Sustainability of External Imbalances

In particular since the mid-1990s, sustainability of large and persistent current account positions—a deficit in the United States matched by surpluses run notably by Japan, China, Germany, and oil-exporting countries—have been attracting much attention from policy makers and economists alike. The emergence of so-called “global imbalances” has been accompanied by two other developments: the “uphill” flow of financial capital from emerging markets to industrial countries and a large accumulation of international currency reserves.

The balance of payments records all economic transactions between residents and non-residents during a specific period of time. In the balance of payments statistics, an economy’s current account is decomposed into international flows associated with transactions in goods and services, net factor income—also called primary income—and unilateral current transfers—also called secondary income (IMF, 2008, p. 13).

This chapter is devoted to a widespread concept of external sustainability which is originally motivated by the notion of fiscal sustainability used in the literature on public finance. Fiscal sustainability is typically defined as the government’s ability to indefinitely continue the same set of fiscal and/or monetary policies while remaining solvent (Burnside, 2005, p. 11). This notion encompasses two central aspects: It builds upon the concept of solvency, i.e., an entity’s ability to repay its debt without explicitly defaulting on it. Beyond that, it imposes a “baseline” on future policy actions (Milesi-Ferretti and Razin, 1996a, p. 4) by requiring the policy stance to be unchanged.

The main task of this chapter is to identify testing conditions that imply the validity of the intertemporal budget constraint and, equivalently, the transversality condition in the data. Empirical tests, by their nature, examine the question whether the IBC is satisfied provided that there will be no major changes in the relevant features of the macroeconomic environment and no changes in the fiscal or monetary policies (Corsetti and Roubini, 1991, p. 355). Further, as sections 4.1 and 4.2 in this chapter will show, it has been so far only possible to find sufficient conditions for the respect of the IBC in the data. In other words, empirical tests can provide evidence in favor of sustainability, yet they cannot verify the lack of sustainability. Different sufficient conditions for the validity of the IBC in the data have different implications for the path of the current account balance. Following the terminology coined by Quintos (1995, p. 411) for the area of fiscal sustainability, we divide them into two categories: those which imply a stationary current account series and those which entail a nonstationary current account series.

This chapter gives an overview of the empirical studies on the intertemporal budget constraint (IBC). Based on the sufficient conditions for the validity of the IBC derived in the previous chapter, the relevant empirical literature can be mainly divided into three groups. The first group seeks to determine the order of integration in the net international investment position (NIIP) and the current account series because difference-stationarity of the NIIP and the current account (of any order) is sufficient to satisfy the IBC. When the NIIP is stationary in levels or first differences, the current account is stationary in levels and sustainable in the strong sense; when the NIIP is stationary in (at least) second differences, the current account is stationary in first differences and sustainable in the weak sense. The first group of the studies on the validity of the IBC is examined in section 5.1.

One approach to external sustainability is based on the idea that external imbalances are sustainable as long as they are the outcome of agents’ optimal decisions (e.g., Edwards, 2007; Blanchard and Milesi-Ferretti, 2009, 2011). An example for external imbalances which are not worrisome are current account surpluses in countries in which the population ages faster than in other countries and which increase their savings in anticipation of the future dissaving once when the number of retirees increases (Blanchard and Milesi-Ferretti, 2009). Another example are current account deficits run by countries which have deeper and more advanced financial markets than other countries and which attract international investors and accumulate foreign liabilities (Mendoza et al., 2007; Caballero et al., 2008a).

There exists a large number of indicators on which both policy makers and economists rely in their assessment of external sustainability. The general consensus is that no single indicator is capable of fully capturing external sustainability (IMF, 2002). This chapter focuses on the most widely used indicators; many of them involve the notion of solvency, that is, require that the economy meets its intertemporal budget constraint.