Revisiting Current Account Sustainability Measures for Jamaica: An Assessment. Lance Rochester 1

Transcription

1 April 2009 Revisiing Curren Accoun Susainabiliy Measures for Jamaica: An Assessmen Lance Rocheser 1 Inernaional Economics Deparmen Research and Economic Programming Division Bank of Jamaica Absrac This paper assesses he susainabiliy of he Jamaican curren accoun defici over he period and he medium-erm using 7 approaches. Of hese, 6 indicae ha he Jamaican curren accoun is no susainable while 1 indicaes weak susainabiliy. The resuls poin o a marked deerioraion in he curren accoun owards he laer par of he sample, in paricular, he period JEL Classificaion: F32, F35 Keywords: susainabiliy, curren accoun. 1 The views expressed in his paper do no necessarily reflec hose of he Bank of Jamaica.

2 Table of Conens Page Number 1.0 Inroducion Jamaica s Curren Accoun: Trends and Developmens Susainabiliy Measures Based Upon Ne Indebedness The Accouning Approach Resuls The Exernal Susainabiliy Approach Resuls The Porfolio Approach Resuls The Presen Value Consrain Approach Resuls Coinegraion Resuls Susainabiliy Measures Based Upon Smoohing Techniques The Ineremporal Benchmark Model Resuls The Macroeconomic Balance Approach Resuls Conclusion References Appendix 27 1

3 1.0 INTRODUCTION Several episodes of economic crises in emerging marke economies were riggered by large and unsusainable curren accoun deficis (CADs). The lack of access o inernaional credi markes and he resuling global economic downurn ha ensued during he subprime crisis in 2008 exposed he vulnerabiliies of counries ha were dependen on exernal financing, remiances and foreign invesmen o finance heir CADs. In he laer half of 2008, for example, Iceland, Hungary, Armenia and Belarus, among ohers, approached he IMF for funding o save off balance of paymens crises which were induced by ighened world credi markes. Jamaica s CAD has deerioraed seadily since 1962 o 20.0 per cen of GDP in In he conex of he global recession and credi crunch, Jamaica s need for exernal funding has generaed renewed ineres in he susainabiliy of he counry s curren accoun posiion. There are several ways o examine and define a susainable exernal balance, mos of which focus on a counry s ineremporal solvency. An economy is solven if he presen value of fuure rade balances is equivalen o he presen value of is foreign deb. This suggess ha counries wih large CADs can be solven if compensaing posiive rade balances are envisioned in he fuure (Mcgeigan, 2000). According o Milesi-Ferrei and Razin (1996), however, solvency assessmens can be inadequae in evaluaing he susainabiliy of curren accoun balances because hey overlook a counry s willingness o pay deb and assume ha foreigners are willing o lend o he counry on curren erms. The auhors argue ha susainabiliy assessmens should evaluae wheher a curren accoun balance would resul in a drasic policy shif or a balance of paymens crisis if he curren governmen s policy sance and/or if he presen privae secor behaviour remains unchanged. Osry (1997) exended his concep by also examining he risks associaed wih curren accoun posiions. Boh exernal and inernal shocks may affec he willingness or abiliy of invesors o lend, resuling in once susainable curren accoun posiions becoming unsusainable. This paper groups he approaches o measuring curren accoun susainabiliy ino wo caegories. The firs includes approaches which are concerned wih he counry s ne 2

4 indebedness. This caegory includes he accouning approach, porfolio approach, exernal susainabiliy approach, presen value consrain approach and he coinegraion approach. According o hese approaches, a curren accoun posiion is susainable once i does no lead o an increase in he counry s exernal liabiliies or worsening of he Inernaional Invesmen Posiion (IIP). The second caegory includes wo approaches, he ineremporal benchmark model and he macroeconomic balance, which uilize smoohing echniques o produce an opimal curren accoun. The ineremporal benchmark model applies his echnique o produce an opimal consumpion-smoohing curren accoun agains which he acual curren accoun is compared. The macroeconomic balance approach uses susainable medium-erm projecions along wih parameer esimaes o produce he opimal curren accoun. Some of hese approaches were examined for Jamaica by Hudson and Senne (2003). Our inenion is o revisi and exend hese measures. Of he seven measures of curren accoun susainabiliy, six of hem indicae ha he Jamaican curren accoun is unsusainable. The accouning, porfolio, macroeconomic balance and exernal susainabiliy approaches produce curren accoun norms which are above he Bank s curren projecions. The variance beween hese wo implies a likely worsening of he counry s inernaional invesmen posiion (IIP) or an increase in he counry s liabiliies. The presen value consrain approach indicaes insolvency since he presen discouned value of he counry s fuure income is insufficien o offse he sock of liabiliies. The ineremporal benchmark model indicaes unsusainabiliy since he acual and opimal curren accouns do no converge. However, he coinegraion approach indicaes weak susainabiliy given he correlaion beween he economy s inflows and ouflows. The paper is organized as follows: Secion 2 looks a Jamaica s curren accoun over he pas decade; secion 3 looks a he five susainabiliy measures which are based on ne indebedness; secion 4 looks a he final wo susainabiliy measures which uilize smoohing echniques and secion 5 provides he conclusion. 3

