1
The Impact of Trade and Financial
Openness on Global Imbalances
Prepared by (Name and Student Number)
Stephanie Brood, 6149480
Name of Supervisor
Drs. N.J. Leefmans
Name of Second Reader
Dr. D.J.M. Veestraeten
Submission date
15th of July 2014
Kind of Project
Master Thesis Economics, Track: International Economics and Globalisation
University, Faculty
2 Abstract
In this study, the relationship between trade and financial openness and current account balances is investigated for 22 advanced countries and 80 developing countries. First, previous literature is reviewed to give an overview of past theoretical and empirical research concerning the relationship between trade and financial openness and the current account balance. Second, an ordinary least squares regression is performed to quantify the relationship between trade and financial openness and the current account balance. Previous literature indicates that, theoretically speaking, trade and financial openness are likely to increase global imbalances. The empirical findings of the present study show that trade openness has no significant relationship with the current account balance in almost all regressions for all country groups. Furthermore, financial openness has a significantly negative or insignificant relationship with the current account balance for developing countries and the full sample. Depending on the measure used, a significantly positive or insignificant relationship between the current account balance and financial openness is found for advanced countries. This implies that if a significant relationship does exist, an increase in financial openness is likely to decrease global imbalances.
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Table of Contents
1. Introduction ... 4
2. The History of Global Imbalances ... 8
2.1 Dispersion of Current Account Balances ... 9
2.2 Creditor versus Debtor Regions ... 10
3. Impact of Trade and Financial Openness on Global Imbalances ... 12
3.1 Trade Openness ... 13
3.1.1 Evolution ... 13
3.1.2 Impact on Global Imbalances ... 14
3.2 Financial Openness ... 15
3.2.1 Evolution ... 15
3.2.2 Impact on Global Imbalances ... 16
3.3 Empirical Findings on the Relationship Between Trade and Financial Openness and the Current Account Balance ... 17
4. Empirical Methodology and Data ... 18
4.1 Independent Variables ... 19
4.1.1 Trade Openness Variables ... 19
4.1.2 Financial Openness Variables ... 20
4.1.3 Control Variables ... 20
4.2 Ordinary Least Squares (OLS) assumptions ... 23
4.3 Tests for Multicollinearity ... 24
4.4 Unit Root Tests ... 24
4.5 Tests for Heteroskedasticity ... 26
4.6 Model Specification ... 27
5. Estimation Results ... 28
5.1 Variables of Interest ... 28
5.2 Control Variables ... 32
6. Discussion of Empirical Model Findings... 33
6.1 Validity ... 33
6.1.1 Internal Validity ... 33
6.1.1.1 Omitted Variable Bias ... 34
6.1.1.2 Error in the Measurement of Trade and Financial Openness ... 34
6.1.1.3 Simultaneous Causality ... 35
6.1.2 External validity ... 36
6.2 Recommendations for Future Research ... 36
7. Conclusion ... 37
References ... 39
4 1. Introduction
Global imbalances have been increasing over the last decades. Global imbalances are the phenomenon where some countries are persistently running negative current account balances, while others are persistently running positive current account balances (Faruqee & Lee, 2009).
The current account balance contains all transactions in goods and services and income and current transfers between an economy and the rest of the world. Transactions in financial items are included in the financial account, while the capital account includes transactions in nonproduced nonfinancial assets and capital transfers (IMF, 2007). The current account balance is the financial account balance less the capital account balance. As the capital account balance generally accounts for a very low value, the financial account balance is often seen as the counterpart of the current account balance (IMF, 2007). Therefore, next to current account imbalances, high absolute values on the financial account are also an indicator of global imbalances. For the United States, one of the largest contributors to global imbalances, the current and financial account balances since 1980 are shown in Figure 1.
Figure 1: Current – and Financial Account Balance of the United States; graph constructed by the author based on IMF. (2013). WEO Database and OECD. (2014). OECD National Accounts Statistics.
Figure 2 shows the increase in global current account imbalances, the increase in current account surpluses of emerging and developing markets and the increase in current account deficits of advanced countries.1 Patterns of trade flows from advanced countries to emerging and developing countries have fluctuated considerably over time, as can be seen in Figure 2. Until the 2000s, emerging and developing countries on aggregate have generally run net current account deficits. These deficits were financed by advanced countries that were running corresponding surpluses. Since the 2000s, however, capital started flowing from emerging and developing economies to advanced economies, causing emerging and developing economies to run current account surpluses, while advanced economies are increasingly running current account deficits.
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A positive current account balance is defined as a current account surplus and a negative value of the current account as a current account deficit.
-1 0 0 0 -5 0 0 0 5 0 0 1 0 0 0 Bi lli o n s U SD 1980 1990 2000 2010 Year
Financial Account Balance Current Account Balance
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Figure 2: Current Account Balance; graph constructed by the author based on IMF. (2013). WEO Database.
The United States accounts for a very large part of the global current account deficit. The country is said to be at the center of global imbalances (Faruqee & Lee, 2009). As a counterpart of this deficit, mainly East Asian countries and oil-exporting countries are running increasingly large current account surpluses (Faruqee & Lee, 2009). China is one of the players in East Asia that is running a substantial current account surplus. Therefore, China and the United States will be used as examples throughout the course of this thesis.
Figure 3: Current Account Balance of the United States and China; graph constructed by the author based on IMF. (2013). WEO Database.
Figure 3 shows the increase in dispersion of the current account balances of the United States and China from 1980 until 2011. Especially since the mid-1990s the gap between the current account balances of the two countries has been widening. In the period from 1995 to 2011, the current account deficit of the United States increased from -113.57 to -457.73 billion USD, while the current account surplus of China increased from 1.62 to 136.10 billion USD.
