Current accounts in debtor and creditor countries

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i

CURRENT

ACCOUNTS

IN

DEBTOR

AND

CREDITOR

COUNTRIES

AartKraay

Jaume

Ventura No. 97-12 July, 1997

massachusetts

institute

of

technology

50 memorial

drive

Cambridge, mass.

02139

WORKING

PAPER

DEPARTMENT

OF

ECONOMICS

CURRENT ACCOUNTS

IN

DEBTOR

AND

CREDITOR

COUNTRIES

AartKraay

Jaume

Ventura No. 97-12 July,1997

MASSACHUSEHS

INSTITUTE

OF

TECHNOLOGY

50

MEMORIAL

DRIVE

CAMBRIDGE,

MASS. 021329

siOL

3

Current

Accounts

in

Debtor

and

Creditor

Countries

Aart

Kraay

The

World

Bank

and

Jaume

Ventura

M.I.T.

July

1997

Abstract: Thispaper reexamines a classicquestion in international economics:

What

Isthe currentaccount response toa transitory

income shock such

asa temporary

Improvement

In theterms oftrade, a transferfrom abroad or unusually high

production?

To

answer

this question,

we

construct a world equilibrium

model

in which

productivityvaries acrosscountries

and

international borrowing

and

lending takes placeto exploit

good

investmentopportunities. DespiteIts conventional Ingredients, the

model

generatesthe novelprediction thatfavourable

Income

shocks lead to currentaccountdeficits Indebtorcountries

and

currentaccountsurplusesIn creditor countries. Evidence from thirteen

OECD

countries broadlysupportsthis prediction of thetheory.

We

are gratefultoRudi Dornbuschfordiscussing these ideaswith us.

We

alsothank Daren Acemoglu,Jakob Svensson andparticipants in seminarsatHarvard, Princeton, MIT, RochesterandTheWorldBankfor theirusefulcomments. Further

comments

arewelcome. Pleasecontact the authorsatakraay@worldbank.org (Kraay) orjaume@mit.edu (Ventura).

Theviews expressedhereinare theauthors', and donot necessarilyreflectthoseoftheWorld Bank.

Introduction

This paper reexaminesa classicquestion in international economics:

What

is

the currentaccount responseto

a

transitory

income shock such

as a temporary

improvement

inthe termsof trade, atransferfrom

abroad

or unusually high

production?

To

answer

this question,

we

constructa world equilibrium

model

inwhich

productivity varies across countries

and

international borrowing

and

lending takes place to exploit

good

investmentopportunities. Despite itsconventional ingredients, the

model

generatesthe novel prediction thatfavourable

income shocks

leadto

currentaccountdeficits in debtor countries

and

currentaccountsurpluses increditor countries. Evidence from thirteen

OECD

countries broadly supportsthis prediction of

the theory.

A

simple thoughtexperiment reveals

how

natural ourresultis as a

benchmark

case. Consider acountrythat receives afavourabletransitory

income

shock.

Suppose

further thatthis countrysaves this

shock

and has

two investmentchoices,

domestic capital

and

foreign loans.

To

the extent thatthe

shock

does

notaffectthe

expectedprofitabilityoffuture investments at

home

and

abroad, a reasonable

guess

isthatinvestors allocate the marginal unitofwealth (the

income

shock)

among

assetsinthe

same

proportions astheaverage unitofwealth. Since

by

definition the

shareof adebtor country'swealth invested in domesticcapital

exceeds

one,

an

increase inwealth (savings) results in a greaterincrease in domesticcapital

(investment), leading toa deficit

on

the currentaccount (savings

minus

investment). Conversely, in creditorcountries the increase in wealth

exceeds

investmentat

home,

as

a

portion of thiswealth increase is invested abroad.This

produces

a current

The

sharp resultthat

comes

out ofthissimple

example

followsfrom three

assumptions. First, the

income shock

issaved.

Second,

investing in foreign capital is

not

an

option forthe country. Third,the marginal unitof wealth isallocated

among

assets

as

the average

one

is.

We

maintain the firsttwo assumptions throughoutthe

paperwithout (excessive) apologies.

The

firstassumption isa basic tenet of

consumption-smoothing

models

ofsavings. Despite

some

empirical failures ofthe

simplestofthese models,

we

feel thejury isstill out regarding the relative importance

ofconsumption-smoothing as a savings motive atthe business cyclefrequencythat

we

focus

on

here.^

The

second

assumption can

be

easily removed.^ If

we

keep

the

other assumptions, afavourable

income shock

still leads to

a

currentaccountdeficit

if

and

onlyiftheshare of domesticcapital in the country'swealth

exceeds

one

or,

equivalently, if

and

only ifforeign debt

exceeds

the stockofoutwardforeign

investment. Otherwise afavourable

income shock

leadsto a currentaccount surplus.

The

bulkof thetheoretical effortofthis

paper

is devoted toassessingthe merit of the third assumption underlying oursimple example, namely, thatthe marginal unitof wealth (savings) is invested inthe

same

proportions asthe stockof wealth.

To

do

so,

we

constructa simple world equilibrium

model

in which productivity varies acrosscountries

and

international borrowing

and

lendingtakes place to exploit

good

investmentopportunities. In the model,

we

distinguish

between

production

uncertainty

and

random changes

in technology. In

each

date,

some

countries

have

"good"production functionsthat exhibit high average productivity,whileother

countries

have

"bad" production functionsthat exhibitlow averageproductivity. In

normal times, production functions

do

not

change

but outputis uncertain.

We

usethe

^

_The

_importance

ofconsumption-smoothingdepends onthefrequencyofthedataone is

analyzing.Itis obviously importantforthe analysisofquarterlydata(most peoplespendmore

than theyearnoverChristmasandotherholidays,and

somewhat

lessthan theyearn inother

times), andalmostassurelyisabadtheoryforunderstanding savingsratesoveraquarterofa

century.

See

Deaton (1992)forasurveyofevidenceonintertemporalmodelsofsavings.

^ _{Moreover,thisassumption}

isconsistentwiththestrong

home

equitypreference in

OECD

economiesthathasbeen documentedby Frenchand Poterba(1991) andTesarand Werner

term output

shock

to refertoproduction surprises.

These shocks do

notaffect the probabilitydistribution offuture productivityand, as a result, they

have

only transitory

income

orwealth effects

on

investors. Occasionally, countries perform

economic

reformsorexperience

changes

in their

economic

environment that

change

their"bad" production functionsto "good" ones, or viceversa.

These

events

have

persistent effects onthe average level of productivity,

and

we

label

them

productivity shocks.

Sinceproductivity shocks

change

the probabilitydistribution of future productivity,

they both

have

income

orwealth effects

on

investors,

and

also affecttheir investment

strategies.

In our basic model,

we

assume

that investors exhibitconstant relative risk

aversion

and have

no labourincome.

As

a result, the sharesofwealth invested in

domestic capital

and

foreign loans

depend

only

on

asset characteristics, i.e. expected

returns

and

volatilities. Since these are not affected by output shocks,

we

findthat the marginal unitofwealth (theoutput shock) is investedasthe

average

one

is.

