The implications of persistent and widening global current account imbalances have been at the center of policy debates over the last half decade. While the concerns subside each year, as a rapid unraveling of the imbalances fails to materialize, the intellectual challenge of determining what drives these imbalances remains. To the extent that some policymakers view the configuration of imbalances to be undesirable, a salient question remains what policies would cause those imbalances shrink.
These imbalances are large. The U.S. deficit was 6.5% of GDP, while China’s surplus was 9.1%, with balances in the next two years projected at 10%. The rest of the Developing Asian region is running an average current account surplus of 5.4%. Finally, the sustained elevation in oil prices has added oil exporters to the list of surplus countries. Figure 1 highlights the lopsided nature of imbalances, with the U.S. deficit primarily financed by East Asia and the Middle East.
As a consequence of the magnitude of their surpluses, China and other Asian emerging market countries have often been identified as the main causes of the widening U.S. current account deficits. More specifically, these economies’ underdeveloped and closed financial markets are alleged to be insufficiently attractive enough to absorb the excess saving in the region, resulting in a “saving glut”. Clarida (2005a,b) argues that East Asian, particularly Chinese, financial markets are less sophisticated, deep, and open so that Asian excess saving inevitably flows into the highly developed U.S. financial market. Bernanke (2005) contends that “some of the key reasons for the large U.S. current account deficit are external to the United States” and remediable only in the long run. That is, it is the saving glut of the Asian emerging market countries, driven by rising savings and collapsing investment in the aftermath of the financial crisis, that is the direct cause of the U.S. current account deficit. Therefore, the long term solution is to encourage developing countries, especially those in the East Asian region, to develop financial markets so that the saving rate would fall. Once policies improving institutions and legal systems amenable to financial development and liberalizing the markets are implemented, “a greater share of global saving can be redirected away from the United States and toward the developing nations.”
Standing in stark contrast to the saving glut thesis is the more parochial view that a fall in the U.S. national saving, most notably in the form of its government budget deficit, is the main cause of the ongoing current account deficits – the “twin deficit” argument. While the twin deficit effect has been empirically investigated in the literature (e.g., Gale and Orszag, 2004), as far as we are aware, very little investigation has been made to shed light on the effect of financial development on current account balances, with the exception of Chinn and Ito (2007a). In this investigation encompassing a sample of 89 countries over the 1971-2004 period, we found that more financial development leads to higher saving for countries with underdevelopment institutions and closed financial markets that includes most of East Asian emerging market countries.
This paper takes a closer look at the effect of financial development on current account balances and the saving-investment determination. Financial development cannot be defined and measured simply (see Beck et al., 2001). Chinn and Ito (2007b) used private credit creation (as a ratio to GDP) as a shorthand proxy measure for financial development. Clearly this is a simplification with implications that should be investigated. Hence, in this paper, we undertake a closer look at the effect of different types of financial development – whether banking, equity, bond, or insurance market sector – to gain different insights. Additionally, we investigate various dimensions of financial development, such as size, degree of activity, and efficiency. Given the ongoing asset market booms in China and other emerging market countries in East Asia, size measures alone might lead to misleading inferences.
Other factors are suggested by the current debate. Bernanke argues that the openness of financial markets can also affect the direction of cross-border capital flows. Alfaro et al. (2003), on the other hand, show that institutional development may explain the Lucas paradox, i.e., why capital flows from developing countries with presumably high marginal products of capital to developed countries with low ones. In short, financial development might be mediated by financial openness and institutional development. Hence, we will examine interaction effects as well.
Our empirical analysis relies upon a dataset composed of 19 industrialized countries and 70 developing countries for the period of 1986 through 2005. Financial development is assessed from various perspectives: different types of financial markets such as banking, equity, and bond markets, as well as different aspects of financial development such as the size, activeness, and cost performance of the industry. The analysis involves making one key trade-off: in refining the measures of financial development, we reduce the set of countries covered, as well as the time sample. We believe that the payoff to making this trade-off is on net positive.
To anticipate our findings, we find the following. First, we confirm a role for budget balances in industrial countries when bond markets are incorporated. Second, empirically both credit to the private sector and stock market capitalization appear to be equally important determinants of current account behavior. Third, while increases in the size of financial markets induce a decline in the current account balance in industrial countries, the reverse is more often the case for developing countries, especially when other measures of financial development are included. However, because of nonlinearities incorporated into the specifications, this characterization is contingent. Fourth, a greater degree of financial openness is typically associated with a smaller current account balance in developing countries.
The paper is organized as follows. Section 2 recaps the debate over financial development, openness and institutions, and how those factors are related to the current pattern of current account imbalances, and saving and investment flows. Section 3 details the empirical methodology and results. Section 4 draws out the policy implications; Section 5 concludes.
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