- <u>Net foreign assets (NFA): They can affect the current account balance in two opposing ways. First, a large</u> stock of foreign liabilities (negative NFA) will require a country to run current account surpluses to pay them off (negative relationship). Second, the country will need to pay interest on those liabilities, generating outbound income payments and thus tilting down the current account (positive relationship). Empirical evidence supports a positive relationship, which means that the CAB deteriorates with more negative NFA. However, this relationship may not hold for very highly indebted nations, possibly due to more heightened concerns about sustainability (IMF 2013). We use lagged NFA to avoid endogeneity issues.

- • <u>Macroeconomic uncertainty: Higher macroeconomic uncertainty naturally leads to a rise in saving since risk-</u> averse households set aside resources as a precaution against possible adverse changes in income (Skinner 1988; Zeldes 1989). The buffer stock theory of consumption (Carroll 1992) also suggests that agents facing incomplete markets and borrowing constraints respond to changes in labor market conditions by altering their stock of precautionary wealth. As for investments, the asymmetric nature of adjustment costs makes downside uncertainty more important than upside uncertainty (Abel and Eberly 1994). Indeed, disinvestment is costlier than investment, and favorable shocks have a smaller effect on profitability than adverse shocks. To reduce the risk of being locked into unprofitable irreversible projects, firms facing macroeconomic uncertainty may become reluctant to invest (Dixit and Pindyck 1994; Servén 1998). Therefore, higher macroeconomic uncertainty is expected to increase saving, reduce investment and improve the CAB. Given the long history of double-digit inflation in Turkey, we take inflation uncertainty (measured as the volatility over the previous 24) as a proxy for macroeconomic uncertainty. In specification checks we also use alternative windows (36 months) in construction of the variable.

- <u>Global uncertainty: Higher global uncertainty is expected to increase saving and reduce investment in line</u> with the buffer-stock theory. Moreover, higher volatility in the global financial market is associated with lower availability of foreign financing for emerging markets, thereby contributing positively to the current account balance. We use Cboe’s volatility index (VXO), which measures the volatility in financial markets, as a proxy of global uncertainty.

- <u>Lagged current account balance: At an annual frequency, current account balances tend to show high</u> persistence associated with habit formation in consumption and saving, or agglomeration effects in investment. We capture this persistence by including the lagged values of the dependent variable.

Finally, we include a dummy variable to control for the impact of the 1994, 2001-2002 and 2009 crises on the current account.

_Source_ : Authors’ elaboration based on literature review.

**Some of the factors proposed as potential determinants are in fact jointly determined with the current account balance, notably the fiscal variables and NFA.** To deal with this ‘simultaneity’ problem, we instrument variables that are likely to be endogenously determined with the current account balance. The instruments consist of lagged values of the variable in question, which are predetermined at time t.  Pre-determination, however, does not necessarily imply ‘exogeneity’ if anticipation effects are present. For these reasons, a caveat is necessary: the results presented here should be read as conditional associations between variables, rather than as strict causal relationships.

**Relative variables (i.e. relative income, relative GDP growth and trade openness) are defined as deviation from the weighted average of the trading partners.** The weights for trading partners are based on the average importance of each country as an export destination for Turkey and the weights are calculated using the COMTRADE data. The final weights include the 30 largest trading partners.

**Since annual data are used, estimation of single-country determinants puts relatively strong limits on the number of variables to be included in an OLS regression, even in the first step of general-to-specific exercise.** Following Haddad and Nedeljkovic (2012) a preferable solution for confronting parametric model uncertainty and a limited number of observations is model averaging. Model averaging in the present context means that different combinations of the potential current account determinants (not all at once) are used as particular models and each

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