Since countrieswith high productivity are debtors,

we

find that positive outputshocks

lead to current account deficits in thesecountries,

and

tocurrentaccount surpluses

in creditor countries. Thisdistinction

does

notapplyto productivity shocks.

We

find

instead thatfavourable productivityshocks always lead to currentaccount deficits, as

investors react tothe increase in the expected return todomesticcapital by

increasing theirholdings ofdomestic capital

and

reducing theirholdings offoreign loans.

The

usefulnessof this

benchmark model

is that it highlightsthe setof

assumptionsthatunderlie ourexample: shocks

have

onlytransitory

income

effects,

investors exhibit constant relative risk aversion,

and

there is

no

labour income.

We

then proceed to relax theseassumptions. First,

we

find that if relative risk

aversion decreases with wealth, positive output shocks raise wealth

and

induce

investors totake riskierinvestmentpositions.

As

a result, the share ofthe

shock

invested in riskydomesticcapital

exceeds

itsshare in wealth. Second,

we

show

that,

ratioof financial to

human

wealth

and hence expose

the investortogreater risk. This

induces investorstotake safer investmentpositions in their financial wealth,

and

so

the shareof the

shock

invested in domestic capital fallsshort ofits share in financial

wealth.

We

obtain a simple rule todetermine

when

a positive output

shock

leads to a

currentaccountdeficit: the country's debt has to

exceed

a certain threshold that

depends on

how

attitudes towards risk varywithwealth

and

thesize of labour

income. This threshold can

be

eitherpositiveor negative,

and

is zero in the case of

constant relative riskaversion

and no

labour income.

Our

research naturally relates to existingintertemporal

models

of the current account.^

The

earlygeneration ofintertemporal models, such as

Sachs

(1981,1982)

Obstfeld (1982),

Dornbusch

(1983)

and

Svensson and

Razin (1983),

were

designed

to study the effects of terms oftrade

shocks

and

todevelop rigorous theoretical foundationsfor the Harberger-Laursen-Metzlereffect.

We

share with these

models

the notion thatcountries

save

transitory

income

shocks so asto

smooth

consumption

overtime.

However,

since these

models

abstractfrom capital accumulation,

income

shocks

can only

be

invested in foreign loans.

As

a result theypredict that positive transitory

income

shocks lead tocurrentaccount surplusesin all countries.

Simply allowing forcapital accumulation is notsufficient to obtain the

main

result of this paper, however.

Subsequent

contributionsby

Sachs

(1981), Persson

and

Svensson

(1985)

and

Matsuyama

(1987)extended the early intertemporal

models

to include capital accumulation byinvestors with perfect foresight.

These

models

were

designedto analyzethe currentaccount response to persistent shocks

tothe profitabilityofinvestment.'' Sincethe assumption of perfect foresight implies

thatthe return to investment is certain, arbitrage requires thatthe marginal productof

capitalequal the world interest rate. This condition,

combined

with the assumption of

diminishing returns atthe countrylevel, uniquely determines the domestic stockof

SeeObstfeld andRogoff (1995)fora surveyofthese models.

"_{Theseshocks correspond}

capital independently ofthe country's wealth. Hence, transitory

income

shocks which

raisewealth but

do

notaffectthe marginal productof capital are again only invested

in foreign loans, leading to currentaccount surpluses in all countries.

One

can understand our contribution as recognizingthat investment risk has

important implicationsfor

how

the current account reacts to transitory

income

shocks.

Once

investmentis modelled as a risky activity, theappropriate arbitrage condition

equatesthe return

on

investmentto theworld interest rateplusa risk

premium.

Since

the latterincreaseswith the share ofwealth heldas risky domestic capital, transitory

income

shocks which

do

not affectthe profitabilityof investment, but

do

raise wealth,

must

in part

be

invested in domestic capital forthe arbitrage conditionto

be

satisfied.

In particular,

we

find thatthe share ofthe

income shock

that is invested in domestic

capital

exceeds

the

income shock

itself in debtorcountries, but not in creditor countries.^

The

paper is organized as follows: Section 1 developsthe basic model.

Section 2 presents the

main

result ofthe paper. Section 3 explores the robustness of this result. Section 4 presents empirical evidence forthirteen

OECD

countries.

Section 5 concludes.

Zeira (1987) provides anoverlapping-generationsmodelofasmallopen

economy

in which

thereis capitalaccumulation andinvestment risk.The latterarisesfrom astochastic

depreciation rate.This model is usedto

show

thatcross-countrydifferences inthe rate oftime preference couldexplainthe Feldstein-Horiokafinding thatsavings and investment are highly correlatedin a cross-sectionofcountries. Interestingly, hefindsa U-shapedrelationship

between thesteady-state level ofdebtofa countryand its rate oftime preference.

He

does not

1.

A

Model

of International

Borrowing

and

Lending

The

world equilibrium

model

presented here is

based on

theviewthat international borrowing

and

lending resultsfrom differences in investment

opportunities acrosscountries ratherthan differences in the rate oftime preference.^ At

each

date,

some

countries

have

"good" production functionsthat exhibit high

average productivity, whileother countries

have

"bad" production functions that

exhibit low average productivity. Investors in all countries areallowed toborrow

and

lend from

each

otherat

an

interest rate r, which is determinedin world equilibrium.

We

assume

thatthe penaltiesfor defaultare large

enough

that international loans are riskless. Firms

own

theircapital stocks

and

are financed bysalesof equity in

stock markets.

We

assume

thatthe cost of operating in foreign stock markets is high

enough

that only domestic investors

and

firmstrade in the domestic stock market. This is

an

extreme, yetvery popular deviceto generate the strong home-equity

preferenceobserved in real economies.^

We

draw

adistinction

between

production uncertainty

and

random changes

in

the stateoftechnology. In normal times, countries

have

time-invariantbut stochastic production functions.

We

usethe term output shocksto refer to production surprises

which occurduringthese normal times. Since these shocks

do

not affectthe

probability distribution offuture productivity, they

have

only transitory

income

or wealth effects

on

investors. Occasionally, countries perform

economic

reforms or

experience other

changes

in their

economic

environmentthat

have

persistent effects

on

their average level of productivity.

We

label these events as productivityshocks

and model them

as

random changes

in the production function. Since productivity

®_{See Buiter(1981)and cLarida (1990)}

forworldequilibrium models inwhichborrowing and

lending is motivatedbycross-countryvariation in ratesoftime preference.

^_{See Obstfeld (1994)}

foradiscussion oftheeffectsoffinancialintegration ina model similar

shocks

change

the probability distribution offuture productivity, they both

have

income

orwealth effects

on

investors,

and

also affect their investmentstrategies.

A

number

of simplifications serve to highlightthe bare essentials of our

arguments.

We

consideraworld with infinitely

many

atomistic countries, indexed by

j=1,2,... . This allows usto ruleout large-country effects

and

concentrate

on

the pure

effects of international linkages. Also,

we

assume

that there exists a single

good

which is

used

forconsumption

and

investment. This device permitsus tofocus on

intertemporaltrade

and

eliminate the complications that arisefrom

commodity

trade.

Finally,

we

restrict our analysisto the steady stateofthe

model

in which both world

average

growth

and

the interest rate are constant. This allows us tofocus

on

the effects of country-specific shocks as

opposed

to global shocks. While these

assumptionssimplify theanalysis considerably,

we

are convinced that removing

them

would

not affectthe thrustofour arguments.

