Current Account Reversals and Currency Crisis-Empirical Regularities



Are external crises characterized by large nominal devaluations invariably
followed by sharp reductions in current account deficits? Or do reductions in
external imbalances occur even without a sharp exchange rate devaluation? And
what is the impact of crises and reversals in current account imbalances on
economic performance? Our paper addresses these questions by characterizing
real and nominal aspects of sharp external adjustments in low- and
middle-income countries. It presents stylized facts associated with sharp
reductions in current account deficits (reversals) and with large nominal
devaluations (currency crises), and studies empirically what factors help
predict crises and reversals and what factors explain macroeconomic performance
following such events.

Econometric analysis of leading indicators of reversals in current account
imbalances shows that these are more likely to occur in countries with
persistent deficits, low reserves, and unfavorable terms of trade, and are less
likely to occur in countries that receive high official transfers and whose
debt is largely concessional. Growth after reversals tends to be faster in more
open economies and in countries whose real exchange rate was less appreciated
prior to the reversal.

Currency crises are more likely to occur when reserves are low, the real
exchange rate is appreciated, and external conditions are unfavorable--high
interest rates and low growth in industrial countries. Growth tends to decline
the year of the crisis, and to recover thereafter.

A comparison of currency crises and current account reversals shows that these
are distinct events. Less than one-third of all current account reversals are
preceded by a currency crisis, suggesting that the conventional wisdom that
large nominal depreciations precede a turnaround in the current account is not
accurate. This points to the need of looking more closely at current account
reversals, distinguishing between those that reflect an external crisis and
those that do not.