4.1. FDI, the Quality of Institutions and Financial Crisis
Table 3 presents results from the GLS Random Effects estimation for 49 countries over 1985–2014. Column 1 is the baseline model, which consider fundamentals as explanatory variables along with the financial crisis measure and its interaction term with the openness index (as suggested by [
19]). Here, we add FDI as percentage of the GDP. Specifications displayed in Columns 2, 3 and 4 incorporate the three institutional indices (Economic, Legal and Political) separately in addition to the FDI variable. Column 5 include the three institutional indices together along with the rest of variables of Column 1. Following the conventional practices, we show some specification test. All estimates consider the potential heteroskedasticity issue; for this reason, we compute White robust standard errors for all regressions [
32]. We also prove the validity of our proposed model with the Hausman test. We also discuss the importance of time dummies; here, we jointly test their validity in all models and these results are presented for each regression column. In line with the compliance of these specification test, our model is well suited.
FDI is significant in most of the specifications at least at 10% level, and it is associated with improvements of the current account balances. In our estimations, an increase of 1% in FDI as percentage of GDP is associated with an improvement of the current account by between 0.35% and 0.45% of GDP. It may be argued that the higher the FDI inflows, the greater the boost on exports—hence improving the current account balance—since FDI may allow improvement in productivity through technological transfer, and the import of know-how; moreover, FDI may look four economies with high levels of productivity in the first place, reinforcing the cycle. In our sample, Netherlands and Switzerland, two of the countries with highest FDI net inflows (between 3.50 and 5.15% of GDP) and high productivity, recorded current account surpluses between 6% and 11% of GDP during the period 2005–2014.
Contrary to the stage of development hypothesis, the current account would be negatively related to the growth rate—fast growing countries tend to run surpluses ceteris paribus. However, such coefficient is not statistically significant. Higher fiscal balances are positively associated with current account surpluses, as is suggested by the twin deficit hypothesis. Moreover 1% increase in the budget balance improves the current account by between 0.20% and 0.28%, in line with previous estimations [
5,
20]. Openness ratio is highly significant and countries that are 10% more open than the sample mean tend to run, on average, between 0.36% and 0.47% larger current account balances. In addition, consistent with previous findings, crude oil balance and demographics variables are not significant for our four specifications.
Columns 2, 3 and 4 display results from a specification that incorporates separately the institutional quality indices provided by Kuncic [
24]. Column 2 exhibits that an improvement in the quality of Economic Institutions is significant to explain current account balances, since better Economic Institutions allow lower current account balances by attracting capital inflows. This may be the case of some of the advanced economies—with the ability of implementing sound macroeconomic and stabilisation policies—that attract capital due to finance their deficits. In Column 3, results show that the better Legal Institutions, the greater the incoming of capital inflows to the economy, since it is logical that a clear regulatory framework and legal certainty provide confidence to overseas investors to finance such economies. The Political Institutions index, however, was not significant in the specification reported in Column 4, which may suggest that macroeconomic management and clear legal frameworks—that may allow investors to obtain higher and/or safe returns—are more important for investors than political institutions. In Column 5, when including the three institutional indices at the same time, only the Economic Institutions index is significant. The latter may be absorbing the effect of the Legal Institutions variable, which now become not significant. This may be related to a high correlation between Economic and Legal indices, since countries presenting better legal and regulatory frameworks may also tend to establish better—and sometimes independent—economic institutions. This result is congruent with other studies finding that current account balances are shown to deteriorate in the face of greater institutional quality [
17,
19].
We also consider the effect of financial crises on the current account balances as previous studies do. Estimation results presented in
Table 3 indicate that the financial crisis variable and its interaction with the openness ratio are mostly significant across models at 10% level. Overall, the more open an economy, the more likely that the current account will improve following financial crises. This result is similar to the seminar work of Gruber and Kamin [
19], where they find that in economies with an openness ratio of 0.25–0.30%, the overall effect of financial crisis on current account balances is positive, as in the case of East Asian economies during the 1997 financial crisis, and, as we present below, this was also the case of some of the Advanced Economies during the 2008 GFC.
Figure 3 presents the contributions of individual determinants of current accounts in each our nonoverlapping 5-year periods for some of the advanced economies (exhibit a) and the East Asian emerging economies in our sample (exhibit b). It is calculated by computing the contribution of each variable to the current account predicted value. That is multiplying the actual value of each variable by the corresponding variable’s coefficient estimated by RE panel effects, for each country, which is then GDP-weighted averaged to compute the country-group average. Besides the constant term, the highest contribution to current account deficits in our subset of exhibit are the quality of Institutions and fiscal balances. Meanwhile, the level of per capita income, the openness ratio and FDI are factors explaining most of the surpluses. In the subset of exhibit b, the contribution of the quality of Institutions to explain the current account balances is rather small in comparison to advanced economies. Actual levels of the current account are closer to those predicted by fundamentals and by our additional variables—FDI and Institutions specially in the first three subperiods and in the last subperiod for both subsets of countries. The positive net effect of financial crises on current account balances is also visible from both figures. It is clear, however, that the contribution of financial crisis to the current account balances is low in comparison to other determinants in our sample.
