From a capital account surplus to a current account deficit

Unsustainable capital inflows precede currency and banking crises, such as the current crises in Turkey and Argentina and the crises in Iceland, Ireland and Spain in the last wave of financial turbulance ten years ago. The empirical question asked in this paper is whether the capital inflows are caused by excessive spending by domestic nationals or, alternatively, whether the capital inflows cause increased spending by raising domestic asset prices, in particular stock prices. To anwer this question data from Iceland’s experience ten years ago is used to estimate an unrestricted VAR system in the gross capital inflow (separated into bank borrowing, portfolio investment and direct foregn investment), real exchange rates and stock prices. The results of the estimation are used to plot the impulse response function. These show that a capital inflow causes the appreciation of the real exchange rate and the elevation of stock prices, which then increases domestic spending through a wealth effect creating a current account deficit. Granger causality tests indicate that the capital flows “Granger cause” movements in stock prices and real exchange rates and not the other way around. We finally split our sample so that we can separate the effect of capital flows in the pre-crisis period of perfect capital mobility and the post-crisis period of capital controls. We find that the relationships exist under perfect capital mobility but not in the capital control regime. The sources of the turbulance in Iceland can thus to a large extent be traced to developments in international capital markets.