In recent years, concerns with respect to global imbalances have increased for several reasons (Faruqee & Lee, 2009; Obstfeld & Rogoff, 2009). First, Faruqee and Lee (2009) argue whether these widening global imbalances are sustainable. According to them it is only a matter of time until these global imbalances become a key macroeconomic risk to the world economy. Second, Obstfeld and Rogoff (2009) state that high absolute values of current and
-4 0 0 -2 0 0 0 2 0 0 4 0 0 6 0 0 Bi lli o n U SD 1980 1990 2000 2010 Year
Advanced Countries Emerging/Developing Countries World
Current Account Balance
-1 0 0 0 -5 0 0 0 500 Bi lli o n s U SD 1980 1990 2000 2010 Year
United States China
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capital account balances become problematic when debt as a percentage of the gross domestic product (GDP) increases. The increase in debt will increase uncertainty about counterparties and financial products. This imposes a significant risk on global financial stability as it may give rise to self-fulfilling debt crises and currency collapses (Obstfeld & Rogoff, 2009). Third, global imbalances may become a problem in the event of exchange rate and other asset price movements. Unfavorable exchange rate and other asset price movements may have several consequences for a country. The ratio of debt to GDP of these countries could be increased, resulting in financial instability, as described above. Furthermore, their external borrowing rates may increase, because of a decrease in the demand for their reserves. As a consequence, it will become more difficult for these countries to finance an increasing current account deficit (Obstfeld & Rogoff, 2009). Fourth, countries with increasing surpluses on their current accounts are experiencing capital outflows. Because of the increased availability of capital on the world market, world real interest rates are being kept low. This imposes deflationary pressures on the world economy and an environment where bubbles are more likely to arise is created (Obstfeld & Rogoff, 2009). Finally, global imbalances may reflect inefficient national regulatory systems. When large net capital inflows inflate asset prices, it may imply that financial balance sheets are strong while this is actually not the case. Therefore, in the event of inflated asset prices it will be difficult for the government to supervise the financial sector. When big institutions are not operating under government protection, financial instability may arise (Obstfeld & Rogoff, 2009).
Considering the above-mentioned concerns with respect to global imbalances, it is important to know its determinants. In many papers the determinants of current account balances in both advanced and developing countries have been explored (Bracke, Bussière, Fidora, & Straub, 2010; Chinn & Ito, 2007; Chinn & Ito, 2008-1; Chinn & Prasad, 2003; Faruqee & Lee, 2009; Gruber & Kamin, 2007). Several determinants of current account balances have been found in these papers, amongst which trade and financial openness. Trade and financial openness are the two determinants of current account balances that will be most thoroughly evaluated in this thesis.
Trade and financial openness have followed an upward trend, especially since the 1990s and 2000s, see Figure 4.
Figure 4: Trade Openness measured as Exports plus Imports as a Ratio to GDP and Financial Openness measured by KAOPEN; graph constructed by the author based on World DataBank. (2014). WDI and Chinn and Ito (2006).
-. 4 -. 2 0 .2 .4 .6 In d e x 35 40 45 50 55 60 % o f G D P 1980 1990 2000 2010 Year Trade Openness (% of GDP) KAOPEN-index
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Figure 4 shows that the extent of trade openness, measured by trade as a percentage of world GDP, has been increasing since the 1980s. In 1980, the amount of trade accounted for around 40 percent of world GDP. This number has risen to over 60 percent in 2011. The figure shows that also financial openness, measured by the ‘KAOPEN index’, has been increasing since the 1980s.2 The KAOPEN index shows an increase from -0.33 in 1980 to 0.44 in 2011.
The increase in trade and financial openness may have contributed to the increase in global imbalances for the following reasons. First, countries with a larger extent of trade openness find it easier to export and import goods. If this leads to some countries exporting more, while others import more, it will stimulate global imbalances (Faruqee & Lee, 2009). Second, when a country has a high degree of financial openness, it will be easier for this country to finance the difference between exports and imports, as financial openness provides countries with enhanced opportunities to acquire capital from foreign resources (Faruqee & Lee, 2009). This induces imbalances on the current and capital account, as the complementary relationship between domestic investment and savings is disturbed (Bracke et al., 2010). Third, increasing amounts of international capital flows will be the outcome of increased financial openness when countries differ in financial development (Bracke et al., 2010; Mendoza, Quadrini, & Ríos-Rull, 2009). These capital flows will affect the capital account balance and, therefore, the current account balance as well.
As indicated above, research indicates that, theoretically speaking, a relationship between trade and financial openness and global imbalances is likely to exist (Bracke et al., 2010; Chinn & Ito, 2007; Chinn & Ito, 2008-1; Chinn & Prasad, 2003; Faruqee & Lee, 2009; Gruber & Kamin, 2007; Obstfeld & Rogoff, 2009). However, empirical studies show insignificant or weakly significant results with respect to the relationship between trade and financial openness and current account balances. The significant results do provide some evidence of increased trade openness increasing current account balances for a sample of all countries and for advanced countries and reducing the current account balance for developing countries (Chinn & Ito, 2007; Chinn & Ito, 2008-1; Chinn & Prasad, 2003; Chinn, Eichengreen, & Ito, 2011; Gruber & Kamin, 2007). These results imply that increased trade openness reduces global imbalances, because, as stated before, the aggregate of advanced countries is running a current account deficit and the aggregate of developing countries is running a current account surplus.
My research question will therefore be “what is the impact of trade and financial openness on global imbalances?”
The purpose of this thesis is to remove the ambiguity that is currently found in research concerning the relationship between trade and financial openness and the current account balance. There are three main additions that will be applied in this thesis compared to empirical research in other papers. First, additional measures of trade and financial openness will be used. In previous empirical research, trade openness is measured by the sum of exports and imports as a ratio to GDP and financial openness is measured by either the amount of capital controls or the KAOPEN index. In addition to these trade and financial openness measures, in this thesis, the Sachs Warner index and private capital flows as a ratio to GDP will be included as measures for respectively trade and financial openness. Second, a more extensive set of control variables will be added to the regression in this thesis. This set
2
The KAOPEN index aims at measuring the extent and intensity of capital controls, and is further elaborated upon in Appendix 1 (Chinn, Ito, 2008).
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of control variables will be created by combining all control variables used in previous literature. Third, the dataset used in this thesis will capture an extended timeframe compared to datasets used in other research. Until now, empirical research on this topic captures periods until 2009. The dataset used in the present study will cover the period from 1980 until 2011.
To quantify the relationship between trade and financial openness and the current account balance, ordinary least squares (OLS) regressions will be done. This is consistent with the models used in previous empirical literature. The current account balance as a ratio to GDP will be regressed on trade and financial openness variables, controlling for several domestic and global factors. Primarily data from the Worldbank, the International Monetary Fund (IMF) and the KAOPEN index will be used to get quantified information on 22 advanced countries and 80 developing countries. As mentioned before, the dataset covers the period from 1980 until 2011. Non-overlapping five-year averages of the data will be used for each country in order to capture medium-term, rather than short-term, variations in the current account balance and its determinants (Chinn & Ito, 2007; Chinn & Ito, 2008-1). Period dummies will be included to control for unobserved variables that vary over time but are constant across countries (Stock & Watson, 2012).
Furthermore, previous research has indicated that similar shocks affect the current account balance differently in advanced and developing countries. Therefore, next to the regression for the full sample, separate regressions will be done for those two country groups (Chinn & Prasad, 2003).