Indeed, it was commonly acknowledged that, the widespread currency depreciations in East Asian countries during the 1997 crisis episode allowed the crisis-inflicted countries to boost their exports and hence the trade balance. This was made possible at the back of growing global demand due to the regional nature of the crisis, the consequences of which had been largely contained. In contrast, we find that the reversal in the current accounts in the aftermath of the GFC of developed countries during 2010–2014 (0.22%) was slightly greater than in the aftermath of the 1997 Asian crisis during the subperiod of 2000–2004 (0.16%). There was also a different pattern in the improvement of current accounts in this period; trade balance improved in some of developed countries that were directly involved in the crisis not through the boost of their exports, as in the Asian crisis, but through a sharp reduction in imports.
For instance, in 2009, the US exports decreased by 13.8%, while its imports dropped by 22.7%; in the United Kingdom, exports and imports were reduced by 19.6% and 21.3%, respectively, and in Spain, the fall in exports and imports were 17.9% and 28.0%, respectively. Such sharp drops in imports followed from the collapse of output in these countries, particularly given that all the three countries and particularly the former two were at the epicentre of the GFC. The collapse in output, in turn, followed from the deep loss in confidence in the banking system and the credit crunch, resulting in the collapse of the world trade. Consequently, economic activity in the crisis-hit countries remained subdued for an extended period of time, in contrast to the v-shaped recovery enjoyed by the Asian economies in the late 1990s. On average, and as shown previously in
Figure 2a,b, trade balance to GDP ratio in these countries enhanced during the period of 2008–2011, allowing the current account in most affected economies to improve over the same period.
The above assessment of the contribution of financial crises on current accounts points to two separate channels through which a financial crisis episode impacts of current accounts: trade channel and financial channel. Our results in
Table 3 supports the view that the greater the openness to trade, the larger the improvements in current account balances in the wake of a financial crisis. Cross-country evidence from the GFC period reveals that countries that were more open to trade experienced greater contractions in output, as compared with precrisis forecasts [
33], and greater cumulative drop in output, consumption, investment and aggregate demand over the period of 2008–2009 [
34]. Given the substantial increase in the financial integration across the globe, financial linkages across countries have also come to play a crucial role in the transmission of shocks across countries (see, e.g., [
35]). The next subsection will examine the role of the financial channel on the dynamics between FDI, Institutions, financial crisis and the current account balances.
4.2. The Role of Financial Development
To examine the role of the financial channel on current accounts, we incorporate as proxy two indices of the IMF’s Financial Development Indices (1980–2013), developed by Svirydzenka [
26]. The first is the
Financial Development Index (FDIX), which measures the depth and the quality of both financial markets and financial institutions. The second is the Financial Institutions Index (FIIX), which only quantify the depth and the efficiency of financial institutions. To capture the role the state of financial markets plays in the consequences of FDI and the Quality of Institutions on current accounts, we provide different specifications in
Table 4.
Overall, FDIX and FIIX as proxies of financial development are significant and they do not alter our main results from the earlier specifications. In Column 1, we appreciate that financial development—measured by FDIX—is significant at 5% level to explain current account balances. In Column 2, once we incorporate institutional indices, FDIX becomes significant only at 10%. In such case, FDI becomes not significant. In Column 3 and Column 4, FIIX is strongly significant, even when including the Economic Institutions index, which may be strongly correlated to FIIX (Financial Institutions Index). This result is mostly in line with other studies reporting that more developed financial markets are associated with economies running current account deficits [
5,
22]. In our final specification, Column 5, we also include the exchange rate of each country as explanatory variable. Results are mainly the same as in previous estimation, except for the fact that most of the year dummies are not significant. The latter may suggest that some of the differences of the current account balances across time may be due to the long-run movements of the exchange rate. This variable was not included in previous specification since the financial crisis variable may be already capturing the large depreciations of the exchange rate commonly experienced during financial crisis.
Across these four specifications, our results reveal that countries with highly developed financial sectors tend to run smaller surpluses or higher deficits in comparison to countries with less development financial sectors. The diversity of credit instruments and the amount of credit that financial development is able to generate in the economy might allow those countries to attract capital flows when running current account deficits. Our earlier findings with respect to the link between fiscal balance, the quality of Institutions, FDI and financial crisis—and its interaction with the openness ratio—mostly prevail in these specifications. In
Figure 4, we display the variable contributions when predicting current account balances, using the model from
Table 4, Column 2, that is including the FDIX as financial development proxy. As in the case of previous figures, we show two subsets of countries: advanced economies involved in the 2008 GFC, and East Asian countries involved in the 1997 financial crisis. In contrast to
Figure 3, we may appreciate a high contribution of the proxy for financial development, which contribute more to current account deficits in Advanced Economies in comparison to East Asian Countries.
It is important to note that when performing the Hausman test, some models (
Table 3: column 4 and
Table 4: columns 2, 4 and 5) are not consistent, and a fixed effects model is preferred over the random effects (which is established as our main technique). However, as it is mentioned above, our approach needs to focus on cross-country differences since those are very important for determining current account balances. Some can question about the inclusion of variables, which could be highly related (the correlation matrix is exhibited in
Table A2). However, the VIF test was applied to Pooled regressions using the same specification (same factors, including time dummies) corresponding to each specification of the Random Effects models presented in
Table 3 and
Table 4. In all cases, the VIF is lower than 5 (commonly considered as a strict lower bound), suggesting the absence of multicollinearity.