The Role of Remittances and FDI for the Current Account: The Case of Cambodia

Q1. Why does a standard SOE-RBC model fail to explain Cambodia’s current account, and what does the paper add?

A standard SOE-RBC model with only transitory productivity, permanent productivity, and world interest rate shocks leaves 58 percent of the variance in Cambodia’s current account-to-output ratio unexplained and achieves only a 0.80 correlation with the observed series, because it omits two empirically large and persistent external financing flows — FDI (which averaged around 11 percent of GDP over the sample) and net unilateral transfers (remittances and grants) — that directly affect both the capital account and saving behavior in a developing country with shallow domestic capital markets. The paper follows Chang and Fernández (2013), who establish that world interest rate and transitory productivity shocks matter more than permanent productivity for business cycles in emerging markets, and extends that framework specifically for a low-income developing economy where external capital inflows are a primary driver of investment and consumption rather than an auxiliary shock. FDI is modeled as an exogenous shock to the net-FDI-to-output ratio with its own AR(1) process, and it enters the model with a direct spillover onto permanent productivity growth (parameter γ, with a posterior mean of 0.08), capturing the technology-diffusion channel of FDI.

Q2. What is the model structure and what shocks does it incorporate?

The model is a two-good SOE-RBC framework with Cobb-Douglas production (F = a_t K^α h^(1-α)) where output growth is driven by a stationary transitory productivity level a_t and a non-stationary permanent productivity trend g_t; households maximize utility over consumption and leisure with CRRA preferences (σ = 2) and discount factor β = 0.96, subject to a budget constraint linking consumption, capital accumulation (with quadratic adjustment costs, calibrated posterior mean φ = 15.76), foreign borrowing, and two external inflow variables: net unilateral transfers (NT) and net FDI. The world interest rate R_t is the product of the world risk-free rate R*_t and a country-specific spread S_t that depends negatively on expected future productivity, introducing an endogenous risk-premium channel. The working-capital requirement θ (posterior mean 0.50) requires firms to pre-finance a fraction of the wage bill at the current period interest rate, creating a financial-accelerator-like amplification of world interest rate shocks. The complete list of five structural shocks is: transitory productivity (σ_a), permanent productivity growth (σ_g), world interest rate (σ_R), unilateral transfers (σ_nt), and FDI (σ_fdi). The model is estimated in log-differences of Y, C, and I and in levels of TB/Y, CA/Y, NT/Y, and FDI/Y.

Q3. What does the variance decomposition show and how does it allocate current account variation across shocks?

Table 3 shows that for the current account-to-output ratio, FDI and unilateral transfers together account for approximately 50 percent of variance (~27 percent for FDI and ~23 percent for unilateral transfers), while transitory productivity and world interest rate shocks together account for the bulk of the remainder; permanent productivity growth (σ_g) contributes negligibly to CA/Y variance; the measurement error in CA/Y (σ_CA) is approximately 4.12 percent, indicating the model fits the current account data very closely. The paper notes that “the shocks of world interest rate and transitory productivity play more important roles than the shock of permanent productivity growth in explaining macroeconomic fluctuations,” consistent with Chang and Fernández (2013) and the standard SOE-RBC finding. For output, consumption, and investment, transitory productivity and world interest rate shocks dominate (each accounting for roughly 30–50 percent of variance across the macro aggregates). The FDI shock plays a comparable role to the interest rate shock for output fluctuations, reflecting that FDI inflows to Cambodia are large enough to function as a de facto external financing channel. A model without FDI and transfers (Appendix Table A1) shows that measurement error in CA/Y rises to 58.31 percent, confirming the quantitative importance of the two additional shocks.

Q4. How do impulse responses to the five shocks illuminate the current account dynamics?

A positive transitory productivity shock of 1 percent causes output, consumption, and investment to expand on impact, but the expansion in domestic absorption (C + I) exceeds that of output because the persistence of the shock (ρ_a = 0.91) leads consumption-smoothing households to borrow against higher expected future income, producing a current account deterioration of approximately 1 percentage point on impact — consistent with a temporary boom financed by current account deficits. A positive world interest rate shock reduces consumption and investment by roughly 1 percentage point on impact as borrowing costs rise and firms reduce the wage-bill they pre-finance; trade balance and current account improve initially (~1 percentage point) as domestic absorption falls more than output, but then deteriorate as the higher interest payment on the accumulated debt stock (with persistence ρ_R = 0.87) pushes the current account below its steady state after period 1. A positive FDI shock raises consumption and investment while keeping output unchanged on impact, deteriorating the current account by approximately 1 percentage point; because FDI raises permanent productivity growth (γ > 0), the accumulation of capital eventually raises output so that the current account gradually recovers toward its steady state, but domestic absorption remains above output due to the joint persistence of FDI and productivity (ρ_fdi = 0.87, ρ_g = 0.72). A positive unilateral transfer shock has a negligible impact on consumption, investment, and output (magnitudes below 0.06 percent) because the shock is low-persistence (ρ_nt = 0.15) and consumption-smoothing households save most of the windfall; however, the transfer improves the current account by its full magnitude (~1 percentage point) essentially one-for-one by definition.

Q5. How well does the model fit the historical current account trajectory and what does the shock decomposition reveal about phases of Cambodian development?

The estimated model produces a time-series of fitted current account-to-output ratios with a 0.93 correlation with the observed data and only 4.1 percent measurement error; the model initially over-predicts by about 5 percentage points (due to uncertainty about initial conditions), but then closely tracks the observed trajectory of deficits averaging roughly −11 percent of GDP from the mid-1990s through 2018. The shock decomposition (Figure 5) shows that FDI and unilateral transfers dominate the current account in the earlier part of the sample (mid-1990s to mid-2000s), while transitory productivity shocks contribute more in the later period (post-2010) — a pattern the authors interpret as consistent with the stylized fact that capital inflows drive growth in early-stage development, while productivity improvements become the primary driver as the economy matures. The world interest rate shock contributes relatively little throughout the sample, suggesting that Cambodia’s current account dynamics are primarily driven by supply-side (FDI-productivity linkages) and income-transfer channels rather than by global borrowing-cost variation.