5 (% GDP) 2.0 JAMAICA S CURRENT ACCOUNT: TRENDS AND DEVELOPMENTS ( ) Jamaica s curren accoun balance has been consisenly negaive over he period (see figure 1). The raio of he curren accoun defici o GDP increased from 2.4 per cen in 1999 o 20.1 per cen in 2008, averaging 9.2 per cen. This is significanly above he average defici of 2.2 per cen of GDP for a seleced group of emerging marke economies over he same period (see able 1, appendix). In his regard, Jamaica s CAD can be classified as large and persisen. Figure 1 Jamaica: Curren Accoun Defici o GDP ( ) Years CAD (%GDP) The deerioraion in he curren accoun was largely influenced by a widening of he merchandise rade defici associaed wih a faser growh in impors relaive o expors. Impors grew a an annual average rae of 10.6 per cen (US$453.5 million) beween 1999 and 2008, compared o a 5.3 per cen (US$95.5 million) annual average growh in expors. The growh in impors beween 2006 and 2008 was primarily driven by increases in world commodiy prices, paricularly oil. Expor growh was consrained beween 1998 and 2001 due o declines in earnings from Bauxie, Banana and non-radiional expors, primarily garmens. The bauxie indusry was negaively affeced by an 4

6 explosion a Kaiser s Gramercy plan, which necessiaed cubacks in oupu a he local plan beween 1999 and The decline in he banana indusry, which began in 1999, followed a reducion in inernaional prices due o increased compeiion. The EU also indicaed is inenion o eliminae preferenial reamen for Bananas from as early as In addiion, here was a scaling down or wihdrawal of local operaors from he garmen secor. Beween 1997 and 2002, he rend deerioraion was underpinned by fiscal deficis, as well as he emergence of privae secor dissavings in 2000 (Hudson and Senne, 2003). Privae secor dissavings re-emerged beween 2005 and 2008, averaging 7.3 percenage poins of GDP (see able 2, appendix). This was largely driven by foreign direc invesmen inflows in he ourism secor. 3.0 SUSTAINABILITY MEASURES BASED ON NET INDEBTEDNESS 3.1 THE ACCOUNTING APPROACH In he accouning approach, a CAD is seen as susainable if i does no generae increases in a counry s IIP, relaive o is GDP. The change in he IIP is deermined by he ineres rae on a counry s ne liabiliies and he size of he rade balance. An economy s exernal budge consrain is represened as follows: B = (1 + i ) B -1 (X-M) (1) where B is he counry s IIP, i is he ineres rae/rae of reurn on he economy s IIP and X-M is ne earnings from he expor of goods and services (including ransfers). To derive he susainabiliy condiion, equaion (1) is divided hrough by GDP o represen he curren accoun susainabiliy measure (CASM) such ha: 5

7 i g ( x m) b. (2) g where g is he growh rae of GDP and b 1 is he counry s IIP o GDP raio 2. Thus, if he rade balance is zero, he change in he deb-o-gdp raio will depend on he difference beween he ineres rae on he economy s ne exernal liabiliies and he growh rae of GDP. If he domesic growh rae is less han he ineres rae on exernal liabiliies, he deb-o-gdp raio will increase. To mainain a paricular deb-o-gdp raio, he rade surplus mus be sufficien o offse he growh in he deb sock as a resul of he ineres rae/gdp growh rae differenial. The accouning approach can also be used o esablish a benchmark curren accoun balance (referred o as a norm) agains which projeced deficis can be compared. The curren accoun norm is produced by rearranging equaion (2). I represens he curren accoun balance which, if realized, would no lead o an increase in he counry s liabiliies and would herefore be considered susainable. Arisovnik (2006) makes several argumens in favour of he exclusion of FDI relaed influences from he susainable curren accoun balance. He highlighs ha FDI is generally considered more sable han oher financial flows as invesmens in fixed asses may be more difficul o liquidae given ha hese ypes of invesors usually make longerm commimens. FDI flows can have a considerable and immediae posiive impac on economies exernal financial posiions and, hus, on heir developmen prospecs since he financial effec of FDI complemens is poenial echnological, managemen and resrucuring impac. Furher, FDI may improve foreign percepions of he hos economy s crediworhiness and hus conribue o he creaion of a viruous circle involving a reducion in borrowing coss, access o a broader range of financial insrumens and more sable capial flows. In addiion, FDI will increase an economy s expors and improve he curren accoun balance in he longer erm. 2 For complee proof see Hudson and Senne (2003). 6

8 Reisen (1998) conends ha he likelihood of a balance of paymens crisis is reduced if he CAD is financed largely by FDI. 3 Roubini (1998) also expresses he view ha a CAD which is financed primarily by FDI is more susainable han a defici financed by shorerm ho money flows. 4 This paper includes assessmens of he susainable CAD wih and wihou FDI RESULTS The resuls for he accouning approach are presened in Table 3 in he appendix. CASM1 defines he rade balance o include only goods and services (equaion (2)) while CASM1A uses he curren accoun ballance. For he period 2004/05 o 2007/08, he firs curren accoun susainabiliy measure (CASM1, as defined by expression (2)) was negaive. I fell from in FY2004/05 o in FY2007/08. CASM1 remains negaive over he forecas horizon, albei wih an improving rend. CASM1A, which akes ransfers and income ino accoun, is significanly smaller han CASM1, reflecing he conribuion of remiances o he Jamaican economy. Nowihsanding, his measure of susainabiliy was increasingly negaive over he hisorical period and is projeced o remain negaive over he medium-erm. The sign and rend of hese measures of susainabiliy confirm ha he ne exernal deb of he counry is likely o coninue growing over he medium-erm and he CAD is herefore unsusainable. The curren accoun norm calculaions based on he accouning approach are presened in Table 3 in he appendix. Excluding FY 2009/10, he average norm defici over he forecas horizon is 4.7 per cen of GDP. The average curren accoun defici projeced for his period is 8.9 per cen of GDP. Beween FY 2008/09 and FY 2009/10, a sharp 3 Reisen highlighs he fac ha while Singapore ran an average defici of 12.1 per cen of GDP beween 1972 and 1982, almos half of he corresponding ne capial inflows consised of FDI. However, of grea significance is ha, over he period, GDP growh averaged more han 8.6 per cen of GDP and he domesic rae of saving doubled from 21.0 per cen o 40.0 per cen. 4 However, he warns ha foreign currency deb may end up exacerbaing an exchange rae crisis as a real depreciaion leads o an increase in he real burden of foreign deb. An exising large burden of inernaional deb will make i more difficul o finance a curren accoun imbalance. Moreover, a large deb burden can exhaus expor revenues and preclude impors of invesmen goods ha are needed for growh. In such a case he deb burden can creae a rap ha inhibis any growh policies. 7