Firms

and Technology

Production is random. Let_qj

and

kj be the cumulative production

and

the

stockof capital of the representative firm of countryj. Also, definettj as the stateof

technology of thiscountry. Conditional

on

ttj, the production function ofthe

representativefirm is:

dqj =7ij-kj-dt

+

akj-dej

(1)

where

a

is a positive constant

and

theGjS are

Wiener

processes with E[dej]=0

and

E[d9j ]=dt

and

E[d9jd9m]=0 ifj>m. Equation ₍₁₎ is simply a linearproduction function

which states that,conditional

on

the state of technology, the flowofoutput (net of

E[dqj]=7rjkjClt

and

variance-covariance matrix defined by E[dqi^]=a^kfdt

and

E[dqjdqni]=0 ifj^vn. Realizations oftine d0jS are outputshocks. Since these shocks

do

not

change

the probabilitydistribution offuture productivity, they

have

only

income

or wealth effects

on

the

owners

ofthe firm, but

do

not affect theirinvestmentstrategies.

Average

productivityvaries acrosscountries

and

overtime. At

each

date, half

ofthecountries are in a high-productivity regime,n-^

=n

, while the other halfare in a

low-productivity regime,n^

=n,

withn< k.

The

dynamics

ofKj follow a

Poisson-directed process: fO with probability 1

-

(j) dt dTii

=

i (2) ' _{\g{n-.) with probability (j)dt}

\n-K

if TCj

=

7t

where

g(7i;i) = •{_ ., '

; (j),

n

and

n arepositive constantswith n

-

5

< a^

;

' \n

— n

If 7ii

=

7t

E[dKjd9j]=0

and

E[dTtjd7rm]=0 ifj;^m.^ Equation (2) states that

changes

in regime are

rare events (i.e. they occurwith probability that

goes

to zero in the limitof continuous

time) thatare uncorrelated across countries

and

with the output

shocks

in Equation

(1). Sincethe probability ofa

change

in regime is small, productivity levels are

persistent. Since high(low)-productivitycountries expectproductivity eventuallyto

decline (increase), productivity levelsalso exhibitmean-reversion. Realizations ofthe

dTTjSare productivityshocks. Since these shocks

change

the probability distribution of

future productivity, they

have

both

income

or wealth effects

on

the

owners

ofthe firm,

and

they also affecttheirinvestmentstrategies.

Since there are infinitely

many

countries, each periodafraction(t)dtofthe high(low)-productivitycountrieschange regime. Itfollows thatif halfofthe countriesare initially ineach

There

are

many

identical firms in

each

countrywith free

access

toexisting technology.

The

representative firm is divided into kj shares which

have

a (constant) value of

one and

deliver

an

instantaneous dividend equal tothe flow ofproduction per unitof capital.

We

assume

that the realizations ofpast

shocks and

the probability distributions ofthe currentshocks d9j

and

dTij are

known

by investors before

production starts.

However,

the realizations ofthe

contemporaneous

shocks d9j

and

dnij are only

known

after production is completed

and

output is observed. Since

investors

must commit

theirresources before production starts, their investmentsare subject to uncertainty relatedtothe

contemporaneous

realizations ofthe shocks.

Since investors can freelytrade equity afterproduction is completed, their

investmentsare not subject to uncertainty relatedtofuture realizations ofthe shocks.

Itfollows that the return process perceived byinvestors is Tijdt+adcoj,

where

doOj =

—

- dt

+

d9j. Therefore the expected return

and

volatility of holding a shareof

the representative firm aretij

and

o, respectively.^

Consumption

and

Investment

Strategies

Each

country contains

many

identicalconsumer/investors with a logarithmic

utility function:

EjlnCj-e-P'dt

₍₃₎

Despite thefactthat productivityshocksaffectthe returntoinvestment,they do not contribute

tothe

mean

and varianceofthe return processsince both theyoccurinfrequently(with

where

_q

is the consumption ofthe representative

consumer

in countryj. LetHj

and

Xj

be

the wealth ofthis

consumer

and

the shareof wealth that is held in equity, respectively.

We

assume

that aj(0)>0forallj. Then, the consumer's budget

constraint is:

daj

=

[((jtj

-

r)•_Xj

+

r) aj

-

Cj dt

+

aXj-aj-dcOi (4)

Thisbudget constraint illustrates the standard risk-return trade-offbehind investment

decisions. If7i:j>r, increases in the share ofwealth allocated to equity raisethe

expected return towealth by (nj-r)aj, atthe cost of raising the volatilityof this return

byaaj. In

Appendix

1,

we

show

thatthe solution tothe consumer's problem is:

Cj=p-aj

(5)

Tt|

-r

Equation (5) states thatconsumption is a fixed fraction ofwealth

and

is independent

ofasset characteristicsi.e. r,tij

and

c. This is the well-known resultthat

income

and

substitution effects of

changes

in assetcharacteristicscancel for logarithmic

consumers. Equation (6)

shows

thatthe share ofwealth allocatedto

each

asset

depends

only

on

assetcharacteristics, i.e. r, tcj

and

a,

and

not

on

the level ofwealth,

aj. This is nothing but the simple investment rule

we

used

in the

example

in the introduction.

World

Equilibrium

To

findthe world interest rate,

we

use tlie market-clearing condition for

international loans,

^(aj

-kj) =0,

and

the investment rule in Equation (6) to obtain:

T

=

n-a^

(7)

where

n=

lim

—

•

^

Kj '-^j

—

. In

Appendix

1

we

show

thatthereexists a

j^~J

'-'

lim-.Tai

j^-J

.^,

steady-stateinwhich both the worldgrowth rate

and

theworld averageproductivity are constant. In

what

follows,

we

assume

thattheworld

economy

is already in this

steadystate.

Using the world interest rate in Equation (7)

and

the investment rule in

Equation (6)

we

findthat theworld distribution of capital stocks isgiven by:

ki

=

'' 71: -7t^

1+

' . o' J •^i (8)

Equation (8) states thatthe capital stock ofa countryis increasing in both its wealth

and

its productivity. Interestingly, this world ofstochasticlinear

economies does

not

generatethe usual cornersolution ofaworld of deterministic linear

economies

in

which allthe capital islocated in thecountryor countriesthat

have

the highest

productivity. In thepresence ofinvestment risk, these extreme investmentstrategies

are ruledout byinvestorsasexcessively risky. Infact, since

we

have

assumed

that productivity differences are not toolarge relative to theinvestment risk, i.e.

S-u

<

a^, all countries hold positive capitalstocks in equilibrium.

Although world average growth is constant, thisworld

economy

exhibitsa rich

cross-section ofgrowth rates.

To

seethis, substitute Equations (5)-(7) into (4), to find

the stochastic process forwealth:

da. a. 7ti -71

a+-

+

n-c^

-p

dt

+

TZi-n

a+-

dCO; (9)

The

growth rateconsistsof the return tothe country's wealth

minus

the consumption

to wealth ratio.

The

first term in Equation (9) isthe

average

orexpected growth rate,

and

is larger in high-productivity countries, since these countries obtain a higher

average return

on

theirwealth.