The remainder of this thesis is structured as follows. Section 2 will include a chronological overview of the build-up and pattern of global imbalances. In section 3, previous findings on the relationship between trade and financial openness and global imbalances will be described. Section 4 will provide an overview of the data and regression method used in this study. In section 5, results will be given. Section 6 provides a discussion concerning the validity of the regression results and recommendations for further research will be provided. In section 7, conclusions will be drawn.
2. The History of Global Imbalances
Global imbalances are not a new phenomenon (Faruqee & Lee, 2009). However, the current period of global imbalances shows differences in magnitude, persistence and pattern compared to previous periods (Chinn & Ito, 2007; Faruqee & Lee, 2009). These changes can be explained by both structural and cyclical changes (Bracke et al., 2010). First, more countries have opened up to international trade. Mainly emerging market economies have been catching up with advanced economies and have become important players in international markets (Bracke et al., 2010). Second, financial globalization has occurred, with more integrated global financial markets and opportunities for international portfolio diversification (Bracke et al., 2010). Third, macroeconomic and financial conditions have improved, inducing high economic growth, low financial market volatility and easy global financing conditions until the crisis (Bracke et al., 2010). Finally, improved technology, communication and legal frameworks have stimulated international trade and capital flows (Bracke et al., 2010).
This section will provide a historical overview of global imbalances and will be divided into two main topics. First, the increased global dispersion of current account balances will be
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described. The second part of this section will focus on the creditor and debtor regions during the different episodes of global imbalances.
2.1 Dispersion of Current Account Balances
The magnitude of global imbalances has been increasing over the last decades (Faruqee & Lee, 2009). Figure 5 shows this increase in magnitude by using two measures. First, the global aggregate of the absolute values of current account balances, the brown line. Second, this global aggregate value as a ratio to world GDP, the lavender line. These two are the most common methods used in previous literature to measure the increase in the magnitude of global imbalances.3
Figure 5: Aggregate of absolute global current account balances (CA); graph constructed by the author based on IMF. (2013). WEO Database.
Both lines in Figure 5 show that global imbalances have been increasing to unprecedented levels (Bracke et al., 2010). Moreover, the lavender line shows that the rapid pace at which this global aggregate value, as a ratio to world GDP, is rising makes that it is currently twice as large as it was in the mid-1980s (Bracke et al., 2010).
Faruqee and Lee (2009) show that largest current account deficits and surpluses are emerging in the largest countries, which is currently happening in for example the United States and China. Figure 6 shows the increase in dispersion of the current account balances, as a ratio to GDP, of the United States and China from 1980 to 2011. Especially since the mid-1990s this gap has been widening. Over the years, the current account balance of the United States decreased from 0.08 to -2.95 percent of GDP, while the current account surplus of China increased from 0.09 to 1.86 percent of GDP.
3 Faraquee and Lee (2009) find evidence of the emergence of global imbalances by using the Kernel Density Estimation, the global standard deviation of current account balances as a ratio to GDP, the global mean absolute deviation of current account balances as a ratio to GDP and the absolute global sum of the current account balances as a ratio to GDP.
2 3 4 5 6 % o f W o rl d G D P 0 1 0 0 0 2 0 0 0 3 0 0 0 4 0 0 0 Bi lli o n U SD 1980 1990 2000 2010 Year
Global |CA| Global |CA| / World GDP
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Figure 6: Current Account Balance as a ratio to GDP of United States and Developing Asia; graph constructed by the author based on IMF. (2013). WEO Database.
2.2 Creditor versus Debtor Regions
Bracke et al. (2010) state that despite the fact that past and current episodes of global imbalances differ, some general conclusions can be drawn regarding periods of global imbalances. They examine the different episodes of global imbalances by considering creditor and debtor regions and discussing whether the global imbalance period ended in an orderly or disorderlyunwinding, see Table 1. 4
Historical periods of global imbalances
Era Region Orderly Unwinding For
Creditor Debtor Creditor Debtor
Gold standard <1914 Advanced Emerging Yes Yes
Bretton Woods5 None None Yes Yes
1970s Emerging Emerging No No
1980s6 Advanced Advanced Some Yes
1990s7 Advanced Emerging Yes No
2000s Emerging Advanced ? ?
Table 1: Historical periods of global imbalances; Source: Bracke et al., 2010
During the gold standard period before the First World War, capital was flowing from the United Kingdom to countries that were classified as emerging economies at that time, such as the United States, Canada, India and Australia. These emerging countries had no trouble with repaying their debts. Therefore, this period ended in an orderly unwinding (Bracke et al., 2010).
In between the periods of the gold standard and Bretton Woods, especially in the run-up to the Second World War, openness to trade and capital flows diminished because of growing
4 Orderly unwinding: No difficulty in repaying/debt crisis/output collapse or decline/ capital drought; Disorderly unwinding: Difficulty in repaying/debt crisis/output collapse or decline/ capital drought.
5 All countries pegged their currency to the dollar since the United States held the largest amount of gold reserves. The USD was pegged to gold at 35 dollars per ounce.
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Widening of current account positions led to intensive international coordination. Concrete policy
commitments that focused on exchange rates were being established and secured in G5/G7 Plaza and Louvre agreements in the mid-1980s.
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External imbalances in emerging markets were a key source of concern. Financial crises hit nearly all large emerging economies. -5 0 5 10 % o f G D P 1980 1990 2000 2010 Year
United States China
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imbalances. Therefore, no clear creditor and debtor regions existed in this period. Although the Bretton Woods system collapsed because of tensions concerning external imbalances, there was no disorderly unwinding (Bracke et al., 2010).
In the late 1970s, capital started flowing from oil-exporting countries to Latin America. This was the first period not to end in an orderly unwinding. Latin American countries were running large current account deficits and this was not sustainable at the time of rising interest rates. Furthermore, the reduction in absorption among Latin American countries had a negative impact on the oil-exporting countries (Bracke et al., 2010).
In the early 1980s, the main counterparts of the rising deficit of the United States were advanced economies (Bracke et al., 2010). The deficit episode of the United States was corrected during the second half of 1980s. No recessionary effects emerged in the United States, while several creditor countries, such as Japan and Germany, experienced an economic slowdown.