9 depreciaion of he exchange rae is projeced o lead o a growh rae of nominal GDP of per cen. This produced a curren accoun norm of per cen for FY 2009/ THE EXTERNAL SUSTAINABILITY APPROACH The exernal susainabiliy approach (ES) is similar o he accouning approach in ha hey boh require ha he growh rae of GDP be sufficien o offse he growh of he counry s liabiliies. The main difference is ha he ES approach disaggregaes GDP growh ino real growh and inflaion. Similar o he accouning approach, he ES framework defines susainabiliy by he sabiliy of he IIP relaive o he size of he economy. To deermine he level of he curren accoun balance ha sabilizes he IIP a a given level, he accumulaion equaion for ne foreign asses (represened by B ) is employed. This equaion saes ha changes in ne foreign asses can arise from eiher ne financial flows from he purchases or sale of asses by residens and non-residens or o changes in he valuaion of ousanding foreign asses and liabiliies: B B -1 = CA + KG + E (3) CA is he curren accoun balance and KG are capial gains arising from valuaion changes. E, which is ofen assumed o be relaively small or zero, includes facors such as capial accoun ransfers and errors and omissions. Wih he assumpion ha E = 0, he curren accoun and ne financial flows should be equal (IMF, 1998). Dividing boh sides of equaion (3) by nominal GDP in period we have B Y B Y 1 1 * (4) 1 Y Y CA Y KG Y Equaion (4) can be expressed as: 8

10 b 1 b 1 * (1 g )(1 ) ca kg 5 (5) where g is he growh rae of real GDP and π is he exchange rae adjused inflaion rae. Equaion (5) herefore becomes: b - b -1 ca kg g (1 g ) - b (1 g )(1 ) 1 (6) If i is furher assumed ha capial gains are zero and he benchmark level of NFA is denoed by b S, he curren accoun ha sabilizes NFA a b S is: ca s g (1 g ) (1 g)(1 ) s b. (7) In order o esimae he NFA-sabilizing curren accoun balance, assumpions mus be made regarding he arges for poenial growh and he inflaion rae over he mediumerm. Choosing a benchmark for he NFA posiion is somewha arbirary. The IMF s Consulaive Group on Exchange Raes (CGER) uses a backward-looking benchmark (laes acual value). A more forward looking arge can be aken which is consisen wih exernal susainabiliy (IMF, 1998). This paper calculaes norms for an IIP which is fixed and for an IIP which improves over ime RESULTS For he calculaions, a arge inflaion rae of 2.0 per cen and real GDP growh of 3.0 per cen over he medium-erm are assumed. The resuls sugges ha he defici will remain unsusainable over he medium-erm, as he susainable curren accoun defici is 5 Y This is so, given ha: Y 1(1 g )(1 ) 9

11 esimaed o be 5.8 per cen of GDP (see Table 5, appendix). The second se of calculaions were carried ou based on an IIP which improves over ime and reaches per cen of GDP by FY 2012/13 from per cen of GDP in FY 2008/09. The resuls showed a curren accoun defici which improved over ime moving from 5.8 per cen of GDP in FY 2008/09 o 5.0 per cen of GDP in FY 2012/13 (see Table 6, appendix). 3.3 THE PORTFOLIO APPROACH An exension of he accouning approach is he porfolio approach which posis ha susainable CADs depend on he variables ha affec porfolio decisions as well as economic growh. According o his approach, he CAD is susainable if he deb-o-gdp as well as he reserve-o-gdp raios are consan. Long-run GDP growh exers wo indirec effecs on he seady-sae curren accoun ha are consisen wih a sable deb-o-gdp raio. Firs, as he economy expands, he desired level of inernaional reserves (fx) grows. The lieraure on he demand for inernaional reserves idenifies he level of impors and he variabiliy of he balance of paymens as he wo main deerminans (Resein, 1998). The desired level of reserves is given as a quarer of he impor raio (hree monhs of impors). By creaing uncerainy, BOP variabiliy increases he demand for reserves. In principle, uncerainy in he balance of paymens can be incorporaed ino he analysis by making predicions abou he coefficien of variaion from he ime rend in he foreign reserve raio. For he purpose of his analysis, however, uncerainy is ignored. Denoing real annual impor growh by and g as he GDP growh rae, he change in he desired reserve o GDP raio (fx) can be wrien as: 10

12 ( 1) fx fx fx g (1 ) (8) A second channel hrough which GDP growh indirecly impacs on deb dynamics is he Balassa-Samuelson effec. In he long-run, growh relaive o he res of he world leads o real exchange rae appreciaion largely driven by he evoluion of produciviy differenials beween he domesic economy and he res of he world. Real exchange rae appreciaion per uni of GDP growh, denoed by, reduces boh deb and foreign exchange reserves as a fracion of GDP as follows: ( g) ( g ) d CAD fx g (9) (1 ) Equaion 9 describes he seady-sae CAD ha can be susained over he long-run if he deb raio remains consan and desired reserves rise in proporion o impor growh. Following Arisovnik (2006), he susainable CAD can be esimaed as follows: ( g) CAD ( g ) d fx fdi g (10) (1 ) RESULTS The variable is aken as he average annual growh rae of poenial GDP. is he hisorical drif of he real effecive exchange rae per uni of GDP growh which is he percenage change in he real effecive exchange rae relaive o he growh rae of real GDP. The arge level of foreign exchange reserves (fx) is aken o be 3 monhs of impors o GDP. is he growh rae of real impors, d is he raio of olerable exernal deb-o-gdp and fdi is he raio of foreign direc invesmen o GDP. 11

