The interrelation between the current account (CA) and capital account (KA), more recently known as the financial accounts, of the balance of payments is a fundamental relation in open economy macroeconomics. The “interdependence” between these component accounts captures the reactions of the financial and real sectors to systemic disturbances and their interaction during the adjustment process (Fausten, 1989-90). These reactions constitute channels for the intersectoral transmission of disturbances, and expose the susceptibility of the domestic nonfinancial sector to developments in international asset markets. Prominent intermediate variables which play a role in this process include income, foreign direct investment, exchange rates, interest rates, and so on. The interrelation between these component accounts of the balance of payments is well known in both the theoretical and empirical literature. But the nature of that interdependent has not been examined intensively.
One issue of particular interest is the simultaneity of the CA and KA. In the limiting case of freely floating exchange rates, CA deficits are financed entirely by KA surpluses and, conversely, net capital flows are “financed”, or transferred, through commensurate imbalances on current account. Formally, the simultaneity of the two component external accounts is captured in the double-entry bookkeeping practice of balance of payments accounting. The economic substance of this phenomenon derives from the fact that voluntary transactions involve exchanges of equivalents – i.e., any sale or purchase involves a quid pro quo. Both equivalents are determined simultaneously and, in the case of cross-border transactions, are recorded in the external accounts.
The requirement that net flows on the two component accounts of the balance of payments must be mutually consistent implies that at any point in time the flow balances of the two accounts are mirror images of each other (CAB = -KAB). The resulting “redundancy” problem”, viz. that in a closed system with n variables only n-1 variables are independent while the nth variable must be determined residually, is captured in the balance of payments constraint. However, the constraint itself does not identify which variable (or component account) is the residual element, i.e., should be written on the left hand side. The alternative options have inspired alternative “views” of the balance of payments that assign primacy to different sectors of the economy in the determination of balance of payments outcomes (Johnson, 1966). Emphasis on either the CA or the KA as the autonomous driver of cross-border transactions flows has been invoked as a rationale for selecting either the real or the financial sector of the economy for explicit analysis of external balance issues. These alternative structural and analytical perspectives are reflected, respectively, in the traditional “commodity” approach and the more modern “monetary” and “assets” approaches to the balance of payments and exchange rates.
Reliance on the formal equivalence of the alternative component accounts can easily lead to structural misspecification. Modelling a country?s economic interactions with the rest of the world from the alternative narrow behavioural perspective of either component account, or associated approaches, can easily ignore important structural relations. Hence, a reorientation towards an integrated general equilibrium approach to the balance of payments would be conducive to a more reliable modelling strategy. The general equilibrium perspective explicitly acknowledges the quintessential intermediation function of the financial sector instead of modelling it as a self-contained domain of economic behaviour. More importantly, it assigns a central role to the interaction between the financial and nonfinancial (real) sectors for the simultaneous determination of the CA and KA balances. That is, variables in both the financial and the real sectors play essential roles in determining simultaneously the outcomes on current and capital account.
Though the fact of interdependence between these two component accounts is “self evident” and tautological ex post, systematic tests of this interdependence can be conducted to understand its underlying structure. Intuitively, the structure of this interdependency is conceptually informed by the recognition that any economic disturbance and its responses are not restricted to a particular subset of markets. For example, a shock to the financial market exerts a direct influence on portfolio balance which is immediately transmitted to real assets markets and, hence to the income expenditure balance. More formally, systematic shocks of financial markets precipitate balance sheet adjustments in the financial sector that change the parameters for behaviour in the nonfinancial sectors. In the presence of different adjustment speeds in financial and nonfinancial sectors, market clearing is more quickly achieved in some sectors than in others. For an open economy, the consequences of adjustment behaviour are systematically captured by the simultaneous changes in the two component accounts of the balance of payments, the current and capital account outcomes over any period of time must be mutually consistent. Market adjustments feed back into the complex of structural relationships that determine real and financial behaviour and the outcomes on current and capital account. Clearly, this structural relationship is not adequately captured by modelling a particular (subset of) market such as the market for foreign exchange as if it is determined within a small subset of segregated markets (Fausten, 1989-90).
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Current and Capital Account Interdependence: An Empirical Test
