Common international disturbances and the illusion of domestic control: Reassessing the determinants of current account imbalances

This paper re-examines the determinants of current account imbalances by integrating a simple intertemporal small open economy framework with an empirical strategy that combines System GMM estimation and the Common Correlated Effects (CCE) approach. The theoretical framework illustrates how common international disturbances and country-specific shocks jointly shape external-balance dynamics, while the empirical specification explicitly controls for latent common factors through cross-sectional averages. Using an unbalanced panel of 45 countries covering the period 2000–2023, the empirical results yield three main findings. First, current account dynamics display a high degree of persistence. Second, latent common international influences explain a substantial share of the cross-country variation in external balances. Third, explicitly controlling for these common factors leads to a more stable and economically coherent interpretation of domestic determinants. In particular, domestic credit expansion remains negatively associated with external balances, suggesting that domestic financial conditions continue to matter within a broader international environment shaped by common international influences. Overall, the findings help reconcile conflicting evidence in the literature and highlight the importance of accounting for cross-sectional dependence when analysing long-run external-balance dynamics.