13 The porfolio approach indicaes an average curren accoun norm over he forecas horizon of -0.6 per cen of GDP excluding FDI and -6.3 per cen of GDP including FDI. A high level of FDI associaed wih inflows from Angosura pushed he susainable curren accoun o per cen of GDP in FY 2007/08 (see Table 4, appendix) THE PRESENT VALUE CONSTRAINT APPROACH Cashin and McDermo (1998) highlighs ha, in evaluaing he susainabiliy of an economy s exernal imbalance, an imporan quesion is wheher he counry in quesion is solven. Solvency holds if he presen value (PV) of fuure rade surpluses is equal o curren exernal indebedness. Tha is, he counry is able o mee is ineremporal budge consrain under he curren policy sance. The PV approach looks a he counry s financing consrain in nominal erms and no as raios o GDP, as in he accouning approach. To derive he solvency condiion, recall he expression ha defines he evoluion of he counry s ne indebedness: B 1 B 1 r (X M) 1 r (11) All he variables are he same as in he accouning approach bu expressed in he uni of he domesic currency in real erms. Under he assumpion of consan real ineres raes on he economy s ne exernal liabiliies, he above expression can be ieraed forward N periods o ge B 1 ( X M ) N j N j 0 j1 N (1 r) (1 r) B (12) 6 These flows were relaed o he acquisiion of Lascelles de Mercado by he Trinidadian firm Angosura. 12

14 The no ponzi game (NPG) condiion, lim N B N N (1 r) 0, saes ha in he limi, he presen value of he expeced fuure sream of deb (he deb sock) converges o zero, which implies ha real deb (B) mus grow a a slower rae han he growh rae of he discouning erm (he real ineres rae). The NPG condiion implies ha lenders will no allow debor naions o repay heir deb by coninuously borrowing he money needed for deb servicing 7. Given he NPG condiion, a naion s deb a any poin in ime mus herefore be equal o he presen value of he expeced fuure rade surpluses: B 1 ( X M ) n j j 0 j 1 (1 r) (13) Milesi-Ferrei and Razin (1996) are srongly criical of susainabiliy analyses ha focus exclusively on solvency condiions. They noe ha such analyses are complex as imbalances in he curren accoun reflec he decisions of governmen, domesic agens and foreigners. The decisions of governmen may be predicable bu he savings and invesmen decisions of privae agens may no be. They also noe ha he analysis of solvency only considers he abiliy of he debor naion o pay, no heir willingness. As such, alhough he presen discouned value of rade surpluses may heoreically be sufficien o repay he counry s exernal deb, divering oupu from he domesic economy o exernal use in order o service he deb may no be poliically feasible RESULTS This approach was used o calculae wo measures based upon a variable rae of ineres and a fixed rae of ineres. Boh measures indicae unsusainabiliy given ha he ne earnings of he economy, over he long run, will likely be insufficien o offse he curren 7 In a Ponzi scheme he borrower, owing a deb (B), mus pay (1 +r) B when he deb comes due. If he borrower akes a new loan equal o (1 + r) B in order o pay he old lender, he borrower will have o pay (1 + r) 2 B he nex ime around. The deb will herefore grow a he geomeric rae of (1 + r) and, wih his scheme, he discouned deb would no converge o zero. 13

15 level of indebedness of he economy. The wo measures were 0.84 and 0.85, respecively, where any resul greaer han zero indicaes unsusainabiliy. 3.5 COINTEGRATION Hused (1992) noed ha i is useful o es impor and expor for coinegraion because if a long-run relaionship exiss beween he wo, he series would no drif oo far apar and he resuling curren accoun balance may hen be considered susainable. Ongan (2008) sough o highligh he conribuion of he ourism secor o he susainabiliy of he CAD in Turkey. Coinegraion ess were used o evaluae he longrun relaionship beween expors + ourism receips (X + TR) and impors + ourism expendiures (M + TE) for he period of Ongan (2008) assessed he weak susainabiliy hypohesis from he coinegraing vecor which is given as: (X + TR) = a + b(m + TE) + η. (14) where X is expors, TR is ourism revenue, M is impors, TE is ourism expendiure and η is he error erm. In his vecor, if b is equal o one and η is saionary, hen he CADs are srongly susainable. If b is beween 0 and 1(0 < b < 1) and η is saionary or b = 1 bu η is nonsaionary, hen he CADs are weakly susainable. If here is no coinegraion or b = 0, hen he CADs are unsusainable RESULTS For Jamaica, hree equaions were calculaed o assess he size of b using OLS and quarerly daa over he period 2000 o Table 7 considers he relaionship beween expors and impors. Table 8 considers he effec of expors and ourism inflows on 14

16 impors and ourism ouflows. Table 9 sums expors, ourism receips and he inflows of curren ransfers and assesses his agains impors, ourism ouflows and ouflows of curren ransfers. The residual of he long-run relaionship beween impors and expors was found o be saionary. In addiion, from he ess of coinegraion, he value of b falls beween 0 and 1 in all equaions and he residuals were all found o be saionary. Based on he condiions oulined in Ongan (2008), he Jamaican curren accoun is weakly susainable. The value of b increases from 0.29 o 0.46 o 0.77 as more variables are added o he equaion. 4.0 SUSTAINABILITY MEASURES BASED ON SMOOTHING TECHNIQUES 4.1 Ineremporal Benchmark Models Ineremporal benchmark models (IBMs) provide predicions abou he opimal or equilibrium pah of exernal imbalances agains which he acual curren accoun balance can be compared. A key assumpion of such models is ha consumers use savings o smooh consumpion over he periods when heir income is expeced o decline, and hus, economic agens save for a rainy day when hey expec a fuure decline in household income (Campbell, 1987). In his regard, he consumer maximizes an iner-emporal consumpion funcion E j0 i u( c ), 0 1, (15) j subjec o his budge consrain b rb ( y c i g ) where c is privae 1 consumpion, U(.) is a separable uiliy funcion and β is he subjecive discoun facor. b denoes he economy s sock of ne exernal liabiliies a he beginning of period, y denoes real gross naional income, i is real invesmen, g is real governmen consumpion and r is he ineres rae on he economy s ne exernal liabiliies. 15

