The abrupt reversal of capital inflows into Mexico in 1994 has raised again the issue of the sustainability of large and persistent current account deficits in developing countries. In Discussion Paper No. 1509, Gian Maria Milesi-Ferretti and Assaf Razin attempt to identify potential sustainability indicators and assess their usefulness in predicting such external crises. They argue that the normal definition of ‘solvency’ – namely, the ability to honour future external obligations through accumulated trade surpluses – is an inadequate indicator. This is because it presupposes the debtor country’s willingness to redeem its debt and foreign investors’ continued willingness to lend, and it says nothing about the policy course required to transform existing trade deficits into surpluses. Milesi-Ferretti and Razin suggest that sustainability hinges on whether the current policy stance will permit a ‘smooth’ transformation from trade deficit to surplus, i.e. without drastic changes in consumption and economic activity. By contrast, the deficit is excessive if an unchanged policy stance is going to require an eventual ‘drastic’ policy shift.

The authors compare the experiences of three Latin American countries (Chile, Colombia and Mexico), and three East Asian countries (Korea, Malaysia and Thailand), in an attempt to explain why some countries suffered external crises while others did not. In most cases, they find significant differences between the current account deficit experiences of the late 1970s/early 1980s and the 1990s. The earlier episodes were characterized by large fiscal imbalances and exchange rate appreciations, with the consequent need for both fiscal and exchange-rate adjustment policies. The deficits of the 1990s, however, reflected an imbalance between private savings and investment. In addition, the main source of foreign capital had shifted from syndicated loans to portfolio and direct investment. The main conclusion is that the likelihood of external crisis depends not on a single indicator, but on a complex set of factors, particularly how the scale and composition of external liabilities interact with macroeconomic and structural variables.

Current Account Sustainability: Selected East Asian and Latin American Experiences
Gian Maria Milesi-Ferretti and Assaf Razin