The Welfare Cost of the US Current Account Deficits on Developing Countries

A sudden stop is the slowdown or cut-off of capital flows into an economy resulting in consumption and output collapses. Developing countries are known to experience this problem more frequently. The consensus in the literature is that these reversals are caused by poor economic management in these countries. While it is understandable that weak macroeconomic fundamentals lead to sudden stops, this paper shows that developing countries may face a sudden stop even when their macroeconomic indicators do not suggest one is imminent. A combination of certain factors can dry up funds for these countries: A unique borrower, borrowing at a significantly high level, pushing interest rates to the point where a developing country is not able to borrow due to credit rationing. The US has run a significant current account deficit over the last 30 years, borrowing far more than any other major economy. This paper analyzes the impact of the US deficits on developing countries that are trying to finance their projects. It provides regression results, then develops and simulates a theoretical model to investigate this. The Arellano-Bond dynamic panel-data regression results show that the US deficits are negatively associated with the current account deficits of the developing countries. The developing country loses its ability to borrow freely when the US’s borrowing exogenously increases. The real business cycle model shows that this entry to the market causes a sudden stop-type effect even when the developing country is not experiencing any immediate problems in its economy. The simulation results show that the reduced borrowing opportunities for the current period and possibly future periods distort the production process and decrease welfare in developing countries. These results suggest that developing countries, when planning their projects and the related need for borrowing, need to be wary of these conditions in addition to their own situation. Moreover, when a sudden stop occurs, international institutions such as the IMF and the World Bank should be cautious. They should examine whether the sudden stop was the result of poor planning and macroeconomic conditions or the result of an external factor such as the US increasing its borrowing to crowd out other borrowers.