1. INTRODUCTION In an open economy policy makers are concerned with two macroeconomic goals – internal balance and external balance. Internal balance is achieved when the economy’s resources are fully utilized and stability of price level is attained. External balance is achieved when an optimal level of current account balance is attained. By optimal balance it is meant that ‘a country’s current account is neither so deeply in deficit that the country may be unable to repay its foreign debt in the future nor so strongly in surplus that foreigners are put in that position’ (Krugmman and Obstfeld, 2003). The current account is an important indicator of a country’s economic performance. Movement of this macroeconomic indicator conveys information about actions and expectations of all market participants in an open economy (Bannaga 2004). In particular, the behavior of current account balance provides useful information about change in macroeconomic policy stance and Determinants of Current Account Deficit in Developing Countries: The Case of Bangladesh A.F.M. KAMRUL HASSAN University of Rajshahi E-mail: [email protected]ABSTRACT Co-integration and Error Correction Model (ECM) are employed to study the behavior of Current Account Deficit (CAD) of Bangladesh and its determinants. The determinants of CAD include budget surplus, domestic saving, domestic income growth, foreign income growth, foreign interest rate, terms of trade, export and real exchange rate. A long-run equilibrium (co-integration) relationship is found between CAD and its determinants, although some variables are non-stationary. Out of eight independent variables only three of them namely, terms of trade, export and foreign interest rate, are found to have significant impact on CAD both in the long and short run. ECM formulation of the CAD model shows that more than 72% discrepancy between actual and long-run value of CAD is corrected in each year. The important implication of the study is that domestic economic policy has little to do with correcting CAD as all significant factors are related to the external economic conditions. 5
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1. INTRODUCTION
In an open economy policy makers are
concerned with two macroeconomic goals –
internal balance and external balance. Internal
balance is achieved when the economy’s
resources are fully utilized and stability of
price level is attained. External balance is
achieved when an optimal level of current
account balance is attained. By optimal
balance it is meant that ‘a country’s current
account is neither so deeply in deficit that the
country may be unable to repay its foreign
debt in the future nor so strongly in surplus
that foreigners are put in that position’
(Krugmman and Obstfeld, 2003).
The current account is an important indicator
of a country’s economic performance.
Movement of this macroeconomic indicator
conveys information about actions and
expectations of all market participants in an
open economy (Bannaga 2004). In particular,
the behavior of current account balance
provides useful information about change in
macroeconomic policy stance and
Determinants of Current Account Deficit inDeveloping Countries: The Case of Bangladesh
SAV 0.01701 -0.5799 0.527200.79133 0.40389 0.83115 0.0177 1.000
BS FIR RER TOT DGDP EX FGDP SAV
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(0.02508) (-3.579) (-0.2957) (-0.5309)
(3.086) (6)
R2 = 0.7982; Adjusted R2 = 0.6846; DW =
2.04; RESET[F(3, 13)] = 2.1198;
B-P-G[x2(9)] = 6.637; NRM[x2(2)]=1.7814.
∆ is first the difference operator. Various
diagnostic tests show that this ECM
specification is adequately specified.
Residuals are normally distributed,
homoscedastic and serially uncorrelated. The
coefficient of error correction term (ECt-1
) in
regression equation (8) is negative and
significant which is the requirement of valid
co- integration.
6.2 Analysis and Findings
Estimation results of regression equation (2)
show that CAD has a long-run equilibrium
relationship with it determinants as specified
in model (1). Except DGDP, signs of response
of these variables are as per expectation. But
only three variables, namely FIR, TOT and
EX, have statistically significant relationship
with CAD. In the long-run a 1% increase in
FIR reduces CAD by 0.372%, that is, increase
in FIR reduces demand for international
capital which reduces CAD. TOT has positive
impact on CAD. 1% increase in TOT is
associated with 0.196% increase in CAD.
This positive association between TOT and
CAD indicates that elasticity of substitution
between foreign and domestic goods is less
than unity as pointed out by Backus (1993).
