Research Proposal.docx

RESEARCH PROPOSAL Yashodhara Thorat, B-7253 Prapti Mohanty, D-7837 Mansi Mate, A-7075 What are the factors determining the Current Account Deficit in Developing and Developed countries?

INTRODUCTION The current account balance refers to the difference between the value of imports and exports of goods and services. The increase in the import levels compared to the exports gives rise to the deficit in the current account, also known as Net Exports of the Balance of Payments (BoP) of a country. It is one of the measures of International Trade. The current account is determined by many factors such as: Budget Balance, Trade Openness, Net Foreign Assets, Terms of Trade, Real Effective exchange rate, Foreign Direct Investment, Real GDP growth and various others. Trade surpluses does not guarantee economic prosperity. Similarly, trade deficit does not always lead to economic weaknesses.The effects of CAD dependon economic situation of the country involved. Thus, it can have positive as well as negative consequences, which impact employment level, currency value, interest rate, inflation, savings ratio and production. However, the detrimental effect of CAD can decelerate the economic growth. For instance, when a country engages in long term borrowing from abroad which burdens the country with a very high interest payment kept aside the principle amount, this in turn increases the un-sustainability. Due to this unstable nature, there is a decline in investor's confidence which leads to withdrawal of capital and further leads devaluation and depreciation of currency. Therefore, the increase in the current account deficit leads to overall deficit in budget balance. Hence, it is important to study the current account deficit.

LITERATURE REVIEW A number of researchers have empirically investigated the determinants of the current account deficit for fifteen developed and developing countries. Researcher(Das, December 2016) is the first to empiricallycharacterise that current account balance of the developed country depends positively on factors such as net foreign assets, exchange rate stability and trade openness and is negatively linked with real GDP growth, commodity price and real effective exchange rate. On the contrary, emerging countries witness positive correlations with trade openness, real GDP growth and commodity price and are negatively associated with net foreign assets and exchange rate stability.

The international macroeconomic outlook observes a mainstream debate on the importance and nature of current account imbalance and its potential path in the global economy. To assess the current account imbalance of 30 countries, factors like FDI and banks’ nonperforming loans to the countries have also been considered. (Papergeogieu & Steel , January 2016)editors of the European Economic Review on Model Uncertainty in Economics (2016), claim that both global imbalances and financial market deregulations feature prominently among causes for global financial crises. That being said, there is limited investigation on the relationship between the two. There is robust evidence that financial market regulations can affect current account deficits and that different aspects of these regulations can have opposing effects on the current account. Particularly, we find that easing bank entry barriers is negatively associated with current account balance whilst securities market deregulation and bank privatisation tend to raise current account balances. Financing of credit has often been linked to emergence of current account imbalances. Since most of the deficit countries experienced credit booms at the same time as these imbalances were building up, there is investigation on the link between domestic credit developments and the current account balance. Estimation results depict that flows of bank loans to the nonfinancial private sector are a significant determinant of the current account and that alongside changes in competitiveness, they constituted the most vital factor driving the build-up of the current account imbalances in the deficit countries. Accordingly, retarding an increase in private sector indebtedness proves itself a promising way to dampen the formation of unsustainable current account imbalances. One primary concern of economic policy in developing countries is the choice of appropriate exchange rate regime to accelerate the pace of economic growth. It is important to see whether the choice of a country’s exchange rate regime may affect current account imbalances for lower developing economies. (Gnimassoun, May 2015) in his 2015 study of The Importance of the exchange rate regime in limiting current account imbalances in sub-Saharan African countries, first vitally identified key determinants of external balances. Post this, estimating current account imbalances over a two-decade long period of 1990-2010 he showed that flexible exchange rates are more effective in preventing such disequilibria. (Bertola & Prete Lo , March 2015)from the Manchester School in 2016 analysed the possible implications of labour market reforms for an open economy’s human capital investment and future production. As per his model, labour market deregulation can imply more positive current-account balances if financial markets are imperfect and if institutions not only alter labour allocation but also smooth income. Empirically, in OECD country-level data, found by (Unger, May 2017) in his study of labour market volatility and financial development in the advanced OECD countries (2016), found that labour market regulation has been positively associated with current-account surpluses on average and fiercely more when and where financial market access was more limited. The aforementioned results are robust to inclusion of standard determinants of current-account imbalances and are not motivated by cyclical phenomena.

