Aurora Borealis
1 September 2015 CFA Institute Journal Review

Official Financial Flows, Capital Mobility, and Global Imbalances (Digest Summary)

  1. Nicholas Tan, CFA

Net official flows on current accounts—mainly foreign exchange intervention—have a large effect on current account balances. The impact is larger when international capital flows are restricted and smaller when capital is highly mobile. Lagged net official flows have a positive effect on current accounts that may operate through the portfolio balance channel.

What’s Inside?

Official financial flows, which are dominated by purchases of foreign exchange reserves, have increased in the last 15 years and currently run at more than $1 trillion a year. At the same time, current account imbalances have reached record levels and are a source of tension for both advanced and emerging economies. Reserve accumulation affects the exchange rate and current account even when intervention is sterilized. The authors explore whether official flows impede current account adjustment. They also isolate exogenous official flows from endogenous official flows, explore the interaction of capital mobility with official flow effects, and consider the lagged effects of official flows.

How Is This Research Useful to Practitioners?

Net official flows are found to have a significant effect on current account balances. The estimated effect is larger with instrument variables, reflecting a possible downward bias in regressions without instruments because of an endogenous response of official flows to private financial flows. The estimated effects based on the samples used in the study are 42 cents to the dollar, on average, with instrument variables and 24 cents without the variables. Net official flows are also affected by the extent of capital mobility, with higher capital mobility causing net official flows to have a smaller effect on the current account (from 66 cents to the dollar to 18 cents in the baseline).

Lagged net official flows, captured by the coefficient on the lagged stock of net official assets, have an important effect through the portfolio balance channel. Persistent changes in the relative supply of assets in different currencies have persistent effects on exchange rates and current account balances. This lagged net official flow effect increases with capital mobility, which may indicate that the portfolio channel is less important when private flows are tightly restricted.

An implication of these results is that, in some countries, persistent large net official outflows contribute to sustained current account surpluses. In cases in which official flows are originally designed to stabilize the exchange rate, a policy change to stop net official flows and allow the exchange rate to appreciate would lead to a large decline in the current account balance. Consequently, countries that want to offset the loss of net external demand and keep output at potential should loosen monetary and/or fiscal policies.

How Did the Authors Conduct This Research?

The authors run baseline regressions across 79 advanced and emerging market countries, with the samples running from 1986 to 2011. One equation analyzed is with the current account as a function of net official flows and control variables (e.g., net official assets stock, measure of capital mobility, interaction terms involving net official flows, and interaction terms involving net official assets). Another equation analyzed is with private flows as a function of official flows and control variables. When net official flows have no effect on the current account, then they must cause a one-for-one reduction in net private flows.

The authors use instrumental variables to address the potential endogeneity of net official flows to shocks to current account balances and net private flows by isolating the variation in net official flows that are not driven by shocks that simultaneously drive the current account and/or private financial flows. These instruments include the presence of International Monetary Fund programs in the country, whether the country is an emerging market economy, and the presence of oil-based sovereign wealth funds in the country. The authors carry out various robustness checks and still arrive at similar conclusions.

Abstractor’s Viewpoint

In an era when so-called currency wars are the norm and most major economies are going through some form of quantitative easing and devaluing their currencies for near-term competitiveness and economy priming, the long-term effects need careful analysis to gauge how these economies will fare against each other. The interplay of current account imbalances between advanced and emerging economies needs careful dissection to better forecast fund performances across geographical segments.

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