Long-Run Current Account Deficits in Transition Economies : A Neoclassical Explanation

The distinct tendency toward substantial current account (CA) deficits in numerous transition economies is remarkable. This paper points out that the high ratios of human to physical capital and the resulting high rates of return on physical capital may be one important factor that can account for the magnitudes of these deficits. Budget deficits (as an alternative explanation of CA deficits) are unrelated to CA deficits in transition economies, although they are positively related to CA deficits in developing countries. The behavior of formerly centrally planned economies (henceforth referred to as FCPEs) in transition has attracted great interest in the economic literature.1 FCPEs differ considerably from other world economies: the existing economic variables in the FCPEs have not resulted from a long-run operation of market forces. Due to this distinctive feature, transition economies constitute a plentiful area for economic research. This paper discusses the remarkable phenomenon of large current account (CA) deficits in numerous FCPEs. In many of these economies, CA deficits exceeded 5 percent of the gross domestic product (GDP), and the trend toward large deficits is expected to continue, at least for the next few years. The intention of this paper is to formulate a plausible hypothesis on the nature of these deficits. The paper follows a very simple idea: the decades of central The author is affiliated with the Department of Economics and Management, Faculty of Informatics and Management, University of Hradec Králové, Czech Republic. Research for this paper was supported by the Grant Agency of the Czech Republic (grant number 402/04/ 0642). The author would like to thank Nauro Campos, Randall Filer, Max Gillman, Stanley Reynolds, Ivana Studená, Mark Schaffer, and participants of the CERGE-EI Macroeconomics Seminar in Prague and the CEPR Annual Transition Economics Summer Workshop for Young Academics in Budapest for helpful discussions and suggestions; two anonymous referees for their helpful comments; and Pavel Kopecký for his technical assistance. 22 EASTERN EUROPEAN ECONOMICS planning are viewed as a forceful supply shock leading to markedly obsolete physical capital (due to large production and investment inefficiencies) but relatively fair human capital (due to subsidized education and, perhaps, due to favorable family backgrounds––i.e., income and education of parents). 2 Human and physical capital are believed to be complements in production. The standard augmented neoclassical growth model implies high real rates of return on physical capital in economies with high ratios of human to physical capital, as long as the imbalance between human and physical capital (plus the effect of diminishing returns if the economies are poor) is not sufficiently offset by a low level of technology.3 The high rates of return on physical capital lead naturally to very large physical capital inflows (CA deficits) in open economies; in this framework, the magnitudes of CA deficits are given only by the degree of the international capital mobility and by the costs of capital installation.4 To a certain extent, this scenario may have applied in post-1945 Europe and Japan, and it may be an important part of the story in numerous transition economies today. In this setup, there is absolutely no reason to complain about the size of the CA deficit.5 Of course, this extremely simple framework should be viewed only as a very rough approximation of the economic reality in the FCPEs. It seems plausible that this neoclassical framework is more relevant for the advanced reforming countries; for this reason, attention in this paper is primarily paid to the six most advanced Central European FCPEs. Nevertheless, even for these economies, the present framework definitely reflects only a portion of reality. In particular, this neoclassical model can provide a rationale for large CA deficits, but it cannot determine the exact magnitudes of deficits that are sustainable in individual countries. Central European and Other Transition Economies This section is primarily focused on a description of six fast-reforming Central European countries––the Czech Republic, Estonia, Hungary, Poland, Slovakia, and Slovenia. On average, these countries have been relatively successful in the fundamental restructuring of their economies (namely privatization) and in adopting the basic institutional framework necessary for the smooth functioning of a market economy.6 Nevertheless, the long period of central planning left even the most advanced FCPEs relatively poor; the 1994 GDP per capita levels of the six Central European economies are presented in Table 1. In addition to the six advanced reformers, this section discusses some data for Belarus, Bulgaria, Latvia, Lithuania, Romania, Russia, and Ukraine. Items of the Balance of Payments Central European economies have been considerably open to foreign trade and capital flows. These economies have attracted a good deal of foreign financial