Trade reform, policy uncertainty, and the current account

Rapid trade liberalization is often followed by a surge of imports and a deterioration in the current account. The macroeconomic counterpart of this is a decline in private savings. This paper discusses the impact of policy uncertainty on private savings. The author uses the Ordinal Certainty Equivalence approach to establish that trade policy uncertainty by itself will further reduce savings if: (a) there is a positive risk aversion; and (b) the intertemporal substitution elasticity exceeds 1. The result shows that, with positive risk aversion, policy uncertainty will in fact reinforce the negative savings impact of an anticipated policy reversal, especially when that negative impact is strong. This suggests that with high risk aversion and high intertemporal substitution, a rapid trade reform that is not fully credible may depress private savings significantly, with attendant negative impact on the current account.