Analysis of Current Account Reversals via Regime Switching Models

The analysis of sharp and persistent reductions of current account deficits, which can be characterized as the transition from an unsustainable to a more sustainable level of current account balance, relies often on ad hoc criteria for identification of reversal episodes. Within this paper, an empirical framework in terms of a regime switching approach is presented allowing simultaneous identification of current account reversal episodes and their determinants. Additionally, this approach is extended towards analysis of the impact of a reversal on the path of economic growth. Empirical investigation of a panel containing merely of developing countries suggests a different timing of reversals compared to timing delivered by ad hoc criteria. However, several determinants of reversals discussed in the literature remain valid. Our estimates of costs implied by the occurrence of a current account reversal amount to a severe reduction of economic growth, where output costs are found to vary largely across countries.