In the 1990s, capital was flowing from advanced countries to emerging countries in Emerging Asia, Central and Latin America and Central and Eastern Europe.8 This period ended in disorderly unwinding for the debtor countries as indicated by the Tequila crisis of 1995, the Asian crisis of 1997 and the Russian crisis of 1998 (Bracke et al., 2010; Obstfeld & Rogoff, 2009)
The current episode of global imbalances is different from the previous ones. Bracke et al. (2010), Chinn and Ito (2007) and Faruqee and Lee (2009) highlight the increased persistence and stationarity of current account balances since the mid-1990s. Countries are running increasingly large current account deficits or surpluses, but rarely switch from one to the other (Chinn & Ito, 2007).
Next to this increase in persistence of current account balances, also the pattern of capital flows has changed. Since the 2000s, capital started flowing from emerging to advanced countries. The Asian crisis of 1997 and the corresponding events and policy changes are said to be a cause of the change in the direction of capital flows (Obstfeld & Rogoff, 2009). The crisis highlighted the weak fundamentals of Asian banking systems and most affected countries asked for support by the IMF. In order to obtain financial assistance from the IMF, some conditions were imposed on the Asian countries. As a result of the implementation of these conditions and the financial assistance from the IMF, the Asian countries started running surpluses on their current accounts (Obstfeld & Rogoff, 2009).
Maintaining solid saving-investment balances and implementing foreign exchange intervention policies further supported the enhanced surpluses of the Asian countries. The solid saving-investment balance was the result of high savings relative to investment in the Asian countries.9 The relatively low investment level of Asian countries is a consequence of the unsophisticated financial sectors and limited provision of public goods (Bracke et al., 2010). The aim of the foreign exchange interventions was to maintain high economic growth rates by increasing exports and accumulating stocks of international reserves that could be used as a buffer against future financial crises (Obstfeld & Rogoff, 2009). The foreign exchange intervention strategy that was implemented involved interventions regarding the prevention of appreciations of the pegged exchange rates of Asian countries. The Asian currencies faced upward pressures caused by rapid growth in international reserves. By preventing appreciation of their currencies, the Asian countries remained internationally
8 The US was also running a current account deficit. However this accounted for only 1.5% of their GDP. 9 In newly industrialized Asia, gross saving returned to the pre-crisis level, while the level of investment decreased. In developing Asia, saving increased to a level higher than the pre-crisis level. The level of investment increased as well, but at a slower pace than the level of savings (Bracke et al., 2010).
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competitive. Therefore, the demand for their export products was high and foreign exchange reserves were accumulated (Obstfeld & Rogoff, 2009).
Next to the Asian countries, oil-exporting countries started to run surpluses on their current accounts. This was a consequence of the dot-com boom resulting in increases in global commodity prices (Obstfeld & Rogoff, 2009).
The current account surpluses of Asian and oil exporting countries could only be sustained if counterbalancing actions were taken elsewhere (Altuzarra, Ferreiro, & Serrano, 2010; Obstfeld & Rogoff, 2009). This happened in advanced countries, such as the United States. The expansionary fiscal policy of the United States and the sharp reduction in interest rates resulted in increases in real estate prices and property investment (Obstfeld & Rogoff, 2009). Following the stimulative actions with respect to property investment, the asset prices in the United States started rising further. This in turn resulted in increasing consumption levels, because of an increase in perceived household wealth (Obstfeld & Rogoff, 2009). Moreover, savings drought occurred in the United States. The decrease in savings was caused by a reduction in the business cycle volatility, which lowered the need for precautionary savings. This eventually reduced permanent saving levels as well (Bracke et al., 2010; Chinn & Ito, 2007; Chinn & Ito, 2008-1; Obstfeld & Rogoff, 2009). The increase in consumption and decrease in savings resulted in a rise in the level of imports to the United States, mainly because of increased absorption of Asian export products. This in turn decreased the current account balance of the United States (Obstfeld & Rogoff, 2009).
Furthermore, the increase in international reserves held by Asian countries, was invested in countries with more sophisticated financial markets. This turned out to be mainly deficit countries, such as the United States (Gruber & Kamin, 2007). The capital inflows resulted in an increase in the capital account balance of the United States and a corresponding decrease in their current account balance.
In short, in contrast to previous episodes of global imbalances, currently emerging and developing economies are transferring net savings to advanced economies (Bracke et al., 2010). Asian countries have adopted export-led strategies and are accumulating international reserves, hereby maintaining higher current account balances. The United States has experienced capital inflows and increases in consumption and investment levels relative to savings, inducing lower current account balances (Altuzarra et al., 2010; Obstfeld & Rogoff, 2009).
There are several determinants underlying the above-mentioned variations in current account balances. Trade and financial openness are the determinants of interest in this thesis. In the next section, the relationship between trade and financial openness and global imbalances will be described.
3. Impact of Trade and Financial Openness on Global Imbalances
Under the wave of modern globalization, trade and capital flows have been rising to unprecedented levels. This increase has been going on for decades, but especially accelerated during the 1990s. In this period, international barriers to trade and investment decreased. Decreasing transportation costs, technological innovations and deeper communication networks further enhanced international production opportunities and economic growth (Das, 2010). The widening of current account positions could be partially caused by this global economic and financial integration (Bracke et al., 2010). This section will be used to explain this relationship.
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Trade and financial openness are not disconnected and may reinforce each other. First, a country more open to trade is likely to import technology and knowledge. This will make the country more attractive to foreign capital. Therefore, the amount of capital inflows is likely to increase and the capital account balance will increase. These capital inflows will in turn stimulate domestic investment. This increase in domestic investment will deteriorate the current account balance (Chinn & Prasad, 2003). Second, it is easier to finance increased current account deficits through trade and financial openness, as export earnings and international resources expand (Chinn & Prasad, 2003). Third, increasing trade openness implies that the country has the capacity to generate foreign exchange earnings through exports. This may signal a better ability of the country to service external debt, which may attract foreign investment. The capital inflows will result in an increase in the capital account balance, while decreasing the value of the current account (Chinn & Prasad, 2003).
The first part of sections 3.1 and 3.2 will provide an overview of the history of respectively trade and financial openness. In the second part of these sections, theoretical explanations concerning the relationship between respectively trade and financial openness and the current account balance will be evaluated. In section 3.3, the empirical findings on the relationship between trade and financial openness and the current account balance will be described.
