Essays on current account imbalances in European countries

This dissertation consists of three chapters in exploring the current account imbalances in the European countries. The first chapter investigates the effect of household indebtedness on the Twin Deficits phenomenon in European countries. Annual data from 1981 to 2012 for 28 European countries are used. Panel regression with fixed effects and General Method of Moments (GMM) approaches are adopted to examine the standard determinants of the current account imbalances and the effect of household indebtedness on the Twin Deficits hypothesis. Empirical findings indicate the existence of positive co-movement between the fiscal balance and current account balance, thus indicating the presence of the Twin Deficits phenomenon in the European region. Meanwhile, there is a negative association between gross household debt and the current account balance. This inverse relationship implies consistent behavior with the Twin Deficits between fiscal balance and current account balance, where increase in the gross household debt contribute to the growth of the current account deficit. Thus, the household debt may marginally exacerbate the Twin Deficits phenomenon. These results can be observed particularly in the countries with low fiscal deficits, public debt and household debt. The second chapter explores the behavior of the current account deficit and fiscal deficit from the view of thresholds to provide additional understanding on the Twin Deficits phenomenon. Annual data of eleven Euro Area countries from 2000 to 2012 are adopted in this study. This paper examines endogenous thresholds namely public debt, fiscal deficit, household debt, trade openness and financial development as threshold variables, using the sample splitting method (Hansen, 2000). The aim is to examine the Twin Deficits behavior from the perspective of countries above or below the threshold levels. This is due to the fact that households may behave in differently in term of consumption and risk preference in the countries above or below the threshold levels. Empirical findings indicate that there is evidence of Twin Deficits phenomenon in the baseline model without threshold effects. In terms of the threshold effects, there is a significant positive association between the current account balance and the fiscal balance in the countries with public debt, household debt, fiscal deficit, trade openness and financial development below their respective threshold levels. On the other hand, there is no or weak evidence of the Twin Deficits phenomenon in the countries with public debt, household debt, fiscal deficit, trade openness and financial development above the threshold levels. Intuitively, household behavior may indicate Ricardian Equivalence as the effect of the fiscal policy is offset by the opposite behavior from households, such that as the government borrows more (fiscal deficit increase), households may save more. This means that Ricardian Equivalence behavior is more likely observed in the countries with high levels of public debt, household debt, fiscal deficit, trade openness and financial development. The third chapter investigates the current account sustainability in eleven European (EU) countries using annual data of exports and imports from 1980 to 2013. Im et al. (2003) panel unit root and Pedroni (1999) panel cointegration are employed to identify the stationarity of the variables and existence of a long-run relationship between the parameters of interest, which are exports and imports. The pooled mean group estimator proposed by Pesaran et al. (1999) is used to estimate the magnitude of the interaction of the exports and imports from the long-run and short-run perspective and at the individual country level, based on a series of sub-periods. The determination of the current account sustainability is based on existence of significant long-run association between exports and imports. If the interaction coefficient is within the equilibrium of one, then there is no violation of the long-run budget constraint and current account is sustainable. In addition, significant negative error-correction terms also indicate that existence of convergence in the long-run and current account is consider as sustainable. In terms of the short-run perspective, current account may be unsustainable if the deviation of the short-run coefficient from equilibrium of one is large. Empirical results show no violation of the long-run budget constraint in the eleven EU countries in the long-run, which implies a sustainable current account over time. However, the sustainability of the current account may shift towards unsustainable when taking into consideration different time frames, namely the effect of formation of the EU in 1992 and debt crisis starting in 2008. The short-run results at the individual country level provide different insight as compared to the results of the error-correction terms. Large short-run imbalances may lead to indications of unsustainable current accounts even though there is no evidence of violation of the long-run budget constraint.