 5 % level of significance
** Significant at 10% level of significance
 is the coefficient of serial correlation

5. Conclusion

This paper examined the determinants of current account and debt sustainability scenario

in line with the intertemporal model of current account in eight Asian countries. Determinants of

current account as predicted by the model are found valid only in a few countries. This shows

that current account is not explained by only the determinants like budget deficit and economic

growth. Other factors like foreign aid, remittance, and capital movement may also play an

important role in determining the current account. As a result, countries may have persistent

current account deficit even without high fiscal deficit and growth, and vice versa.

Intuitively, one could argue that low-income countries are vulnerable to current account

deficit owing to their limited capacity to generate foreign exchange to finance their imports.

However, current growing trend of remittance inflows to developing countries has been helping

them to maintain external balance amidst weak trade balance. Hence, Cassimon et al. (2008)

16
rightly argue that there is no one-size-fits-all model to analyze current account balance

sustainability.

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