17 The opimal level of consumpion c * hen becomes: 1 j c ( r / ) b (1 r) E ( (1 r) z j0 j (16) where is he consumpion iling parameer and z = y i g which is defined as he naional cash flow. The consumpion iling parameer indicaes he porion of he curren accoun ha would occur if he naional cash flow was a is permanen level (Ghosh and Osry, 1995). Based on he opimal pah of consumpion, he opimal curren accoun can be specified using he naional income ideniy such ha: ca y i g c (17) When = 1, he consumpion iling componen is zero. For > 1 he economy is saving or iling consumpion o he fuure. For < 1, he economy is dissaving or iling consumpion o he presen (Ghosh and Osry, 1995). Since consumpion is assumed o vary based on expeced changes in naional income i.e. he consumpion iling parameer is no equal o uniy, he acual curren accoun mus be derended o remove his componen. The opimal curren accoun can hen be compared o he smoohed/derended acual curren accoun. The consumer s budge consrain is used o produce he consumpion smoohing componen of he curren accoun which is given by: CA E j1 (1 r) j z j (18) To derive he opimal consumpion-smoohing curren accoun, (18) mus be esimaed. Ghosh and Osry (1995) esimaed an unresriced VAR of he form: 16

18 z ca sm z ca 1 sm 1 (19) The consumpion-smoohing curren accoun, ca sm, is he residuals of he coinegraing relaionship beween privae consumpion (c ) and he naional cash flow (z ) regression. The firs implicaion of he model is ha he curren accoun Granger-causes subsequen movemens in naional cash flow. This hypohesis can be esed using he sandard - saisic on 12 from expression (19). If his parameer is negaive and significan, hen he curren accoun Granger-causes naional cash flow and he prediced (opimal) series is equal o he acual series (Ghosh and Osry, 1995). As shown in Campbell (1987), an implicaion of he permanen income hypohesis is ha savings will increase when income declines and vice versa. In his conex, here is a curren accoun surplus when ne oupu is expeced o decline and a CAD when ne oupu is expeced o increase. The formal es of susainabiliy for he enire sample period is based on wheher or no he prediced (opimal) series is equal o he acual series. The opimal curren accoun balance is given by: ca = 1 x 10 ( I ) (1 r) (1 r) (20) The acual curren accoun balance is given by01 x. The wo will be equal if and only if 10 ( I ) (1 r) (1 ) r 1 =01 (21) 17

19 This implies ha and (1 r) (Ghosh and Osry, 1995). These parameers are produced by esimaing he VAR given in equaion (19). The hird implicaion of he model is he equaliy of he variance beween he acual and he opimal consumpion smoohing curren accoun. Hypohesis esing can hen be used o assess he severiy of he deviaion of acual curren accoun from he prediced opimal balance. An above-normal deviaion exiss when D 1. 5 and a large deviaion exiss when D 3 where D is he deviaion of he acual curren accoun from he prediced opimal balance is he mean deviaion over he sample and is he sandard deviaion (Hudson and Senne, 2003). A cavea relaes o he behavioural assumpions in he model which sae ha consumers can perfecly smooh heir consumpion over ime and ha his can only be done via he curren accoun. Campa and Gavilan (2006) noe mixed resuls in he lieraure regarding wheher consumers perfecly smooh heir consumpion over ime. In addiion, here is also concern abou wheher he curren accoun is he only insrumen which consumers can use o smooh consumpion. Flucuaions in invesmen and oher domesic spending may also be correlaed wih consumpion RESULTS Annual daa from 1961 o 2007 from he Naional Income and Produc Accouns as well as he Bank of Jamaica were used. The ineres rae on he economy s ne exernal liabiliies, r, was assumed o be he average of he ineres raes on he counry s commercial and mulilaeral loans from The variables c and z were boh I (1) based on he Augmened Dickey Fuller es for uni roos (see Table 10, appendix). In order o esimae he consumpion iling parameer, he long-run relaionship beween z and c was assessed using he Engle-Granger wo-sep approach. This differs from he 18

20 vecor error correcion model (VECM) employed by Hudson and Senne (2003). The approach was chosen since he aemp a using he VECM did no produce significan coefficiens for he coinegraing vecor. The consumpion iling parameer,, was produced from he OLS regression of z on c. This parameer was found o be 0.98 and since i is less han one, he counry is iling consumpion owards he presen i.e. i is consuming more han is permanen cash flow (see Table 11, appendix). The presence of a single coinegraing equaion beween z and c is a necessary condiion for he esimaion of he de-rended curren accoun. For he Engle-Granger approach, ordinary -saisics are unreliable wih I(1) regressors and herefore canno be used o evaluae he properies of he residual. The McKinnon criical values are appropriae in his insance and hese indicaed ha he residuals from he long-run relaionship were non-saionary. However, he shor-run error correcion model produced saionary residuals. The coefficien on he error correcion erm was also significan and negaive indicaing ha a coinegraing relaionship exiss. This suggess ha Jamaica did no breach he ineremporal solvency condiion over he period (see Table 12, appendix). The residual from he dynamic equaion was hen used o esimae he derended curren accoun. The long-run es of susainabiliy suggess ha he prediced and acual curren accouns do no converge as = 5.11 which is significanly differen from zero, while = The average deviaion over he sample was 3.6, which indicaes ha he acual curren accoun was, on average, above he opimal curren accoun over he four decades. The average deviaion from 2003 o 2007 was 5.8 which signals a sharp change in he counry s exernal posiion given ha he acual curren accoun was consisenly and significanly over he opimal for ha period. Table 13 presens he parameers of he fied VAR defining he opimal curren accoun. The 19

