The management of a country’s balance of payments is the area of macroeconomic policy where unrestricted capital mobility brought the biggest, if not revolutionary, changes. The ‘traditional’ approach to BoP analysis was based on realities of largely closed (or only partly open) economies with a limited role of cross-border private capital flows and the ability of national governments to influence saving and investment decisions of domestic economic agents. Such an analysis usually started from domestic factors of competitiveness, in the first instance labour unit costs denominated in foreign currency. These factors determined the trade and current account balance. Capital account transactions had to counterbalance the current account. If a country ran a current account deficit it needed, for example, foreign credit (private or official), foreign direct investment (FDI) or other kinds of capital inflow to finance that deficit. If it ran a current account surplus this surplus had to be absorbed in the form of capital account transactions with the opposite sign, that is, through various forms of capital exports or outflows, or increasing official reserves (which is also a form of capital export).

If the current account balance was considered unsustainable, given difficulties in conducting counterbalancing capital account transactions, policy adjustment was needed. The adjustment might be implemented through the instruments of exchange rate policy (devaluation or revaluation of domestic currency), trade policy, monetary and fiscal policies (which determined the level of domestic absorption), and others.

Summing up, in a world of restricted capital mobility the current account balance determined capital account flows. In a world of free capital mobility, however, the reverse causality dominates. In a small open economy, net capital flows (at least their private component) have a largely exogenous character and the current account balance must adapt to changes in the capital account (through changes in real exchange rates).

Figures 7.5 and 7.6 illustrate the mirror character of changes in net private financial flows and current account balances in two emerging market regions - CEE, and Latin America and the Caribbean - which are dominated by small open economies with largely open capital accounts. Their experience in the 1990s and 2000s confirms the phenomenon of limited control of national macroeconomic policy over current account balances and real exchange rates in a world of unrestricted capital movement. Even if a country’s monetary authority controls its nominal exchange rate through some sort of currency peg or managed float,

Net private capital flows and current account balance in CEE countries, 1990-2011 (USD billion)

Figure 7.5 Net private capital flows and current account balance in CEE countries, 1990-2011 (USD billion)

the real exchange rate adjusts to the BoP equilibrium through inflation differentials.

Other regions than CEE and Latin America and the Caribbean do not represent so clear a mirror pattern of changes in net private financial flows and current account balances due to the impact of other factors, such as the role of official development aid (sub-Saharan Africa), or changes in the official reserves (both international reserves of monetary authority and sovereign wealth funds) in the case of developing Asia, the Middle East and North Africa, and the CIS economies.

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