The

second

term in Equation (9) isthe unexpected

component

in the growth rate,

and

is

more

volatile in high-productivity

countries, sincethese countries hold a larger fraction oftheirwealth in risky capital.

2.

Determinants

of

the

Current

Account

The

model

developed

above

describes aworld equilibrium inwhich high-productivity countriesborrow from low-productivity countriessince theformer

have

access tobetterinvestmentopportunities than the latter.

The amount

that

high-productivitycountriesborrow is limited only bytheirwillingness to bearrisks.

To

see

this, let fj bethe netforeign assets ofcountryj, i.e.fj=aj-kj ,

and

use Equation (8) to

find that:

Since

n

< n < jt, high-productivity countries are debtors,fj<0, while low-productivity

countries arecreditors, fj>0. Equation (10)

shows

that, for a given level of investment

risk, the

volume

of borrowing

and

lending is largerthe largerare the cross-country

productivity differentials. Also note that, foragiven productivitydifferential, the

volume

ofborrowing is larger the lower is the investment risk. Finally, observe thata

countrycan

move

from lenderto borrower (borrowerto lender) if

and

onlyifit

experiences a positive (negative) productivityshock.^°

Next

we

examine

the behaviorof the curentaccount in thisworld equilibrium.

First,

we

derive the stochasticprocessforthe currentaccount

and

comment

on its

salient features. Second,

we

provide

an

intuition astothe

main

economic

forcesthat

determine

how

the current account responds toshocks. Throughout,

we

emphasize

the differences in the currentaccount

between

debtor

and

creditor countries.^

^

^°

in thisworld, asudden and largecurrentaccount deficitthatturns a countryfrom creditorto

debtorshould be seenas apositivedevelopment.This notionis clearlyatodds with

widely-held beliefs inpolicycircles.

^^ _The

reader mightask

why

emphasizethedebtor/creditordistinction instead ofthe high/low

productivitydistinction.Therearetwo reasons. Fromatheoretical viewpoint,onecould defend

Current

Account

Patterns

Since the currentaccount is tfiectiange in netforeign assets, i.e. dfj,

we

apply

Ito's

lemma

to (10)

and

use Equation (9) to find tfiefollowing stochastic processfor

foreignassets: df;

=

/ _{Kj -71}

a +

- _4-71-a^

-p

f-dt+|a+^

^

J

fdcOi+f

'- (11)

Equation (11) states that net foreign assetsfollowa

mixed

jump-diffusion process

and

provides a complete characterization of their

dynamics

as afunction ofthe du:

forcing processes dOj

and

drtj

(remember

that dcO: dt

+

dB:),andallthe

parametersofthe

model

a, p, (j), n

and

n .

Considerfirst the prediction of the

model

forthe averageor expected current

account in debtor

and

creditorcountries. Taking expectations of (1_{1) yields:}

E[d,,]

=

TCi -Tt

+

-

₊

n-<f

-p

fdt

₊

<t)g(Ttj) Kj

-n

•f-dt (12)

thischoice bypointing out thatthedebtor/creditordistinction is more robust, inour model, only cross-countrydifferencesinaverage productivitydetermine whetheracountryis adebtorora

creditor. If

we

assume,forinstance, that highaverageproductivity isassociatedwith high

volatility in production,it isthen possiblethat the high-productivitytechnology might be

unappealingenoughtoturn high-productivitycountriesintocreditors (seeDevereauxandSaito

(1997)). In thiscase, alltheresults presentedinthis paper would still hold trueforthe

debtor/creditordistinction, but notforthehigh/lowproductivitydistinction.From anempirical

viewpoint andanticipating thatthepredictions ofthe modelwillbeconfrontedwiththe data,

onecoulddefendthe useofthedebtor/creditordistinction based ontheobservationthat existing measuresof net foreignassetpositionsofcountries areof

much

better qualitythan thoseof theiraverage productivity.

Equation (12) separates the expected current accountinto two pieces, whicli capture the effects ofexpected savings

and

expected

changes

in asset returns, respectively.

The

firstterm reflects consumption "tilting" by agents. Ifthe expected return to

wealth

exceeds

(does not exceed) the rate oftime preference, i.e.

' Ttj -71^

a +

—

'

,2

+

Ti

-a

>

_{(<) p},

consumers

will findit optimal tosave (dissave) so as

to"tilt"theirconsumption profile.

These

savingsor dissavings are allocated across

assets in the

same

proportions as the existing stock ofwealth. Ceteris paribus, this

means

that, in growing economies, debtors countries

on

average run currentaccount

deficits, while creditors

have

surpluses on average.

The

opposite is true in

economies

with negative growth.

The

second

term in Equation (12) captures the effects of

mean

reversion in productivity. Since productivityin debtor countries is

above

its long-run average. It is expected todecline, while the converse is truefor

creditorcountries. Reductions (increases) in productivity induce investors to reduce

(increase) theirholdings ofcapital

and

instead lend (borrowfrom) abroad. Ceteris paribus, this

means

thatdebtor countries

on

average experience currentaccount

surpluses, while creditor countries

on

average experience deficits.

The

balance of

the two effects is

ambiguous

in growing economies,

and

depends on

all the

parametersof the model.

The

faster the

economy

grows

and

the smaller the

mean-reverting

component

of productivityis, the

more

likelyit is that

on

average debtors runcurrentaccount deficits

and

creditors run currentaccountsurpluses.

Both output

and

productivityshocks contribute tothe variance ofthe current account.

To

see this, notethat itfollowsfrom Equation (11)

and

the definitions ofthe

shocks that: Var [dfj

=

\2

a+^

^

J r rV^\\2

V^i-^7

(l)fdt

(13) 15

In normaltimes (i.e.with probabilityclose to one)cl7i:j=0

and

fluctuations in the current

account are driven bythe output shocks.

These

shocks

have

small effects (oforder

dt'"^)but occurwith high probability (of order 1).Their contribution tothe variance of

the currentaccount is captured bythefirst term of Equation (13). At

some

infrequent

dates (i.e. with probability closeto zero) dnj^tO

and

the behaviorofthe current

account is

dominated

by productivityshocks. Although these shocks occurwith small

probability (of orderdt), they

do have

large effects

on

the currentaccount (oforder 1)

since theyinduce a reallocation ofinvestors' portfolios.Theircontribution tothe variance ofthe currentaccount is captured bythe

second

term of Equation (13).

The

Current

Account

Response

to

Shocks

We

are

now

ready to

examine

perhapsthe

most

novel finding of this paper,

thatthe response ofthe current accountto

an

output

shock

depends on whether

a

countryis adebtor ora creditor. This resultfollowsdirectlyfrom Equation (11). Since n-

-K

a

+

—

> , a positive outputshock, i.e. d9j>0, leadsto a currentaccountdeficit in

o

debtor countries

and

a currentaccount surplus in creditorcountries.

To

develop

an

intuition for this result,

we

focus

on

the savings-investmentbalance.

The

permanent-income consumers

who

populateour world

economy

save

in

orderto

smooth

theirconsumption over time. Sincethe output

shock

representsa

transitoryincrease in income, itis

saved

(recall Equation (9)). Thisis true regardless

ofwhether a country is a debtor ora creditor,

and

isatypical featureof intertemporal

models

of the current acount.