3.1 Trade Openness
3.1.1 Evolution
International trade flows have increased over the past 30 years, as can be seen in Figure 4. This increase has been going on for decades, but especially accelerated during the 1990s. After more than seven years of negotiations, multilateral agreements on the Uruguay Round were completed and the World Trade Organization (WTO) was created in 1995. The installment of the WTO has been an important event in the move towards trade liberalization. 123 countries agreed on many trade arrangements to align global trade regimes and create more transparency. Cuts in duty rates on imports of several products from developing countries were implemented, regular publishing of reports regarding trade policies was agreed upon and rules and procedures for settling disputes were adopted (WTO, n.d.).10
Figure 7 shows the development of trade openness, measured by the sum of exports and imports as a ratio to GDP, in advanced and developing countries. The figure indicates that the increase in trade openness has been happening in both advanced and developing countries. In the 1980s, trade accounted for 80 percent of GDP in advanced economies. This number increased to almost 90 percent in 2011. The increase in trade openness in developing markets has been more rapid than in advanced economies. From 1980 onwards, it increased from about 60 percent of GDP to about 80 percent of GDP in 2011. In other words, the degree of trade openness globally converged among countries over the past decades. This is especially caused by developing economies increasing their participation in international trade (Bracke et al., 2010).
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The degree of openness to international trade is a country characteristic that reflects macroeconomic policy, as it includes actions such as implementing tariff regimes (Chinn, Ito, 2007; Chinn, Prasad, 2003; Chinn, Ito, 2008).
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Figure 7: Trade Openness Advanced and Developing Countries; graph constructed by the author based on World DataBank. (2014). WDI and UN (2012).
3.1.2 Impact on Global Imbalances
Previous literature shows that, theoretically speaking, a relationship between trade openness and the current account balance is likely to exist (Chinn & Ito, 2007; Chinn & Ito, 2008-1; Chinn & Prasad, 2003; Chinn et al., 2011; Faruqee & Lee, 2009; Gruber & Kamin, 2007; Obstfeld & Rogoff, 2009). Countries with more open trade regimes have a higher incentive to produce larger quantities of products in which the country has a comparative advantage. This is a consequence of increased possibilities to export goods for which supply exceeds demand in the domestic market (Faruqee & Lee, 2009). Similarly, countries with a higher degree of trade openness find it easier to import goods for which domestic demand exceeds domestic supply. Therefore, these countries will limit the production of goods in which they have a comparative disadvantage. If this international specialization leads to some countries exporting more, while other countries import more, global imbalances may arise (Chinn & Prasad, 2003; Faruqee & Lee, 2009; Obstfeld & Rogoff, 2009). Moreover, international specialization will contribute to generating global supply chains, hereby further intensifying international trade, as countries become more interdependent on each other (Faruqee & Lee, 2009).
The application of the above-mentioned positive relationship between trade openness and current account imbalances to China and the United States is provided below. Figure 8a shows that the amount of trade, as a percentage of GDP, has been increasing in both China and the United States. From Figure 8b, it can be concluded that, in both countries, this increase in the ratio of trade to GDP is caused by an increase in imports as well as exports. China has experienced a large increase in exports relative to imports. The ratio of exports to GDP of China increased with 2.8 percent more than its ratio of imports to GDP. Especially from the end of the 1990s onwards, the increase in the ratio of exports to GDP of China was substantially. This might be caused by the export-led strategy of Asian countries following the Asian crisis, see section 2.2. The increase in exports relative to imports corresponds to the increasing current account surplus of China. The United States has experienced a large increase in imports relative to exports over the past three decades. The ratio of imports to GDP of the United States increased with 3.2 percent more than its ratio of exports to GDP. The increase in imports relative to exports can be attributed to the savings drought and rising consumption in the United States, as described in section 2.2. This increase in imports relative to exports corresponds to the increase of the current account deficit of the United States. 60 70 80 90 % o f G D P 1980 1990 2000 2010 Year Advanced Developing Trade Openness
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Figure 8a: Trade as a ratio to GDP for the United States and China; graph constructed by the author based on World DataBank. (2014). WDI.
Figure 8b: Exports as a Ratio to GDP and Imports as a Ratio to GDP for the United States and China; graph constructed by the author based on World DataBank.(2014). WDI.
3.2 Financial Openness
3.2.1 Evolution
The world is moving steadily towards increased financial openness, as can be seen in Figure 4 (Chinn & Ito, 2008). Advanced countries have always been relatively open to the rest of the world, see Figure 9. Furthermore, their levels of financial openness have increased since the 1980s (Chinn & Ito, 2008; Mendoza et al., 2009). Emerging and developing countries have slowed down their efforts of opening financial markets in the years preceding the Asian crisis of the mid-1990s, but they have accelerated financial opening again after (Chinn & Ito, 2008). Although financial liberalization progressed in both advanced and developing economies over the last 30 years, the gap between the two country groups did not decline (Mendoza et al., 2009). This implies that still only a small fraction of global cross-border capital flows reaches developing countries (Bracke et al., 2010; Chinn & Ito, 2008).
20 30 40 50 60 70 % o f G D P 1980 1990 2000 2010 Year
United States China
Trade Openness 0 10 20 30 40 % o f G D P 1980 1990 2000 2010 B
Exports China Imports China Exports USA Imports USA
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Figure 9: Development of Financial Openness; graph constructed by the author, based on Chinn and Ito (2006). 3.2.2 Impact on Global Imbalances
As already highlighted in the introduction, an increase in the capital account balance reduces the value of the current account. Therefore, as the extent of financial openness of a country affects the amount of capital flows, it affects the current account balance as well (Chinn & Ito, 2007; Chinn & Ito, 2008-1; Obstfeld & Rogoff, 2009).
Capital flows represent money made available to finance the difference between exports and imports. If the imports of a country exceeds its exports, the country will borrow money, resulting in capital inflows. This country will then experience an increase in the capital account balance, while its current account balance will decrease (Chinn & Ito, 2008-1).
Patterns of high consumption and low savings, such as what has been happening in the United States, can only be sustained if foreign countries are willing to finance excessive import levels. A country will find it easier to finance a trade imbalance if they have access to a wider base of international borrowing and lending. This access to international capital increases as a country increases its financial openness (Bracke et al., 2010; Chinn & Prasad, 2003; Faruqee & Lee, 2009). In short, countries with a higher degree of financial openness are more likely to be able to maintain current account imbalances.
Furthermore, countries with a higher degree of financial openness will be more efficient in financing investment needs, by inducing capital flows to projects with the highest returns. These countries will have the ability to use savings most productively, because of a larger availability of investment and funding opportunities. This larger availability of investment and funding opportunities will also allow for portfolio diversification, which may induce welfare-improving and more efficient capital allocation, because of improved diversification of risks.11 These events will stimulate savings and/or investment and, therefore, increase the amount of international capital inflows or outflows, resulting in an increase in current account imbalances (Bracke et al., 2010; Faruqee & Lee, 2009).
