Trade Reforms and Current Account Imbalances: When Does the General Equilibrium Effect Overturn a Partial Equilibrium Intuition?

Permanent shocks such as trade liberalizations are hard to discuss in a standard dynamic Hechscher-Ohlin model due to potential interest rate over-determination. We make three contributions. First, we introduce an endogenous discount factor which solves the problem of interest rate over-determination. Second, we show that trade liberalization in a developing country generally leads to capital outflow, whereas it produces an opposite pattern for developed countries. Therefore, efficient trade reforms can contribute to global current account imbalances. Third, following a trade reform, the current account imbalance first widens and then falls back to zero. As an application, this model predicts an inverse-V-shape pattern for current account imbalances following China’s accession to the WTO: Even without policy distortions, China’s current account imbalance should rise for a few years before it starts to shrink.