Having decidedto

save

the output shock, investors

must

then decide

how

to

allocate these additional savings

between

domestic equity

and

foreign loans.

We

departfromprevious intertemporal

models

ofthe currentaccount in

how

we

model

this decision. Sincethe investor's desired holdings ofequityare equal tothe

country'sstockof capital in equilibrium, Equation (6) can

be

interpreted in terms ofa

familiar arbitrage condition:

7t

=r

+

cT^--!- (14)

Equation (14) states that expected rate of return to equity, Kj,

must

equal the world

interest rate, r, plus the appropriate risk orequity

premium,

o^(k/ai). Inthis world of

logarithmic investors, this risk

premium

is is nothing but thecovariance

between

the return to equity

and

the return to the investors' wealth.

The

larger is the share of

domestic capital in investors' wealth, the larger isthis covariance

and

the larger is the

risk

premium

that investors require to hold the marginal unitofequity.

The

additional

savingsthat resultfrom the output

shock

allow investors to increasetheir holdings of

riskydomestic equity without increasing the risk oftheir portfolios, provided thatthey

keep

the share ofequity in their portfoliosconstant. Thus, the marginal unit of wealth

(the outputshock) is invested in the

same

proportionsasthe averageone. Since by

definition the share ofa debtor country's wealth devotedtodomestic capital

exceeds

one,

an

increase in wealth (savings) results in a greaterincrease in domestic capital (investment), leading toa deficit

on

the currentaccount. Conversely, in creditor countries the increase inwealth

exceeds

investment at

home,

as aportion ofthis

wealth increaseis invested abroad. This produces acurrent accountsurplus in

creditor countries.

This discussion

emphasizes

the importance of allowingfor investment risk in

predictingthe currentaccount response to

an

outputshock.

To

the extentthatthis

form of uncertainty is important, existing

models

of the currentaccountthat

assume

investment is a risklessactivity, orelse abstract entirelyfrom capital accumulation.

provide a misleadingdescription of

how

the current account respondsto output shocks.^^

We

now

turn tothe response of the currentaccountto productivityshocks.

n-

-n

First, since

o

+

—

>

, the

second

term ofEquation (1 1)

shows

that a positive

o

productivityshock, i.e. d7ij>0, generates

an income

effectthat leads toa current

accountdeficit in debtor countries

and

a currentaccountsurplus increditor countries.

This effectis formally equivalenttothat of

an

output

shock

and

requires

no

further discussion.

Second, a productivity

shock

has a rate-of-return effect

on

investmentsince it

changes

the probabilitydistribution offuture productivity.^^

When

a creditor (debtor) country receivesa positive (negative) productivityshock, the expected return to

equityincreases (falls). This induces investorsto hold a larger (smaller) fraction of

their portfolioin domestic equityand, as result, generates

an

investment

boom

(bust).

The

counterpartofthis investment response isacurrentaccount deficit(surplus)

and

is reflected inthe third term of Equation (11). Since rate-of-return effects of productivity

shocks

consistof reallocations in thestocks ofassets,their effects

on

the current accountare

much

larger (oforder 1) than the

income

effects ofthe

same

shocks (oforder dt).^"Since productivityshocksare infrequent but

have

large effects,

they

would

show

up as

large spikes in atimeseries of the current account.

^^

Thelarge equitypremium observed inthedatasuggeststhat investmentriskisan important

featureof realeconomies.

A

prediction ofthismodel isthatthisequitypremium,o^+Hj-n,

should be largerin debtorcountries.

To

the bestofourknowledge, thisresultis

new

andhas

notbeentestedyet.

^^

As Equation(5)shows, incomeandsubstitution effectsofchangesintheexpected return to equitycancel inour world oflogarithmicconsumers. In modelswithmoregeneral preferences these rate-of-return effects of productivityshockscouldbeassociatedwithconsumption

booms

or busts,depending onthe balanceof theirincomeandsubstitutioneffects.

^*

And,forthatmatter,

much

largerthan theincomeeffectsofoutputshocks (oforderdt'^).

3.

Investment

Strategies

The

theorydeveloped

above

predicts thatthe current account response to

output shocks is different in debtor

and

creditorcountries. Instrumental in deriving

this result

were

ourassumptions regarding

how

investors trade risk

and

return.

These

assumptions ensured thatthe marginal

and

average propensitiesto invest in

foreign loans coincide.

However,

there is a long

and

distinguished literature that

analyzes

how

optimal investment strategies

depend on

attitudestowards risk, the

size

and

stochastic propertiesof labour

income

and

the correlation

between

asset returns

and

changes

in the investmentopportunity set

and

otheraspects of the investor's environment.^^

A

general finding of this literature isthat

one

should not

expect thatmarginal

and

average propensitiesto invest coincide.

The

purpose of this section isto

show

thata modified version ofour result

holds in a generalized

model

thatallows attitudes towards riskto varywith the level of wealth

and

introduces riskless labourincome.^^

In thegeneralized

model

presented

here, marginal

and

average propensitiesto investin foreign loans differ.

However,

we

find asimple rule which determines

when

a positive output

shock

leadsto a current

accountdeficit: the country's debt has to

exceed

a thresholdthat

depends

on (1)

how

attitudestowards riskvarywithwealth,

and

(2) the size oflabour income. This threshold can

be

eitherpositive or negative,

and

is zero in the

benchmark

case

of

constantrelative risk aversion

and no

labourincome.

We

therefore

have

the modified

resultthatfavourable outputshocks lead to currentaccountdeficits in sufficiently

indebted countries. Otherwise, they lead tocurrentaccount surpluses.

See Merton (1995)foran overviewof this research,and Bodie, Merton andSamuelson

(1992) foranexamplewithrisky labourincome.

We

do notexplore the implicationsforourargument thatarisefromthepossibilitythatasset

returnsbe correlated withchanges inthe investors'environment. Thesecorrelations giverise toa hedgingcomponent inasset

demands

that greatlydepends onthespecificsofthe model.

Two

Extensions

To

allow attitudes toward risk to vary with the level ofwealth,

we

adoptthe following

Stone-Geary

utilityfunction:

oo

Ejln(Cj+pj)e~P'dt

(15)

where

the PjS are constants, possibly different acrosscountries.

The

coefficientof

C:

relative riskaversion, i.e.

—

, varies across countries

and

over time, asfollows.

For agiven level of consumption orwealth, risk aversion isdecreasing in

Pj.

More

importantforour purposes, if _Pj<0

(Pi>0), investors exhibitdecreasing (increasing) relative riskaversion astheir level ofconsumption increases.^^

To

introduce labour income,

we

assume

thatthere is an additional technology

that uses labourto producethe single good.^^

Normalizing the labourforce of

each

countrytoone, the flow ofoutput

produced

using the

second

technology is given by

A,j •dt. Labour productivity, ?ij , is

assumed

to

be

constant although it mightvary

across countries.

Workers

are paida

wage

equal tothe value of theirmarginal

product, i.e. ^jdt.