Q6. What does the COVID-19 scenario exercise predict and what is the model’s forecasting accuracy?

Combining simultaneous shocks calibrated to IMF and World Bank 2020 projections for Cambodia — a 1-percentage-point drop in transitory productivity (consistent with a World Bank projection of 1 percent GDP contraction), a 2-percentage-point drop in the FDI-to-output ratio (World Bank 2020 forecast), and an 8-percentage-point drop in unilateral transfers-to-output (reflecting IMF’s Sayeh and Chami 2020 estimate of 20 percent or more remittance decline plus EU EBA trade preference suspension) — the model predicts the current account-to-output ratio will fall to −14 percent in 2020, essentially identical to the World Bank’s external forecast of −14.1 percent. The three shocks propagate differently: the productivity drop temporarily improves the current account by approximately 2 percentage points as domestic absorption contracts more than output, but then worsens it in 2021 as output falls and consumption reverts; the FDI drop similarly has a transient current-account-improving effect before the productivity-growth channel drags output down; the transfer drop has an essentially one-to-one negative effect on the current account (8 percentage points lower) that quickly reverses. The combined prediction of −14 percent, coinciding with the World Bank’s external forecast, is presented as validation of the model’s out-of-sample performance.

Q7. What is the role of the endogenous vs. exogenous discount factor, and why does it matter?

The paper tests whether specifying the discount factor as endogenous (depending on lagged consumption as in Schmitt-Grohé and Uribe 2003, to ensure stationarity of net foreign assets) versus exogenous materially affects the current account dynamics, and finds it does not — the discount factor specification is immaterial for explaining Cambodian current account fluctuations because FDI and unilateral transfers, which dominate the variance decomposition, are exogenous to the household’s saving-patience parameter that the discount factor governs. This result simplifies model specification choices for similar small open economy applications: the patience assumption matters for long-run external position dynamics in models where standard RBC shocks dominate, but loses its influence when there are large direct external financing flows. The finding extends to the working capital parameter θ, which also does not significantly alter the current account dynamics despite affecting the transmission of world interest rate shocks to investment and output.

Q8. How does this paper contribute relative to existing SOE-RBC literature and what are its limitations?

The key contribution relative to Aguiar and Gopinath (2007), García-Cicco et al. (2010), and Chang and Fernández (2013) is to demonstrate quantitatively that for very low-income developing countries where FDI and remittances are large relative to GDP, the standard SOE-RBC shock triplet (transitory productivity + permanent productivity + world interest rate) is misspecified and will systematically fail to fit current account data; adding the two external financing shocks reduces the CA/Y measurement error from 58 percent to 4 percent, a quantitatively enormous improvement. A limitation noted by the paper is that the working paper version (MPRA 108489) covers only Cambodia over 1993–2018, so cross-country generalizability to other developing economies with large FDI and remittance flows (e.g., Bangladesh, Nepal, Vietnam) is not formally established; the model is also log-linearized around the steady state, which may miss non-linear dynamics during extreme events like the COVID-19 shock. Additionally, FDI is treated as an exogenous process despite the literature on FDI determinants suggesting it responds endogenously to domestic institutional quality, trade policy, and productivity trends.

Key Concepts

SOE-RBC (small open economy real-business-cycle) model : a dynamic stochastic general equilibrium model in which a small economy takes world prices and interest rates as given; households maximize lifetime utility by choosing consumption, investment, and foreign borrowing; the current account emerges as the net change in the foreign debt position; log-linearized around the steady state and solved via perturbation methods.

Bayesian Markov Chain Monte Carlo (MCMC) estimation : a method for estimating the posterior distribution of structural parameters by combining prior beliefs with the likelihood of observing the data; the paper uses prior distributions from Chang and Fernández (2013) for most parameters and Cambodian data for the AR(1) coefficients of the new shocks; parameters with posterior means significantly different from priors (at the 10 percent level) are highlighted in Table 2.

variance decomposition : the share of variance in each endogenous variable attributable to each exogenous shock at the business-cycle horizon; computed from the estimated model’s spectral density; in this paper, used to quantify the relative importance of FDI and unilateral transfers relative to productivity and interest rate shocks for the current account.

unilateral transfers (NT) : net flows of income from abroad that do not require repayment, including workers’ remittances from Cambodian migrants abroad and official government grants from donor countries; modeled in the paper as an exogenous shock to the NT-to-output ratio with AR(1) persistence ρ_nt = 0.15 (low persistence).

FDI productivity spillover (γ) : the elasticity of permanent productivity growth with respect to the FDI-to-output ratio; estimated to be 0.08 (posterior mean), reflecting the hypothesis that FDI brings technology transfer and know-how that raises Cambodia’s total factor productivity trend; the FDI shock thus affects the current account both directly (through the capital account) and indirectly (through the productivity channel).

working capital requirement (θ) : the fraction of the wage bill that firms must borrow in advance at the current period’s interest rate; estimated at 0.50 (posterior mean), implying that world interest rate shocks are amplified through a financial-accelerator mechanism in which higher borrowing costs reduce labour demand and output, beyond the standard intertemporal substitution channel.

country-specific spread (S_t) : the risk premium Cambodia pays above the world risk-free rate, modeled as a decreasing function of expected future productivity; captures the tendency of developing countries to face higher borrowing costs when growth prospects weaken, creating a pro-cyclical external financing condition.