EX is negatively related to CAD as expected.
1% increase in EX reduces CAD by 0.44%.
This negative impact comes through EX’s
impact on trade balance.
Other variables in the regression model (2)
do not have statistically significant
relationship with CAD in the long-run. All
insignificant variables have expected sign
except DGDP. Theoretically it was postulated
that DGDP is positively associated with
CAD. But the estimation result shows that
DGDP is negatively related to CAD. This
negative impact may be due to the fact that
increase in income increases consumption but
less than the increase in income, which raises
saving and reduces CAD. Thus DGDP’s
negative impact might be exerted through its
impact on saving. RER has expected sign,
but its insignificance may be due to the use
of bi-lateral RER instead of a weighted
average RER. Bangladesh is a relatively less
open economy. It is categorized as a below
average open economy by Least Developed
Countries Report, 2004. For this reason
foreign income (FGDP) increase may not
have significant impact on CAD. Impact on
CAD of BS is through redistribution of
income from future to present generation. BS
in Bangladesh may not be so instrumental in
increasing income of the economic agents,
which is reflected in insignificant impact of
BS on CAD. Average consumption in
Bangladesh is very low because of low per
capita income. For this reason income growth
may not add to saving (SAV) enough to
reduce CAD significantly. Besides, small
sample size may well be responsible for
insignificance of these variables. The error
correction specification of regression (2)
presented in equation (6) indicates that the
speed of adjustment is quite high. More than
72% of the discrepancy between actual and
the long-run value of CAD is eliminated or
corrected in each year.
Another important finding of the study is that
different reform measures in the external
sector (i.e. tariff reduction, current account
liberalization through current account
convertibility etc.) did not appear to have any
A. F. M. Kamrul Hassan
20
significant impact on CAD. The CAD model
examined in this paper is found to remain
stable over the study period.
7. CONCLUSIONS
This section concludes the paper by
summarizing some of the main results
followed by a brief discussion of direction
of future research. The aim of the paper was
to examine the behavior of current account
deficit of Bangladesh in the long-run and
short-run using co-integration and error
correction theory. Specifically the paper
examines the impact of government budget
surplus, domestic saving, domestic income,
real exchange rate, terms of trade, foreign
interest rate, foreign income on current
account deficit. The study covers the period
from 1976 to 2003 and uses annual
observations. Augmented Dickey-Fuller
(ADF) and Phillips-Perron (PP) unit root tests
suggests that variables are integrated to
different orders, but Co-integrating
Regression Durbin-Watson (CRWD) and
Engle-Granger (EG) co-integration test
suggest that in the long run variables are co-
integrated. Both long-run static and short-run
dynamic ECM indicate that the important
explanatory variables in determining current
account deficit are foreign interest rate (FIR),
terms of trade (TOT) and export as percentage
of GDP (EX). Foreign interest rate and export
are negatively whereas term of trade is
positively associated with current account
deficit. Short-run adjustment of long-run dis-
equilibrium is quite high as found in ECM
framework. The noteworthy finding of this
study is that no internal economic conditions
do have significant impact on current account
deficit in Bangladesh; all factors are related
to external economic conditions. One
important implication of this result is that
domestic macroeconomic policies do not
have much to do to affect current account
deficit. All significant factors are governed
by the state of world economic conditions.
This ineffectiveness of domestic policy is
further evidenced in the fact that despite
different reform measures, the model of
current account deficit remains stable over
the entire study period.
This study makes an effort to identify the
factors that affect current account deficit of
Bangladesh in the long and short run. There
is still further scope to extend the analysis in
other South Asian countries. Moreover
sustainability of current account deficit of
Bangladesh may well be a potential area of
future research.
21
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A Short Bio of A.F.M. Kamrul Hassan
Obtained B.Com (Hons) and Master of Business Studies (with First Class First positionin both the examinations), and Master of Philosophy (M.Phil.) degrees in Finance &Banking from Rajshahi University, Bangladesh, Area of research interest includedInternational Trade, Monetary Policy, Financial Sector etc.