The

existence oflabour

income

complicates only slightlythe

consumer's budget constraint:

cbj =[((7tj -r)-Xj

+r)aj

+^j

-Cj]dt

+

Xj a^ adcOj (16)

^^_As

iswell-known,consumerswithStone-Geary preferences mightchoose negative consumption.

We

ignorethis inwhatfollows.

Theassumptionofan aggregate lineartechnologybetweenlabourandcapital is

much

less

restrictivethat it might

seem

_atfirstglance. Itarises naturallyinmodels where

some

formof

factor-price-equalizationtheoremholds.

One

could, forexample, usethe modelin Ventura (1997)toendogenouslygenerate alineartechnology.

We

donotdo soheretosave notation.

To

ensurethatall countries hold positive capital stocks in equilibrium,

we

assume

that 3,(0) >

n-G^

The

representative

consumer

residing in country]

maximizes

(15)subjectto

thebudget constraint (16)

and

the (correctin equilibrium) beliefthat r is constant

and

Ttj followsthe

dynamics

in Equation (2). In

Appendix

1,

we

show

that the solution to this generalizedconsumer's problem is:

Ci=p-

a+-^

y ' _J (17) Xi

=

r-a^ J Tti

-r

o

Equations (17)

and

(18) illustrate

how

optimal consumption

and

investment rules

depend on

both attitudes towards risk

and

the presence of labourincome. Note first

that if

consumers

exhibitconstant relative risk aversion, |3j=0,

and

there is

no

labour

income, X,j=0, Equations (17)

and

(18) reduce tothe

consumption

and

investment

rules ofthe previous

model

(Equations (5)

and

(6)).

As

before, consumption islinear

in wealth

and income and

substitution effects of

changes

in the expected return to

equitycancel. Equation (18)

shows

that theshare ofwealth devotedto equity

decreases with wealth if

and

only ifX.j+Pj>0.

To

interpretthis condition, notefirstthat

if _Pj>0,

consumers

exhibitincreasing relative risk aversion,

and

so

choose

toallocate

a smallershareofwealthto riskydomestic capital astheirwealth increases. Second,

note thatin the presence of riskless labour income, A.j >0, increases in financial

wealth raisethe ratio offinancial to

human

wealth, and, ceteris paribus,

expose

the investorto greater risk. In response, agents adopt less aggressive investment

strategies,

and

theshare of financial wealth devoted to riskydomesticcapital falls.

Finally, holding constant the level of wealth, investors with low relative riskaversion,

i.e. high valuesof pj, and/or

a

relatively largestream of riskless labourincome, i.e.

high valuesof \,will devote

a

largershareoftheirwealthto riskydomestic capital.

World

Equilibrium

To

compute

the world equilibrium interestrate,

we

impose once

again the

1 J

market-clearing condition for international loans, lim

-

•

^^aj -

kj

=0

and

usethe

investment rule (18)tofind thatEquation (7) isstillvalid.

Appendix

1

shows

that, if

1 "^

lim

--^^.j

_+Pj

=

, there exists a steady-state in which both theworldgrowth rate ~*°°_^

j=i

and

world average productivityare constants. In

what

follows,

we

assume

thatthis restriction regarding the cross-countrydistribution ofparameters is satisfied

and

that theworld

economy

isin the steady state.

The

world distribution of capital stocks is

now

given by astraightforward generalization of Equation (8): ki

=

(

^i+^A

(

T^\-A

1

+

-' <J _J (19)

As

before, the capital stockofa countryis increasing in both Its productivity

and

wealth,

and

moreover, theworld distribution of capital stocksis non-degenerate since

the restrictionsthat 3,(0)

>

—

—

j-

_and

ti-ti

<

a^,jointly ensure thatall countries 71

-a

.

hold positive capital stocl<s in equilibrium.^^ Inaddition, countries

whose

residents

have

a high tolerance for riskand/or high labour productivity, i.e. high _Pj and/or X,j,

have

large domestic capital stocks.

We

find,

once

more, thatwhilethe world average growth rate is constant, the

world

economy

exhibits a rich cross-section ofgrowth rates.

To

seethis, substitute

Equations (17)-(18)

and

(7) intothe budgetconstraintin Equation (16) toobtain:

da.

a+-

+

K-a^-p

1

+

^i+Pi

a(7r-(/)

•dt

+

o

+

Kj -Tt 1

+

L

+

a

a(7r-o^)

dco, (20)

As

before, high productivitycountries

grow

faster

and

experience

more

volatile

growth than low productivity countries.

Perhaps

the

most

interesting difference

between

this growth rate

and

the special

case

in Equation (9) is that, if _^j+Pj>0

(/\.j+Pj<0), both the growth rate ofa country

and

the volatilityof the growth rate decline

(increase) with the level ofwealth. This is a

consequence

ofthe investment strategy

described n Equations (18). IfX,j+Pj>0 (>.j+Pj<0), investors investa smaller (larger)

share of theirwealth to riskydomestic capital as theirwealth increases, lowering

(raising) both the expected return

on

theirwealth

and

thevolatility of thatreturn.

Determinants

of

the

Current

Account

We

are

now

ready to

examine

the behaviourofthe current accountin this

more

general model.

The

world distribution of loans is given bythefollowing

generalization of Equation (10):

19

Thefirstparameterrestrictionensuresthefirstparenthesesin Equation (19) is positive.

) ^2

n-a

[

a

(21)

As

before, the

model

describesa world equilibrium in which, conditional

on

the level ofwealth, high-productivity countriesborrow from low-productivitycountries in order

to take

advantage

ofbetter investmentopportunitiesat

home.

This is reflected in the

first term in Equation (21). In addition, the international pattern of borrowing

and

lending reflectscross-country differences inattitudes towards risk

and

the

characteristics oflabour

income

across countries. Countriespopulated by investors

who

have

a high (low) tolerance for riskand/ora large (small) stream of riskless labour

income

?ij+Pj>0 (^j+(3j<0)are, ceteris paribus,

more

likelyto

be

debtors.

We

find the currentaccount by applying Ito's

lemma

to Equation (21)

and

using Equations (17)

and

(20)

: dfj-f \2

a+—

V

+

7c

-

a

-

_p /

K-O

J •dt

+

a+-Ttj -7t^ ( X-.

+P

fi+-7t-a^ \ f •dcoj

+

J V

V

^i+pi drt:

n-c

K;

-n

(22)

The

current account again followsa

mixed

jump-diffusion process, with

dynamics

that

can

be

completely characterized interms ofthe underlying shocks, d9j

and

drtj,

and

all theparametersof the model, a, p, (j),

k

,n , X,j

and

_Pj. Since

we

have

assumed

that

iim-T'^i

+p:

=0,

the results ofthe previous section

may

be thoughtofas

describing the determinantsofthe currentaccountfor

an

averageor"typical" country

where

_>.j+Pj=0.

Comparing

Equations (22)

and

(11),

we

see thatthey areidentical

provided that

we

replace fjwith i

+

—

—

^

. Thus, ail ofthe results in Section 2

n-a

generalize in a straightfonward

manner

providedthatthis modified definition ofdebt is

used. Accordingly,

we

restrictourselves here toa brief discussion ofthe additional insightsobtained from the

more

general

mode!

regarding the response ofthe current

accountto outputshocks.