21 1966 = 100 model is valid because 12 curren accoun Granger-causes he naional cash flow. 8 is appropriaely signed and significan, indicaing ha he Figure Prediced (Derended) and Acual (Derended) Curren Accoun ( ) Acual (Derended) CA Year Prediced (Derended) CA Figure 2 plos he acual curren accoun and he prediced curren accoun over he period The graph also reveals ha he CAD more closely conformed o he opimal balance beween 1966 and 1986, compared wih he period 1987 o For he firs period, he average deviaion was 0.15, compared wih an average deviaion of 2.6 in he second period. The volailiy in he deviaions was also less in he earlier period, reflecing a sandard deviaion of 1.2, compared wih 3.5 for he laer period. The closer correspondence beween he acual and opimal curren accoun balances over he earlier period may be explained by relaively more resriced access by Jamaicans o inernaional financing. This resricion may have been he resul of capial conrols, IMF/World Bank agreemens which resriced he sae s access o cerain modes of exernal financing, or he general unwillingness of he inernaional capial markes o hold he deb of small counries such as Jamaica, all of which would have prevened 8 12 is -4.8 wih an associaed -saisic which is greaer han

22 consumpion expendiure from sraying oo far from he naional cash flow (Hudson and Senne, 2003). There was marked deviaion beween he wo series a he end of he sample period. The imbalance breached 1.5 sandard deviaions numerous imes over he sample period. Three sandard deviaions were breached in 1986, 1993, 1995, 2005 and 2007 (see Figure 3). Figure 3 Difference beween Prediced and Acual Curren Accoun Year Difference 1.5 SD 3 SD 4.2 THE MACROECONOMIC BALANCE APPROACH Curren accoun norms are also esimaed as he equilibrium relaionship beween curren accoun balances and a se of fundamenals ha are projeced o be susainable in he medium-erm. The curren accoun norm herefore reflecs a baseline forecas ha assumes ha he counry s oupu gap is closed and ha he full impac of previous exchange rae movemens has been played ou. 21

23 The IMF (2001) projecs he equilibrium curren accoun as a funcion of, iner-alia, he fiscal balance; demographics; ne foreign asses (NFA); relaive income squared; openness and financial deepening. A reducion in he fiscal defici should raise naional savings and hereby lead o a decline in he CAD. Demographics are measures of dependency and reflec he fac ha a higher share of inacive dependen populaion reduces naional saving and decreases he curren accoun balance. Growh in he youngage dependency raio serves o reduce he curren accoun balance. Youh dependency is capured by he proporion of he populaion under 14 years o he indusrial counry average. Economies wih relaively high NFA can afford o run rade deficis on an exended basis and sill remain solven, poenially leading o a negaive associaion beween NFA and he curren accoun. The relaionship beween he wo can be posiive, however, as economies wih high NFA may benefi from higher ne foreign invesmen inflows. Relaive per capia income is included since relaively poorer counries are expeced o impor capial, boh physical and financial, for domesic invesmen which reverses wih rising income. This variable is squared given he nonlinear relaionship wih he curren accoun. This is based on he hypohesis ha a relaively low sages of developmen, increases in income would end o improve a counry s access o foreign capial while a advanced sages of developmen he correlaion beween income and he curren accoun would become posiive (or less negaive). The laer par of he hypohesis reflecs he noion ha counries a he highes income levels and mos advanced sages of developmen end o be capial exporers, an implicaion of he negaive relaionship beween he abundance of exising capial and he marginal reurns on addiional invesmens (IMF 2001). The variable is measured relaive o he Unied Saes. Openness is measured as impors plus expors as a share of GDP and financial deepening is measured as he raio of broad money o GDP. The approach used o esablish he curren accoun norm involves calibraion based on he parameers published by he IMF for developing counries (see Table 14, appendix). 22

24 The curren accoun norm is esimaed using he medium-erm projecions for all he variables. An improvemen in hese variables in he medium-erm will lead o an improved curren accoun posiion. The main criicisms of his approach are ha he calculaions of he norm rely on projecions and are subjec o significan uncerainy. Medium-erm projecions for he curren accoun migh change over ime as a resul of changes in oher variables. Wren-Lewis and Driver (1998) disinguish four sources of such changes. Firs, here may be a rend in some componens of rade, such as a declining (world) expor share. Second, rend raes of GDP growh a home and abroad migh differ. This can imply a differen rae of change for expors and impors and hus a change in he rade balance. Third, esimaed income elasiciies may be differen for expors and impors. Then, even if domesic oupu grows a he same rend rae as foreign oupu, he rade balance (and herefore he underlying curren accoun) would change (Dvornak, 2005). Fourh, he approach does no impose a sock equilibrium. A non-zero curren accoun arge implies a coninuing change in he ne foreign asse posiion. For insance, a counry ha runs an underlying CAD lowers deb ineres receips since i is no a lender and furher increases he CAD (he reverse holds for a counry in surplus). This would require a rend depreciaion unless GDP grows a he same rae as he ne foreign asse posiion (Dvornak, 2005) RESULTS The resuls indicae curren accoun unsusainabiliy in FY 2008/09, FY 2009/10 and FY 2010/11. However, over he remainder of he sample period, he norm remains largely unchanged while he projecion is for an improved curren accoun posiion. The curren accoun is herefore projeced o be susainable for FY 2011/12 and FY 2012/13 (See Table 15, appendix). 23