After having provided a theoretical explanation for the relationship between trade and financial openness and the current account balance. The next section will proceed by explaining the empirical findings with respect to this relationship.
11
This statement relies on the assumption that nominal and real exchange ratesin the world are not distorted.
-. 5 0 .5 1 1 .5 2 In d e x 1980s 1990s 2000s 2010/2011 Deve lopi ng Adva nce d Deve lopi ng Adva nce d Deve lopi ng Adva nce d Deve lopi ng Adva nce d KAOPEN
17 3.3 Empirical Findings on the Relationship Between Trade and Financial Openness
and the Current Account Balance
Previous empirical research has provided different results with respect to the sign and magnitude of the relationship between trade and financial openness and the current account balance. Furthermore, in these studies, different empirical methods have been used to explore the determinants of current account balance variations for both advanced and developing countries (Chinn & Ito, 2007; Chinn & Ito, 2008-1; Chinn & Prasad, 2003; Faruqee & Lee, 2009; Gruber & Kamin, 2007). In the regressions in these studies, the dependent variable is the value of the current account as a ratio to GDP, trade openness is measured by the ratio of exports and imports to GDP and financial openness is measured by either the amount of capital controls or the KAOPEN index. In these empirical studies, both the trade openness variable and the KAOPEN index are computed as deviations from the sample mean.
Chinn and Ito (2007) and Chinn and Ito (2008-1) find little significant evidence of a relationship between trade and financial openness and the current account balance. Their regressions indicate that trade openness is only significantly associated with larger current account balances for advanced countries. Financial openness has no significant relationship with the current account balance for all country groups. Chinn and Ito (2007) and Chinn and Ito (2008-1) investigate the medium-term determinants of global imbalances. Their dataset includes 19 advanced countries and respectively 70 and 69 developing countries over the period from 1971 to 2004. To quantify the relationship between the current account balance and its determinants, Chinn and Ito (2007) and Chinn and Ito (2008-1) are using an OLS regression. They control for conventional macroeconomic variables and factors related to institutional development.
Chinn et al. (2011) find little evidence for a significant relationship between trade openness and the current account balance. They only find a significantly negative relationship between trade openness and the current account balance for developing countries if institutional variables are not included. No significant association seems to exist between the current account balance and financial openness for all country groups. Chinn et al. (2011) examine the medium-term determinants of current account balances by applying updated data to the empirical model used by Chinn and Ito (2007).
Chinn and Prasad (2003) find that trade openness is significantly associated with a decrease in the current account balance for developing countries. For advanced countries, no significant relationship is found between the current account balance and trade openness. Furthermore, their regressions indicate no significant relationship between capital controls and the current account balance for all country groups. Chinn and Prasad (2003) use cross-section and panel regressions to characterize the variation of the current account balance across countries over time. They examine the relationship between the ratio of the current account balance to GDP and a wide range of medium-term macroeconomic determinants. They use a large multi-country database that covers the period from 1971 to 1995.
Faruqee and Lee (2009) find that the global dispersion of current account balances has been steadily rising and conclude that this is consistent with the view that the increase in financial openness has contributed to the increased dispersion of current account balances. However, they argue that financial globalization itself does not fully explain the increase in global imbalances seen in recent years. Furthermore, they find that trade openness increases the persistence of global imbalances, while financial openness reduces the persistence of global imbalances. Faruqee and Lee (2009) examine the global distribution of current account balances from a longer term perspective. Using a panel of over 100 countries that comprise over 95 percent of world output, their analysis examines the individual and collective behavior of current account balances over the past four decades. They interpret the empirical results in the context of increasing trade and financial openness.
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Gruber and Kamin (2007) only find a significantly positive relationship between trade openness and the current account balance if the financial crisis variable and its interaction with openness are included. Financial openness is not included as a variable in their regression specification. Gruber and Kamin (2007) assess some of the explanations of the global pattern of current account imbalances that has emerged in recent years. They particularly focus on the large current account deficit of the United States and the large surpluses of the Asian developing economies. Similarly to Chinn and Prasad (2003), Gruber and Kamin (2007) adopt a panel-regression approach. They use data of 61 countries over the period from 1982 to 2003. Their results indicate that the Asian surpluses are well explained by a model that incorporates, in addition to standard determinants12, the impact of financial crises on current account balances. However, their model fails to fully explain the large current account deficit of the United States, even when the model is augmented by measures of the attractiveness of financial markets of the United States, such as institutional quality and financial development.
Mendoza et al. (2009) find that in countries where financial markets are more sophisticated, foreign liabilities are being accumulated in a gradual, long-lasting process as a result of increased financial openness. They are investigating whether the magnitude and composition of global imbalances could be the result of financial integration among countries with heterogeneous domestic financial markets. They use a multi-country dynamic stochastic general equilibrium model with incomplete asset markets.
From sections 3.1 and 3.2 can be concluded that, theoretically speaking, global imbalances could be increased by increasing trade and financial openness. This is the result of increased opportunities to export and import, increased global investment possibilities and increased access to global capital. However, most of the empirical results mentioned above indicate that trade openness has a weakly significant or insignificant relationship with the current account balance. The significant results do provide some evidence of trade openness reducing global imbalances. Financial openness appears to have no significant relationship with the current account balance (Chinn & Ito, 2007; Chinn & Ito, 2008-1; Chinn & Prasad, 2003; Chinn et al., 2011).
In short, previous literature provides ambiguous results concerning the impact of trade and financial openness on global imbalances.
After highlighting the empirical methods used to estimate the relationship between trade and financial openness and the current account balance in previous literature, the next section will proceed with describing the empirical method that will be used in the present study to estimate this relationship.
4. Empirical Methodology and Data
The aim of this empirical research is to assess whether a statistically significant relationship exists between trade and financial openness and the current account balance. In accordance with Chinn and Ito (2007), Chinn and Ito (2008-1), Chinn and Prasad (2003), Chinn et al. (2011) and Gruber and Kamin (2007), the OLS methodology is used to estimate this relationship. The current account balance as a ratio to GDP is used as dependent variable in the regressions. The dependent variable is regressed on trade openness variables, financial openness variables and control variables. The sample used to estimate this relationship
12
Per capita income, output growth, fiscal balances, initial stock of net foreign assets, economic openness and demographic variables.
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consists of observations on 22 advanced countries and 80 developing countries, see Table 5 in Appendix 2. Next to regressions for the full sample (advanced and developing countries), regressions will be performed for advanced and developing countries separately, because previous research has indicated that similar shocks affect the current account balance differently in advanced and developing countries (Chinn & Prasad, 2003).