K-

-n

Since

o +

—

> , Equation (21)

shows

that a positiveoutput shock, i.e.

o

^i+Pi

d9j>0, leads toa currentaccount deficit in countries

where

fj

+—

—

^

<

and

a

n-a

surplus in countries

where

fj

+—

—

^

> . This result is again bestunderstood in

n-a

terms ofthe savings-investment balance.

As

inthe

model

ofthe previous section,

savings behaviour is verystandard

and

reflects the desireof agentsto

smooth

their

consumption

in the faceoftransitory

income

shocks.

Where

ourresults differfrom

the existingcurrentaccount literature is in

how

these savings are allocated across

assets. Rearranging Equation (18),

we

obtain the following generalization of the arbitrage condition in Equation (14).

K

=r

+

a'-^-7

^—r

'-^

(23)

aj

_{(K-a^)-aj+^j+Pj}

The

risk

premium

is the product oftwoterms.

The

first is the covariance

between

the

return

on

equity

and

the return

on an

investor'sportfolio, which is greater the largeris

the volatilityof equity returns

and

the largeris the share ofwealth invested in

domestic equity, o^-(k/aj).

The

second

term isthe coefficient of relative risk aversion

(7i-a^)-aj

ofthe investor'svalue function,

—r

. In the

model

of the previous

section ?.j+PpO

and

thiscoefficient

was

equal toone. Inthis

more

general setting, it

depends on

both attitudes towards risk

and

the relative importance of riskless labour

income.

Most

importantforour results is thatthisterm is decreasing (increasing) in

wealth provided that Xj+Pj<0 (^j+Pj>0).

Suppose

now

that a country experiences a

positive output

shock

that raises investors' wealth. Ifthe marginal unitofwealth is

invested in exactlythe

same

proportions asthe average unit, the overall risk

premium

falls (rises) if >lj+Pj<0 (>.j+Pj>0),

and

Equation (23)

no

longer holds. Hence, for the

arbitrage conditionto

be

satisfied, the marginal unitofwealth invested in risky

domestic capital

must exceed

(be less than) theaverage unit.

This result qualifiesthe relationship

between

debt

and

the response ofthe current accountto output shocks. If^j+pj<0 (/Vj+Pj>0), acountry

may

be

a creditor

(debtor)

and

yetexperience a current accountdeficit (surplus) in response to a

favourable

income

shock. If relative riskaversion decreaseswith wealth, positive

output shocksthat raise wealth induce investorsto take riskier investment positions.

As

a result, theshare of the marginal unit ofwealth invested in riskydomestic capital

exceeds

its share inaverage wealth.

Depending on

the magnitude ofthis effect,

some

creditorcountries might run currentaccount deficits. Since labour

income

is

less riskythan capital income, positive output

shocks

raisethe ratiooffinancial to

human

wealth

and hence expose

the investor togreater risk. Thisinduces investors

totake safer investmentpositions in theirfinancialwealth,

and

sotheshare of the

shock

invested in domestic capital fallsshort ofits share in financial wealth. Hence,

^°_The

coefficient ofrelative riskaversion ofthevaluefunction tellsus

how

theconsumer

valuesdifferent lotteries inwealth,asapposedtothe coefficientof relative riskaversionofthe

utilityfunction,whichtellsus

how

theconsumervalues different lotteriesoverconsumption.

The latterdependsonlyon preferences, while theformerdependson both preferences and

otheraspects oftheconsumers'environment.

some

debtor countries might run currentaccount surpluses in response toa

favourable output shock.

In

summary,

we

find asimple rule to determine the response of the current

accountto afavourable output shock. Ifthe level ofdebt

exceeds

thefollowing

threshold -fj >

—

'

—

^

, then favourable outputshocks lead to a currentaccount

Tt-a

deficit. Otherwise, they lead to acurrentaccount surplus. This threshold can

be

positiveor negative,

and

inthe special case ofthe previous sectionsis equalto zero.

Finally, notethat using Equation (21)

we

can rewrite this conditionas 7tj>7i. Thatis,

high-outputshocks lead to currentaccountdeficits in high-productivity countries

and

current accountsurpluses in low-productivity countries.^^

Once

again, rememberthatthis isaconsequenceofourassumptionthatthere are no

differencesacross countries involatilities.

See

footnote 11.

4.

Empirical

Evidence

In thissection,

we

present

some

preliminary empirical evidencethat broadly supports thetheory developed above.This evidenceis not intended as a formaltest

ofthe theory, but ratheras suggestivethat

we

are capturing

some

aspectsof the

behaviourofthe current account in the real world.

We

begin by

assuming

that X-^+^i

and

TCj are unobservable. Hence, the threshold level ofdebt

above

which output

shocks lead to current account deficits cannot

be

observed.

Under

thisassumption,

the content ofourtheorycan

be

understood as a probabilistic statementthatthe higheris the level of debt ofthe country, the

more

likelyfavourable output

shocks

lead to currentaccountdeficits.^^

We

take per capita

GNP

growth as

an

imperfect

measure

of the

shocks

emphasized

bythe theory. This

measure

is imperfect since it

does

not distinguish

between

output

and

productivity shocks. Yetto the extentthat output shocks are present in the data,

we

would

expect to findthat thecorrelation of

the currentaccountwith percapita

GNP

growth is smaller in countries with higher levels ofdebt. Accordingly,

we

study

how

thiscorrelation varies with the level ofdebt

of a country.

Data

For ourempirical work,

we

requireappropriate

measures

of debt

and

the current account.

We

constructa

measure

ofdebt usingdata

on

the international

investmentpositions (MPs) of

OECD

economies

as reported in the International

Monetary

Fund's Balance of

Payments

Statistics Yearbook.

The

IIP is a compilation

ofestimatesof stocksof assetscorresponding tothe variousflow transactions in the

^^_{The unconditional}

probabilityofan outputshockleadingtoacurrentaccountdeficit is

Pr(^+Pi>-rfj)=Pr(7ij>7i)=1/2. However,conditional onthe level ofdebtofthecountryandforany

distribution ofXj+Pj, this probabilityis Pr(;\.j+Pj>-rfjlfj) whichis increasinginfj.

capital accountofthe balance ofpayments, valued at nnarket prices.

We

measure

debt as

minus one

times the net holdings of public

and

private bonds,

and

other

long-and

short-term capital of the resident official

and

non-official sectors, expressed as a

ratio to

GNP.

However,

as noted in the introduction, this

measure

ofdebt cannot

be

used

to inferthe share ofwealth heldas claimson domestic capital, since it

does

not

take into accountthe factthatthe countries in our

sample

can hold theirwealth in

three forms:debt, domestic capital,

and

capital locatedabroad. Accordingly,

we

subtractoutwardforeign direct investment

and

holdings offoreign equity by domestic

residents from debt toarrive at

an

"adjusted debt"measure. Figure

A1

plots the time seriesfordebt

and

adjusted debt forthe thirteen

OECD

economies

forwhich

we

are able to constructthesevariables.^^_Table

1 presents an overview of the datafor the

sample

of 13

OECD

countries forwhich it is possibleto construct adjusted debt

measures.

The

first

column

reports the net external debt ofcountryj, expressed as a

fraction of

GNP,

while the

second column

reportsthe holdings ofclaims

on

capital located abroad.