25 5.0 CONCLUSION Of he seven approaches used o evaluae he susainabiliy of he Jamaican curren accoun, five indicae ha he curren accoun is unsusainable while he macroeconomic balance approach indicaes susainabiliy by FY 2011/12 and he coinegraion approach indicaes weak susainabiliy. In addiion, while he ITBM found ha Jamaica did no breach he solvency condiion over he sample period, he long-run es also showed unsusainabiliy of he defici. The accouning, porfolio, presen value consrain and exernal susainabiliy approaches all poin owards unsusainabiliy of he CAD. Hudson and Senne (2003) poin ou ha he assessmen of he Jamaican curren accoun shows he need for fairly dramaic and immediae adjusmens in macroeconomic and srucural policies. They argue ha while fiscal policy adjusmens are required, here is also need for iniiaives aimed a simulaing relaively large growh in he real secor, argeed principally a radable goods and services. Persisenly large CADs are usually an indicaion of srucural weaknesses wihin an economy. Once he value of a counry s receips are significanly less han he value of is earnings for a susained period, here is need o perform an evaluaion of he feaures of he economy ha relae o he producion of goods and services and by exension he goods and services demanded of foreigners. Furhermore, he dependence on remiances and indusries such as mining and ourism which involve a significan degree of profi repariaion and which are highly vulnerable o changes in he world economy reinforces he view ha Jamaica s economy is srucurally unsound. 24

26 6.0 REFERENCES Arisovnik, A. (2006) Curren Accoun Susainabiliy in Seleced Transiion Counries. William Davidson Insiue Working Paper No. 844 Campa, J. and Gavilán, A. (2006) Curren accouns in he euro area: An ineremporal approach. Banco de Espana Working Papers. Campbell, J.Y. (1987) Does saving anicipae declining labor income: an alernaive es of he permanen income hypohesis. Economerica, 55, Cashin, P. and McDermo, C. J.(1998). Are Ausralia s Curren Accoun Deficis Excessive? The Economic Record, 74, Dvornak, N., Kohler, M., and Menzies, G. D. (2005). Ausralia's Medium-Run Exchange Rae: A Macroeconomic Balance Approach. Economic Record, Vol. 81, pp Ghosh, A. and Osry, J. (1995). The Curren Accoun in Developing Counries: A Perspecive from he Consumpion-Smoohing Approach. The World bank Economic Review, Vol. 9, No. 2: Hudson, S. and Senne, R. (2003). Curren Accoun Susainabiliy in Jamaica. Bank of Jamaica Research Paper. Hused, S. (1992). The Emerging U.S. Curren Accoun Defici in he 1980s: A Coinegraion Analysis. The Review of Economic and Saisics, 74, Inernaional Moneary Fund. (2006). Mehodology for CGER Exchange Rae Assessmens. Inernaional Moneary Fund. (1998). Exchange Rae Assessmen. Exensions of he Macroeconomic Balance Approach. Jordan, A. and Sanford, S. (2005). A Derivaion of he Opimal Curren Accoun Balance for Barbados, Jamaica and Trinidad and Tobago. Cenral Bank of Barbados. McGeigan, D. (2000). Curren Accoun and Exernal Susainabiliy in he Balics, Russia, and Oher Counries of he Former Sovie Union. IMF Occasional Paper, No Mancellari, A. and Xhepa, S. (2003). Curren Accoun Susainabiliy. Bank of Albania and Faculy of Economics, Universiy of Tirana, Saranda. hp://pdc.ceu.hu/archive/ /01/sep_2003_sxhepa_amancellari.pdf 25

27 Milesi-Ferrei, M. and Razin, A. (1996). Curren Accoun Susainabiliy. Princeon Sudies in Inernaional Finance No. 81. Princeon Universiy Mishkin, F. (1994). Discussion of Experiences wih Curren Accoun Deficis Among Asian Economies: Lessons for Ausralia? Susan Collins. Inernaional Inegraion of he Ausralian Economy. Reserve Bank of Ausralia Conference. hp:// Obsfeld M. and Rogoff K. (1996). The Ineremporal Approach o he Curren Accoun. The Handbook of Inernaional Economics, Volume III Ongan, Serdar. (2008). The Susainabiliy of Curren Accoun Deficis and Tourism Receips in Turkey. Deparmen of Economics, Isanbul Universiy. The Inernaional Trade Journal, Volume 22, Issue 1 January 2008, pages Osry, Jonahan D. (1997). Curren Accoun Imbalances in ASEAN Counries Are hey a Problem? IMF Working Paper No. 97/51. Rahman, J. (2008). Curren Accoun Developmens in New Member Saes of he European Union: Equilibrium, Excess, and EU-Phoria. IMF Working Papers 08/92. Inernaional Moneary Fund. Reisen, H. (1998).Susainable and Excessive Curren Accoun Deficis. OECD Technical Papers, No Roubini, N. and Wachel, P. (1998). Curren Accoun Susainabiliy in Transiion Economies. NBER Working Paper no.6468 World Bank (2008). The Growh Repor: Sraegies for Susained Growh and Inclusive Developmen. Commission on Growh and Developmen. Wren-Lewis, S. and Driver, R. L. (1998). Real Exchange Raes for he Year 2000: Policy Analyses. Inernaional Economics 54. Insiue for Inernaional Economics. 26

28 7.0 APPENDIX Table 1 Seleced Emerging Marke Economies Curren Accoun (% GDP) Average ( ) Counry Argenina Chile Cosa Rica Croaia Dominican Rep Egyp Hungary Ireland Israel Jamaica Peru Poland Turkey Source: IMF Curren Accoun Decomposiion Table Curren Accoun/GDP Public Dissavings Cenral Governmen Oher Public Eniies Privae Financing FDI/GDP Oher Privae Dissavings Memo Curren Accoun GDP (USMN)