The main interests in this study are the medium- and long-term determinants of variations in current account balances. Therefore, non-overlapping five-year averages of the data will be used. Averages will be constructed over 1980-1984, 1985-1989, 1990-1994, 1995-1999, 2000-2004, 2005-2009 and 2010-2011. This provides seven period observations for each country. In the case of missing annual observations, averages are being calculated based on the remaining years in a period. Period dummies will be included to control for effects that are constant across countries, but vary over time.
Consistent with Chinn and Prasad (2003) and Gruber and Kamin (2007), country-fixed effects will not be included in the model, because including country fixed effects will remove much of the cross-country differences in current account balances that are of main interest in this thesis (Chinn & Prasad, 2003; Gruber & Kamin, 2007).13
In the next section, the independent variables employed in this thesis will be discussed in more detail. Current account balances can take on positive or negative values, but the global mean of current account balances is zero.In order to align the positive and negative values of the current account balance with positive and negative values of its determinants, all
independent variables, except the ratio of net foreign assets to GDP and the dummy variables, are calculated as deviations from the sample mean. Furthermore, including independent variables as deviations from their sample mean controls for rest-of-the-world effects. This is important, as the current account balance of a country is determined by developments both at home and abroad (Chinn & Ito, 2007; Chinn & Ito, 2008-1).
4.1 Independent Variables
The trade and financial openness variables are the explanatory variables of interest in this thesis. Therefore, two measures of each will be included. Different combinations of the trade and financial openness measures will be included in the regressions in order to obtain various results on which the conclusions will be based. The first and second part of this section will provide information on respectively the trade and financial openness measures used. The third part will discuss the control variables.
4.1.1 Trade Openness Variables
As mentioned above, there are two trade openness measures that will be included in the regression: 1) the sum of exports and imports as a ratio to GDP, 2) the Sachs Warner index. These two measures of trade openness are used because of their availability across a large cross-section. The sum of exports and imports as a ratio to GDP is a measure of the outcome of trade restrictions. This measure is widely used in literature considering trade openness. The main difference between the measures of trade openness used in this thesis and in previous studies is the inclusion of the Sachs Warner index. Inclusion of this variable is likely to increase the explanatory power of the model and show whether inclusion of different trade openness measures alters the conclusion with respect to the relationship between trade openness and the current account balance. The Sachs Warner index measures the degree of trade openness of a country based on Sachs and Warner (1995) and Wacziarg and Welch (2003). They classify a country as open if none of the five following criteria holds. First, the
13
Including country fixed-effects does not allow including observed variables that vary across countries but not over time, because those variables will be collinear with the country-specific variables (Stock, Watson, 2012).
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country had average tariff rates higher than 40 percent. Second, its nontariff barriers covered on average more than 40 percent of its imports. Third, it had a socialist economic system. Fourth, the state had a monopoly of major exports. Fifth, its black market exchange rate premium exceeded 20 percent.
Both measures of trade openness are expected to indicate that increased trade openness increases current account imbalances. This is the result of international specialization caused by the increased possibility to export and import goods for which domestic demand is not equal to domestic supply. If this leads to some countries exporting more, while others import more, global imbalances will increase. Therefore, a negative relationship between the current account balance and trade openness is expected to be found for advanced countries, since the aggregate of these countries is running a current account deficit. A positive relationship between trade openness and the current account balance is expected to be found for developing countries, as these countries are running a current account surplus on aggregate.
4.1.2 Financial Openness Variables
Financial openness is another determinant of interest in this thesis. The measures of financial openness included in this thesis are: 1) the KAOPEN index, 2) the ratio of private capital flows to GDP. The KAOPEN index is a measure of the extent and intensity of capital controls, with higher values indicating a higher degree of financial openness (Appendix 1). This measure is widely used in empirical literature. The ratio of private capital flows to GDP is included as another measure of financial openness. Private capital flows are the sum of net foreign direct investment and portfolio investment. Inclusion of private capital flows in the regression specification is the main difference in the measurement of financial openness between the present study and previous literature.
An increase in the capital account balance decreases the value of the current account. Therefore, as the extent of financial openness of a country affects its capital flows, it affects its current account balance as well (Chinn & Ito, 2007; Chinn & Ito, 2008-1; Obstfeld & Rogoff, 2009). Capital flows represent money made available to finance the difference between exports and imports. Therefore, persistent current account imbalances can only be generated if countries are able to rely on access to international capital (Faruqee & Lee, 2009). In other words, an increase in financial openness is expected to increase current account imbalances.
4.1.3 Control Variables
The control variables included in the regressions, as well as previous empirical findings concerning their relationship with the current account balance, are listed below. The control variables correspond to measures used in previous research, unless stated otherwise.
1. Government budget balance
The government budget balance is measured by taxes minus government expenditures as ratio to GDP.
In literature there is an ongoing debate on whether fiscal policy can influence the value of the current account. Empirical results in previous research show a positive relationship between the government budget balance and the current account balance, known as the ‘twin deficits’ (Bracke et al., 2010; Chinn & Ito, 2007; Chinn & Ito, 2008-1; Chinn & Prasad, 2003; Gruber & Kamin, 2007; Kumhof & Laxton, 2013).
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2. Financial development
Financial development is measured by money and quasi money as a ratio to GDP. This is a measure of depth and sophistication of the financial system (Chinn & Prasad, 2003). Some researchers use private credit as a ratio to GDP as a measure for financial development (Chinn & Ito, 2007; Chinn & Ito, 2008-1; Chinn et al., 2011; Gruber & Kamin, 2007).
Based upon conclusions drawn in previous research, financial development is expected to decrease the current account balance in advanced countries and increase the current
account balance in developing countries (Chinn & Ito, 2007; Chinn & Ito, 2008-1; Chinn & Prasad, 2003; Gruber & Kamin, 2007).
3. Dependency ratios for the young and old
To capture the life-cycle theory of consumption and saving, dependency ratios for the young and old are included. The youth dependency ratio is defined as the ratio of younger dependents, people under the age of 15, to the working age population, people between 15 and 64. The old-age dependency ratio is defined as the ratio of older dependents, people older than 64, to the working age population. The life-cycle theory of consumption and saving predicts that young households borrow, middle-aged households save for retirement and households in retirement dissave. Therefore, relatively young and relatively old countries are more likely to run current account deficits (Chinn & Ito, 2007; Chinn & Prasad, 2003; Gruber & Kamin, 2007).