The

third

column

reportsthe difference

between

thefirst two

columns, our"adjusted debt" measure.

We

measure

the currentaccount as the

change

in the international

investment position of a country, expressed as afraction of

GNP.

Since

MPs

are

measured

at market prices, the

change

in the IIP reflectsboth thewithin-period transactionswhich comprisethe conventional flow

measure

ofthe currentaccount,

as well as revaluations in the stockof foreign assets. FigureA2, which plotsthe conventional

measure

ofthe current account

and

the

change

in the IIP for

each

of the countries in oursample, revealsthatthe contribution of revaluation effects tothe

change

inthe IIP is substantial in

most

countries.

Thefinal sampleofcountries isdetermined bythelimited dataavailabilityfortheseseries.

A

complete descriptionofthedata isprovided inAppendix2.

Current

Account

Cyclicality in

Debtor

and

Creditor

Countries

We

are

now

readyto

examine

how

the cyclicalityofthe currentaccount varies

with the level ofdebt ofa country. Table 2 presents afirst lookat the evidence.

The

first

column

reportsthe average level of adjusted debt overthe period 1971-93, while

the

second column

reports the time-seriescorrelation ofthe currentaccount surplus

(expressed as a share of

GNP)

with per capita

GNP

growth overthe

same

period,for

each

ofthe countries in oursample. In sixout of

seven

countries

where

adjusted

debt is positive,the current account iscountercyclical

(Sweden

isthe only exception), while infive out ofsix countries

where

adjusted debt is negative, the current account is procyclical (Japan is the only exception). This pattern is highlighted in Figure 1

,

which plots the cyclicalityofthe currentaccount (on thevertical axis) against the level

of adjusted debt (on the horizontal axis).

There

is a clear negative relationship,

and

the simplecorrelation

between

thetwo variablesis -0.54.

Although highly suggestive, the results in Table 1 should

be

interpreted with

some

caution asthey pool information within countries.

To

the extent that country-specific levels ofproductivityare constantovertime, this

poses no

particular

difficulties.

However,

if

changes

in productivity are importantin the data,the simple

time series correlations in Figure 1

may

obscure variationsovertime in the cyclicality ofthe currentaccountwithin countries.

To

addressthis concern,

we

adoptthe

following strategy. First,

we

pool all country-yearpairs ofobservations

and

rank

them

bytheiradjusted debt.

We

then divide the

sample

in two ata particularthreshold

level ofadjusted debt. Then, forthe two subsamples,

we

compute

the cyclicalityof

the current accountforthetwo

subgroups

and

testwhetherthey are significantly different.^^

^'*

We

removecountry

means

from allvariablesbefore computingthecorrelations.

We

test for

equalityofcurrentaccountcyclicality inthetwo groupsasfollows: First,

we

regress thecurrent

accountonpercapitaincome growth inthetwo subsamples. Undertheassumptionthatthe twopointestimators are independentandasymptoticallynormal,

we

canconstruct the usual

Wald statisticforthe null hypotheses thattheslopecoefficientsareequal inthetwo

Figures 2(a)-2(d) present the resultsof this robustness

check

forvarious

subsamples

ofthe data, in

each

figure,the bold (solid) line plots thecyclicality ofthe current account in debtor (creditor) countries forthe corresponding level ofadjusted

debt atwhich the

sample

is divided intwo, indicated

on

the x-axis.

The

dashed

line

reportsthe p-valuefora test of the null hypothesisthat thecyclicality ofthe current

account is equal in the twogroups. Figure 2(a)

uses

datafor all countries overthe

entire period from 1971 to 1993,

and

reveals thatcurrentaccounts are clearly procyclical in creditorcountries

and

countercyclical indebtors. Moreover, forawide

range ofvaluesof the threshold, thisdifference is significant at the5-10 percent

level. Figures 2(b),(c)

and

(d) present the

same

information forthree

subsamples

of

the data. Figures2(b)

and

2(c) restrictthe

sample

to the 1971-81

and 1982-93

subperiods respectively,

and

reveal thatthe differencein currentaccountcyclicality is

much

more pronounced

in the latterperiod.

However,

if

we

drop thetwo years

following the

1973

and 1979

oil shocks from the 1971-82 subperiod, as is

done

in

Figure 2(d), the pattern

we

emphasize

re-emerges.

Inthe theory developed above, output shocks are

saved

in bothdebtor

and

creditor countries, while thedifferential currentaccount behavior in thetwo sets of

countries arises from thethe differential investmentresponse tooutput shocks. In

debtor countries, a fraction greaterthan

one

of these savings is allocated to domestic

capital, while in creditorcountries athisfraction is smallerthan one.

The

third

and

fourth

columns

of Table 2 provide

some

rough indicators of these two pieces of the theory.

The

third

column

reportsthe within-country time-series correlation

between

percapita

GNP

growth

and

savings.^^ In all countries, there is a strongpositive correlation

between

savings

and

percapita

Income

growth atannual frequencies, consistentwith theview that at least

some

portion ofshocks to

income

are

saved

in

subsamples.

A

rejection of thisnull hypothesisconstitutes evidencethatthecyclicalityofthe currentaccountdiffers inthetwo groupsofcountries.

Savings isdefined as net nationalsavings, expressed as afraction of

GNP.

orderto

smooth

consumption overtime.

As

in the theory,there is

no

obvious

relationship

between

the level ofdebt

and

thecyclical behaviourof savings.^^

The

final

column

ofTable 2 reports thewithin-countrytime series correlation

between

savings

and

the current account. Consistent with the theory, there is a strong

negative relationship

between

the level of debtof acountry

and

the correlation of

savings

and

the current account. Insix out of

seven

debtorcountries, savings

and

the currentaccount are negativelycorrelated, while in five out of six creditors, they arepositively correlated

(Sweden

and Japan

again are exceptions).

Other Explanations

for

the Debtor/Creditor

Distinction

A

notable feature ofbusiness cycles in

OECD

economies

isthat theytend to

be

highlycorrelated across countries.^'' This observation suggests twopossible alternative explanationswhich might account forthe difference in current account

cyclicality

between

debtor

and

creditorcountries. First,

OECD-wide

economic

expansions tendto

be

associatedwith increases in interest rates. In fact, the

time-series correlation

between

OECD

average percapita

GNP

growth

and

growth in the

six-month

LIBOR

is 0.55. Thus, it is possible thatcurrent accountsare

countercyclical in debtor countries only

because

domestic

booms

coincide with high present

and

expected future debtservice obligations.

Second, to the extentthatcountries hold claims

on

foreign capital,current

accountfluctuations also reflectdomestic

and

foreign residents' decisions

on

how

much

capital tohold abroad. This too can potentiallyaccountforthe countercyclicality

®_{This ofcoursedoes not}

ruleoutotherexplanations fortheprocyclicality ofsavings. For example,if

booms

redistributewealth from individualswith low savings propensitiesto

individualswithhigh savingspropensities, savingswould alsobe procyclical. However, aslong

asindividuals allocatetheirwealth using investment rulessuch astheonesdiscussed inthis

paper,oureffectswouldstill arise.

SeeCostello (1993) and Kraay and Ventura(1997)