29 Table 3 Fiscal Year Indicaors of Curren Accoun Susainabiliy Acual 2004/ 05 FY2004/05 - FY2012/ / / / / 09 Projeced 2009/ 2010/ / / 13 CASM1* CASM1A** Curren Accoun Norm Curren Accoun/GDP Goods & Services (% of GDP) Goods, Services & Transfers (% of GDP) Ineres Rae on Ne Exernal Liabiliies (%) GDP Growh Rae (% Chge, Nominal US$) Susainabiliy Scenario GDP Growh Rae (% Change in US$) Table 4 Susainable Curren Accoun (%GDP) Accouning Approach Porfolio Approach Porfolio Approach No FDI Wih FDI 2005/ / / / / / / /

30 Table 5 ES Approach Resuls (%GDP) IIP Ca s CA (proj.) 2008/ / / / / Table 6 ES Approach Resuls (%GDP) IIP Ca s CA (proj.) 2008/ / / / / Table 7 Dependen Variable: EXPORTS Mehod: Leas Squares Dae: 04/16/09 Time: 15:08 Sample: 2000Q1 2008Q3 Included observaions: 35 Coefficien Sd. Error -Saisic Prob. C IMPORTS R-squared Mean dependen var Adjused R-squared S.D. dependen var S.E. of regression Akaike info crierion Sum squared resid Schwarz crierion Log likelihood Hannan-Quinn crier F-saisic Durbin-Wason sa Prob(F-saisic)

31 Table 8 Dependen Variable: XTOUR Mehod: Leas Squares Dae: 04/16/09 Time: 15:08 Sample: 2000Q1 2008Q3 Included observaions: 35 Coefficien Sd. Error -Saisic Prob. C MTOUR R-squared Mean dependen var Adjused R-squared S.D. dependen var S.E. of regression Akaike info crierion Sum squared resid Schwarz crierion Log likelihood Hannan-Quinn crier F-saisic Durbin-Wason sa Prob(F-saisic) Table 9 Dependen Variable: ALLINFL Mehod: Leas Squares Dae: 04/16/09 Time: 15:09 Sample: 2000Q1 2008Q3 Included observaions: 35 Coefficien Sd. Error -Saisic Prob. C ALLOUTFL R-squared Mean dependen var Adjused R-squared S.D. dependen var S.E. of regression Akaike info crierion Sum squared resid Schwarz crierion Log likelihood Hannan-Quinn crier F-saisic Durbin-Wason sa Prob(F-saisic)

32 Table 10 Null Hypohesis: LCT has a uni roo Exogenous: None Lag Lengh: 0 (Auomaic based on SIC, MAXLAG=9) -Saisic Prob.* Augmened Dickey-Fuller es saisic Tes criical values: 1% level % level % level *MacKinnon (1996) one-sided p-values. Augmened Dickey-Fuller Tes Equaion Dependen Variable: D(LCT) Mehod: Leas Squares Dae: 12/31/08 Time: 16:07 Sample (adjused): Included observaions: 46 afer adjusmens Coefficien Sd. Error -Saisic Prob. LCT(-1) R-squared Mean dependen var Adjused R-squared S.D. dependen var S.E. of regression Akaike info crierion Sum squared resid Schwarz crierion Log likelihood Hannan-Quinn crier Durbin-Wason sa Null Hypohesis: LZT has a uni roo Exogenous: None Lag Lengh: 0 (Auomaic based on SIC, MAXLAG=9) -Saisic Prob.* 31

33 Augmened Dickey-Fuller es saisic Tes criical values: 1% level % level % level *MacKinnon (1996) one-sided p-values. Augmened Dickey-Fuller Tes Equaion Dependen Variable: D(LZT) Mehod: Leas Squares Dae: 12/31/08 Time: 16:09 Sample (adjused): Included observaions: 46 afer adjusmens Coefficien Sd. Error -Saisic Prob. LZT(-1) R-squared Mean dependen var Adjused R-squared S.D. dependen var S.E. of regression Akaike info crierion Sum squared resid Schwarz crierion Log likelihood Hannan-Quinn crier Durbin-Wason sa Dependen Variable: LZT Mehod: Leas Squares Dae: 12/31/08 Time: 09:19 Sample: Included observaions: 47 Table 11 Coefficien Sd. Error -Saisic Prob. LCT C R-squared Mean dependen var Adjused R-squared S.D. dependen var S.E. of regression Akaike info crierion

34 Sum squared resid Schwarz crierion Log likelihood Hannan-Quinn crier F-saisic Durbin-Wason sa Prob(F-saisic) Table 12 Dependen Variable: DLZT Mehod: Leas Squares Dae: 12/30/08 Time: 13:05 Sample (adjused): Included observaions: 42 afer adjusmens Coefficien Sd. Error -Saisic Prob. DLCT(-1) DLCT(-2) DLCT(-3) DLCT(-4) RESID04(-1) DLZT(-1) DLZT(-2) DLZT(-3) LCT LZT R-squared Mean dependen var Adjused R-squared S.D. dependen var S.E. of regression Akaike info crierion Sum squared resid Schwarz crierion Log likelihood Hannan-Quinn crier Durbin-Wason sa

35 Table 13 Vecor Auoregression Esimaes Dae: 12/30/08 Time: 09:00 Sample (adjused): Included observaions: 41 afer adjusmens Sandard errors in ( ) & -saisics in [ ] DZT DETREND2 DZT(-1) ( ) ( ) [ ] [ ] DETREND2(-1) ( ) ( ) [ ] [ ] C ( ) ( ) [ ] [ ] R-squared Adj. R-squared Sum sq. resids S.E. equaion F-saisic Log likelihood Akaike AIC Schwarz SC Mean dependen S.D. dependen Deerminan resid covariance (dof adj.) Deerminan resid covariance Log likelihood Akaike informaion crierion Schwarz crierion