Sustainable and Excessive Current Account Deficits

The abundance of private capital flows confronts many emerging-market authorities with a transfer problem. They must decide whether to accept or resist the net capital inflow, or how much to accept and how much to resist. This paper aims at assisting that decision by focusing on the rationale, the sustainability and the source of protracted private-sector driven current account deficits. First, the paper consults the consumption-smoothing (intertemporal) approach to the current account for a prediction about how the "equilibrium" current account should respond to a reform-induced productivity rise and to a cyclical drop in the world interest rate ~ two impulses that have figured prominently in the discussion on the determinants of recent capital flows to the emerging markets. The approach predicts a widening of current account deficits if the country enjoys a persistent idiosyncratic productivity boom. By contrast, the current account deficit should decline in the face of temporarily low world interest rates. Second, the paper presents various long-term sustainability measures of debt-augmenting capital flows, since authorities need to know the required magnitude and time profile of adjustment back to payments balance as deficits will not be financed by foreigners forever. Any judgment about long-term sustainability needs to consider debt-GDP ratios (current versus tolerated by investors), official foreign exchange reserves (current versus targeted), the potential growth rate of GDP and imports, catch-up appreciation of the real exchange rate, and the structure of capital inflows. Third, protracted current account deficits should be resisted when they are seen to finance excessive consumption or unproductive investment. A clear warning signal is usually the coincidence of unsustainable currency appreciation, excessive risk-taking in the banking system and a sharp drop in private savings. A case can be made to accept all foreign direct investment, unless it is distorted by trade restrictions and as long as it can be absorbed by the existing stock of human capital.