METHODOLOGY AND DATA The variables that we are using for determining the current account deficit are: 

Budget balance: Commonly referred to as public fiscal balance, budget balance is the difference between government revenues and government expenditure. Depending on the difference, it can be a surplus or a deficit budget. Based on various empirical studies, this variable is positively related to the current account balance depending on the effects of government’s expenditure on savings rate and the development of the financial markets.

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Foreign Direct Investments: These investments are made by firms or individuals of foreign countries in the domestic country. It not only involves capital investments but also includes supplies of technical know-how and management. FDIs are more sustainable than portfolio investments. The inflow of FDI increases the deficits in the current account.

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Terms Of Trade (TOT): TOT is the ratio of export prices to import prices.The terms of trade favouring import prices deteriorate the balance of payments condition. It increases the expenditure and hence decreases the temporary income of the people. This decreases the savings and causes a rise in the deficits of current account.

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Degree of openness: It is the ratio of exports to the GDP. Elevated degree of openness invites more investments which might increase the level of deficits in the balance of payments. Therefore, the higher degree of openness can be both a positive and a negative influence on the country’s accounts.

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Monetary aggregate: It is a measure of the money in circulation within an economy at a particular period in time. This variable affects the development of financial system which in return affects the savings rate. A rise in the money supply in the economy can increase the savings rate which is a positive in the current account balance.

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Non-performing assets of the banks: These are loans or advances made by the banks to the firms or individuals which remain unpaid. These have a negative effect on the current account.

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Net foreign exchange assets: Level of foreign exchange reserves influences the current account deficit directly as it influences net investment income. FOREX reserves help in reducing the deficits in the current account. Hence, this variable shares a positive relation with the current account balance.

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Real Effective Exchange Rate: This is the rate that determines the value of the currency of domestic country in terms of the other major currencies. The exchange rate policies affect the current account balance, depending on the implementation of the policies. In case of appreciation of real exchange rate, the price competitiveness decreases, thereby increasing the deficits in the current account.

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We are using ordinary least squares(OLS) regression model in this paper to find the major determinants of current account deficits in developed and developing countries separately taking CAD(as % of GDP) as the dependent variable and budget balance(as % of GDP), foreign direct investments( as % of GDP), degree of openness, ratio of export prices and import prices, monetary aggregate (as % of GDP), loans (as % of GDP), FOREX assets (as % of GDP) and effective exchange rate( with base year as 2010=100) are the independent variables.

PRELIMINARY SUPPOSITION AND IMPLICATION The factors concerning CAD can vary between differentnations. However, to some extent, there are a few similarvariables that we have taken which could be affecting the CAD in both the developed as well as developing nations. The chosen economic variables have a good empirical linkage with the CAD, but depending on whether the country is a developed or developing one, the variable could be of great significance in determining CAD or it might have a minor effect comparatively. In Developing countries, CAD are persistent and it is mainly due to higher domestic output growth, unfavourable terms of trade, appreciation of real exchange rate and foreign interest rates. In very backward countries however the CAD is large and is financed through borrowings. In Developed countries, with the fall in prices of export commodities, the countries rely on debt for financing imports which further enlarge the CAD. It also shows the competitiveness of the country in global world. Therefore, it has largely been a concern for both developed and developing countries to minimize the extent of CAD that they have. The important implication of this study is to suggest policy recommendations for an external balance, separately to the developed and developing countries on the basis of the degree of effect each variable has on the CAD. Our main effort is to provide useful information about change in policy position and assessing the desirability of a deficit.

CONCLUSION The overview of this proposal helps us to conclude the remarks of the implications of the said variables on the Current Account Deficit of a country. The nature of current account imbalance, and its probable path in the global economy have been a matter of discussion on

the international macroeconomic viewpoint. The current account on the Balance of Payments plays a vital role in the economic growth of a country. Thus, it should always be kept in check and to the lowest minimum level.

Bibliography Bertola, G., & Prete Lo , A. (March 2015). Reforms, Finance, and Current Accounts. Review on International Economics. Das, D. K. (December 2016). Determinants of Current Account Imbalance in the global economy: a dynamic panel analysis. Journal of Economic Structures. Gnimassoun, B. (May 2015). The importance of the exchange rate regime in limiting current account imbalances in sub Saharan African Countries. Journal of International Money and Finance. Papergeogieu, C., & Steel , M. (January 2016). Model Uncetainity in Economics. European Economic Review , 1-201. Unger, R. (May 2017). Asymmetric Credit growth and Current Account Imbalance in the Euro area. Journal of International Money and Finance, 435-451.