4. Productivity growth
In accordance with most previous empirical research, the growth rate of GDP is used as a proxy for changes in productivity growth, as this measure is available for many countries. The disadvantage of using the growth rate of GDP as a proxy for productivity growth is that it does not control for changes in labor force participation or hours worked. Gruber and Kamin (2007) use the growth rate of GDP per capita to control for changes in productivity growth.
Previous theoretical research shows that productivity growth is expected to decrease the current account balance in advanced countries and increase the current account balance in developing countries. However, empirical research shows no significant relationship between GDP growth and the current account balance.
5. Net foreign assets
Net foreign assets are included in the regression as a ratio to GDP. Instead of this measure, some researchers use the ratio of initial stocks of net foreign assets to GDP or the ratio of the lagged value of net foreign assets to GDP to measure the effect of net foreign assets on the current account.
The current account balance is the sum of the trade balance and the return on a country’s stock of net foreign assets or payment on its net foreign liability position. Therefore, most previous research indicates that a significantly positive relation is found between net foreign assets and the current account balance (Chinn & Ito, 2007; Chinn & Ito, 2008-1; Chinn & Prasad, 2003; Faruqee & Lee, 2009; Gruber & Kamin, 2007).
6. Terms of trade volatility
Terms of trade volatility displays the macroeconomic uncertainty of a country. The net barter terms of trade index is included as a measure for terms of trade volatility. The index is calculated as the percentage ratio of the export unit value indices to the import unit value indices, measured relative to the year 2000. Some other researchers have used the standard deviation of terms of trade to measure the effect of terms of trade volatility on the current account.
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Previous theoretical and empirical research shows ambiguous results with respect to the relationship between terms of trade volatility and the current account balance (Chinn & Ito, 2007; Chinn & Ito, 2008-1; Chinn & Prasad, 2003; Chinn et al., 2011; Gruber & Kamin, 2007; Combes & Saadi-Sedik, 2006).
7. Relative per capita income
Relative per capita income and its squared value are included to capture the stage of development of a country. Previous literature indicates that countries that are in transition from a low to intermediate stage of development are likely to run current account deficits, while countries that have reached an advanced development stage are likely to run current account surpluses (Chinn & Ito, 2007; Chinn & Ito, 2008-1; Chinn & Prasad, 2003). Empirical research shows significant evidence of the positive relationship between relative per capita income and current account balances for advanced countries (Chinn & Ito, 2007; Chinn & Ito, 2008-1; Chinn & Prasad, 2003; Chinn et al., 2011; Gruber & Kamin, 2007).
8. Legal development
To capture legal development a dummy is included taking the value of 1 if the country has a formal legislative body for the specific year and 0 otherwise (Regan, Frank, & Clark, 2009).14 In previous empirical literature, the variable for legal development is constructed by computing the first principal component of the quality of bureaucracy, law and order and the corruption index.
Legal systems establish law and order, minimize corruption and protect property rights. Therefore, an increase in legal development is expected to increase the amount of capital inflows and decrease the current account balance (Chinn & Ito, 2007; Chinn & Ito, 2008-1; Chinn et al., 2011).
9. Oil exporting countries
A dummy for oil exporting countries is included with a value of 1 if the country is a net oil exporter and 0 otherwise. In previous empirical literature, the effect of oil exports on the current account balance is measured by either the nominal oil balance, as a ratio to GDP, or a dummy for oil exporting countries.
Empirical research shows a significantly positive association between net oil exports and the current account balance (Chinn & Ito, 2007; Chinn & Ito, 2008-1; Chinn & Prasad, 2003; Chinn et al., 2011; Gruber & Kamin, 2007).
10. Financial crises variable
In accordance with Gruber and Kamin (2007), the financial crises variable is constructed by using data from Caprio and Klingebiel (2003) and Laeven and Valencia (2013). They have listed all systemic banking, currency and sovereign debt crises until 2011. Gruber and Kamin (2007) find a significantly negative coefficient on financial crises. However, they state that for higher levels of trade openness, financial crises raise the current account balance more substantially.
A complete list of the variables and the corresponding data sources can be found in Table 6 in Appendix 3. The main data sources are the World Development Indicators database of the Worldbank and the World Economic Outlook database of the IMF.
14
If a country has an existing constitution that is suspended, the legislative institutions are coded according to the constitutional specifications for these bodies (Regan, Frank, Clark, 2009).
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After having decided which variables to include in the model, the following section will proceed by checking several assumptions that have to hold in order for the model to obtain efficient regression coefficients.
4.2 Ordinary Least Squares (OLS) assumptions
Four ‘least squares assumptions’ have to be met in order for the OLS regression to provide appropriate estimators of the unknown regression coefficients. If these assumptions hold, the OLS estimators will have sampling distributions that are asymptotically normal, unbiased and consistent when the sample size is large (Stock & Watson, 2012).
The first least squares assumption states that the conditional distribution of ui,given X1i, X2i,…, XKi,has a mean of zero. Standard OLS estimates yield biased results if XKi is correlated with uit. In order to reduce this ‘omitted variable bias’, several control variables are included in the regression. The residuals in Figure 10 roughly form a horizontal band around the zero line, suggesting that the conditional mean of the error term, given the independent variables, is roughly zero. Therefore, assumption one is likely to be met.
The requirement of the second least squares assumption is that (X1i, X2i,….., XKi, ui1, ui2,…, uiT), i=1,….,n, are independent and identically distributed random variables. This assumption is likely met as well. First, because the observations are drawn from a large population. Second, because the observations are drawn by simple random sampling. Every country has a certain combination of values for the ratio of the current account balance to GDP and the independent variables. The ratio of current account balance to GDP and the independent variables are distributed independently from one observation to the next (Stock & Watson, 2012). Figure 10 shows that the residuals lie randomly around the zero line. This underlines the expectation that the second least squares assumption is likely to be met.
The third least squares assumption states that large outliers are unlikely. Figure 10 shows that this assumption is also likely to be met, because no residual stands out from the basic random pattern of residuals (Stock & Watson, 2012).
The fourth least squares assumption states that there is no perfect multicollinearity. This assumption is met as well, as STATA automatically solves the problem of perfect multicollinearity by omitting the regressors that are a perfect linear function of the other regressors (Stock & Watson, 2012).
Figure 10: Residuals against the fitted values. Graph constructed by the author based on regression (1) in Table 4.
Based on the ‘Regressors vs. Fitted Valued plot’ in Figure 10, it can be concluded that the four least squares assumptions are likely to be met, as explained above. Therefore, the OLS
-2 0 -1 0 0 10 20 R e si d u a ls -20 -10 0 10 20 Fitted values
