Financial Regulation and the Current Account
We study the effect of financial liberalization on current account adjustment. The intertemporal model of the current account predicts that smaller liquidity constraints (our proxy for financial liberalization) increase the size and persistence of the cur
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tract We study the effect of financial liberalization on current account adjustment. The intertemporal model of the current account predicts that smaller liquidity constraints (our proxy for financial liberalization) increase the size and persistence of the current account response to a domestic net output shock. This prediction is tested in a sample of 79 countries with an interacted Bayesian panel VAR model, which allows for the impulse responses to vary with the degree of financial liberalization, as well as for cross-sectional dependence and dynamic heterogeneity, two important econometric issues that previous interacted panel VAR work has ignored. Our results suggest that the reaction of the current account balance to a net output shock is approximately 80 percent larger, and more persistent, in the average financially liberalized country than in the average financially repressed country. This finding is robust with allowing
S. Lanau (*) IMF, 700 19th Street NW, 20431, Washington, DC, USA T. Wieladek Barclays, Flat 1016 Anchor House, 21 St George Wharf, London SW8 2FH, UK © The Author(s) 2016 P. Arestis, M. Sawyer (eds.), Financial Liberalisation, DOI 10.1007/978-3-319-41219-1_8
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S. Lanau and T. Wieladek
the VAR coefficients to vary with other determinants of current account adjustment, such as the degree of capital account openness, trade openness, financial development, and the exchange rate regime. Keywords Cross-sectional dependence • Current account adjustment • Dynamic heterogeneity • Financial repression • Interacted panel VAR JEL Classification F32 • F41 • G28
8.1 Introduction1 An assertion among many academic and applied economists is that flexible exchange rate regimes facilitate current account adjustment. Indeed, this view is so widespread that policy recommendations aimed at reducing global current account imbalances typically focus on reform of exchange rate regimes in emerging market economies. But recent empirical evidence casts doubt on this idea (Chinn and Wei 2013). In this chapter we explore the role of domestic financial repression/liberalization as an alternative determinant of current account adjustment. Previous work focused on the relationship between domestic financial liberalization and savings decisions in the closed economy (see Bayoumi 1993b; Bayoumi and Koujianou 1989; Japelli and Pagano 1994; Bandiera et al. 2000, among others). But the impact of financial liberalization on the relationship between domestic shocks and the current account is not well understood. This chapter aims to fill that gap. We first examine the effect of financial repression, modeled in the form of liquidity constraints, in the standard intertemporal model of the current account. This theory suggests that the size impact of log-level/difference net output shocks on, as well as the persistence response of, the current account varies with the degree of financial repression. These predictions are tested with a panel VAR model, where the coefficients are allowed to vary with the degree of fi
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