Sharp reductions in current account deficits: an empirical analysis

We study determinants and consequences of sharp reductions in current account imbalances (reversals) in low- and middle-income countries. We pose two questions: what triggers reversals, and what factors explain how costly reversals are? We find that both domestic variables, such as the current account balance, openness and the level of reserves, and external variables, such as terms of trade shocks, US real interest rates and growth in industrial countries, seem to play an important role in explaining reversals in current-account imbalances. We also find some evidence that countries with a less appreciated real exchange rate, higher investment and more openness prior to the reversal tend to grow faster after a reversal occurs.