What Explains Current Account Surplus in Korea?

Some countries have persistent current account surplus, contributing to global imbalances up to a level that is worrisome. For example, Germany has been continuously experiencing current account surpluses since 2002, amounting to 8.4% of GDP in 2015. China has never experienced current account deficits since 1997, the year that data is first available. Japan's record is even longer; its consecutive current account surplus started from 1981. Recently, Korea joined this large current-account surplus club: since the currency crisis in 1997, Korea's current account balance has been continuously in the black, expanding even more in these recent years. In this paper, we present an empirical methodology that explains how current account balances are determined and by employing it, try to diagnose factors that account for Korea's current account surplus. In fact, the IMF has introduced a methodology, the External Balance Assessment (EBA: Phillips et al., 2013), to assess exchange rate and current account gaps that are defined as the difference between current levels and those consistent with fundamentals. For example, the 2016 External Sector Report, by utilizing this methodology, demonstrates that Korea's real effective exchange rate in 2015 was 4 to 12 percent undervalued than the level consistent with fundamentals. While the IMF's EBA is a state-of-the-art methodology that incorporates major studies in the literature, we feel that it has some limitations when analyzing the movements of Korea's current account balances. The method implicitly assumes that the current account surpluses of these countries will be substantially reduced by changing the exchange rate. However, the current account surpluses of Korea cannot be explained by the exchange rate alone. After the global financial crisis, despite rapid appreciation of the real effective exchange rate, Korea's current account surplus has been continuously increasing. Korea experienced a currency crisis in 1998. Since then it has experienced continuous current account surpluses. The current account surpluses just after the crisis were extremely helpful for the economy to recover from the crisis. Managing a modest level of current account surpluses has also been beneficial for the economy in preventing future crises. However, Korea's current account surplus in 2015 amounted to 7.7% of GDP, causing a concern that it may be too excessive. This exorbitant reliance on external demand can escalate political pressures from trading partners to appreciate the exchange rate. It is also argued that maintaining more balanced demand sources by giving domestic demand a greater role is essential for a sustained growth path. In this paper, we investigated underlying reasons as to why Korea's current account surpluses are widening. We found that the upward trend in Korea's current account surpluses is essentially explained by demographical changes it is currently experiencing. Moreover, we show that since Korea's population is rapidly aging, its current account surplus is expected to disappear by 2042 as it becomes one of the most aged economies in the world. In fact, demographical changes are so powerful that they explain quite successfully the trend of current account balances of other aged economies such as Japan, Germany, Italy, Finland and Greece as well. However, demographics do not explain cross-country differences in the level of current account balances, i.e. the high level of Korea's current account surpluses is mainly explained by a country fixed effect. When we add the real exchange rate as an additional explanatory variable, it is statistically significant with the right sign, but the magnitude explained by it is quite limited. For example, in order to reduce current account surplus by 1 percentage point, a whopping 12% depreciation is needed. Since other economic variables are yet included as explanatory variables, this can be considered to be the maximum estimate of the effect of the exchange rate changes. If it is true that Korea's current exchange rate is 4 to 12 percent undervalued than the level consistent with fundamentals, it is impossible to reduce Korea's current account surplus to a reasonable level by adjusting the exchange rate alone. Another possibility to reduce current account surplus is expanding fiscal policies. We find, however, that the impact of fiscal adjustments on current account surplus is even more limited. According to our estimates, reducing current account surplus by 1 percentage point requires a 5-6 percentage points increase in budget deficits (as a ratio to GDP). The above impacts of exchange rate and fiscal policy adjustments are estimated without considering the endogeneity of these policy variables. If we allow endogenous movements of these variables, the impact of exchange rate adjustment is 1.6 times larger, while that of fiscal policy decreases so that it is no longer statistically significant. When we add other economically fundamental variables such as GDP gap, oil prices, net foreign asset and so on, they contribute to explaining short run fluctuations without much improvement in explaining the trend nor country fixed effects. On the other hand, while the upward trend in Korea's current account surplus since 1997 is mainly explained by demographical changes, the current level of current account surplus, i.e. 7.7% of GDP, is placed quite above the fitted line derived by the economically fundamental variables including demographical changes. This idiosyncrasy of Korea's current account surplus seems to be related to increasing saving propensity of households especially among aged people. However, we will need further detailed analyses for more rigorous evidence to support this argument.