Objectives of the lecture

Assessing the External Position Bank Indonesia International Workshop and Seminar Central Bank Policy Mix: Issues, Challenges, and Policies Jakarta, 9-13 April 2018 Rajan Govil The views expressed herein are those of the author and should not be attributed to the IMF, its Executive Board, or its management. Objectives of the lecture Review of the Balance of Payment (BOP) Accounts Examine the current account from a savinginvestment perspective and a trade perspective Nominal and Real Exchange Rates IMF Approach to Exchange rate Assessment 2 1

Overview of Main Issues Over the past two decades, financial globalization has accelerated due to: - liberalization of capital controls - improved technologies and lower costs Financial globalization was expected to bring about large benefits - better global allocation of capital - improved international risk-sharing possibilities The surge in financial flows, however, also brought with it a spate of costly currency and financial crises 3 Overview of Main Issues The frequency and costs of crises stimulated interest in methods to diagnose external vulnerabilities and assess whether a country s external position can be regarded as sustainable In practice, whether an external position is sustainable requires assessments of - Balance of payment flows - The real exchange rate - External debt - International reserves and the net foreign asset (NFA) position, and - The expected evolution of these variables over the medium term under a set of policy parameters 4 2

External Sector Assessment key analytical questions What is driving recent trends in the Balance of Payments? - Current account - Capital and financial account Is the current account deficit or surplus excessive? Is the real exchange rate in equilibrium? Is the external position sustainable over the medium term? - External financing sources - External debt dynamics - Net International Investment Position (NIIP) Do reserves provide a sufficient buffer against shocks? What are the relevant policy tools? 5 Conceptual Framework External Sector Assessment Flows Stocks Current Account Capital & Financial Accts ER & Competitivenes Reserves & Intervention External Balance Sheet External Balance Assessment Reserve Adequacy All Relevant Indicators: Examples (use judgment) Export Shares, Remittances, CA/Capital Controls, Unit Labor Costs, Terms of Trade, Business Environment, Mismatches Currency/Maturity, External Financing Requirement 6 3

External Sector Assessment guidance Undertake a comprehensive assessment of the external position using a broad set of indicators Analyze the role of domestic factors in generating external imbalances Consider country-specific circumstances: e.g. income level, oil exporter or financial center. What is your bottom line?: - Is the external position consistent with macro fundamentals? - Are there any risks in the short term? - Is the position sustainable over the long term? 7 Resources Available IMF - External Balance Assessment (EBA and EBA-lite) - Debt Sustainability Analysis (External DSA) - IMF Reserve Metric Other - Competitiveness Indicators (price and non-price) - Constant Market Share Analysis 8 4

Balance of Payments Current Account The current account balance is the difference between exports and imports of goods and services plus net income plus net current transfers - Net income includes: - interest paid on foreign debt - interest received on foreign assets - profit remittances - reinvested earnings - labor income paid to nonresidents - Net current transfers includes: - official and private grants - worker remittances from/to abroad 10 5

Capital and Financial Account The capital and financial account records transactions between residents and nonresidents that involve financial assets and liabilities, as well as capital transfers and acquisition and disposal of non produced, nonfinancial assets. They include: - Key elements of Capital Account: - grants to finance acquisition of a fixed asset - debt forgiveness - international transactions in land & other natural resource rights - Key elements of Financial Account - foreign direct investment - portfolio debt flows - portfolio equity flows - other investments Depending on presentation, can include reserves and errors and omissions Flows over time determine changes in the NIIP 11 Balance of Payments Accounts (usually in US$ or euros) Current Account (CA) Trade Exports Imports Services Income Interest Profits Wages Transfers (current) Capital and Financial Account Capital Account Financial Account Direct investment (FDI) Portfolio investment Equity Debt Other investment Net international reserves (-ΔRES) Errors and Omissions 12 6

CA balance and financing the BOP The current account balance can be thought of as the mirror image of changes in the capital and financial account of the BOP and changes in international reserves CA = - (ΔFI + ΔRES) This is an identity and does not imply causality BOP data can be weak and deviations from the above identity are recorded as errors and omissions 13 Analyzing the Current Account basic frameworks Savings-Investment (S-I) perspective Trade perspective 14 7

Analyzing the Current Account basic frameworks Different frameworks for analyzing the current account could result in different perspectives for: - Explaining the drivers of recent developments - Policy recommendations to address vulnerabilities It is common to think of current account developments as being largely driven by exports and imports. From this perspective, exchange rates and competitiveness play a major role. Before discussing this important topic, let s consider the current account from a Savings-Investment (S-I) perspective 15 Gross National Disposable Income Savings-Investment Perspective CA link to national accounts GDP = C + I + X M Domestic Demand Current Account GNDI = C + I + X M + Y f +TR f GNDI DD = CAB GNDI C I = CAB or S I = CAB Fiscal Policy (S G I G ) + (S P I P ) = CAB 16 8

Savings-Investment Perspective CA balance as inter-temporal choice The current account balance seen from the perspective of the difference between savings and investment may be viewed as an additional source of financing or accumulation of assets An open capital account thus affords an opportunity for a country to: - increase current C or I by reducing the country s net foreign asset position, and subsequently face repayment - increase future C or I by increasing the country s net foreign asset position, which means reducing current C and I. 17 Savings-Investment Perspective CA drivers Is current account deficit being driven by: - Low savings? - High investment? - Is the source of imbalance private or public? - What are policy implications? Similar questions for a excessively large CA surplus 18 9

Savings-Investment Perspective CA drivers 19 Trade Perspective A more classic view considers the main drivers of the current account as: - imports and exports - exchange rates and competitiveness 20 10

Exchange rate assessment: overview Exchange rates are central to external sector and multilateral policy analysis Overvalued exchange rate can imply weak price competitiveness, unsustainable current account deficit Undervalued exchange rate can require costly reserves accumulation, lead to overheating Misaligned currencies generate spillovers across countries 21 Exchange rates: Concepts and measurement 22 11

Nominal exchange rates The bilateral nominal exchange rate is the price of one unit of a currency in units of another currency: R: price of one unit of the foreign currency expressed in units of the domestic currency (e.g.,: 1.31 Sing. Dollar = 1 US$) E: price of one unit of the domestic currency expressed in units of the foreign currency (e.g.,: 0.76 US$ = 1 Sing. Dollar) E has a nice interpretation: E = appreciation 23 Bilateral Nominal Exchange Rate Bilateral rates send conflicting messages about the nominal value of a country s currency against the USD (1999 = 100) 160 Appreciation 150 140 130 120 110 100 90 80 70 60 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Thailand Indonesia Philippines Japan China Sources: CEIC 24 12

Nominal effective exchange rate (NEER) Neither E nor R indicates how the currency of a country moves relative to the currencies of all its trading partners (competitors) The Nominal Effective Exchange Rate (NEER) is a geometric weighted average of bilateral nominal exchange rates of a currency against currencies of selected countries i= 1, N a foreign country/economy w i weight of currency of country i t time index NEER up implies domestic currency appreciates 25 Real exchange rate (RER) The real exchange rate attempts to measure the amount of foreign goods needed to exchange for one unit of domestic goods. Thus, it depends on both the bilateral exchange rate and relative price levels: where p is the domestic price level and p* is the foreign price level 26 13

Interpreting RER Movement Example 1: Suppose that E is fixed; if p increases more than p * (RER ) goods produced domestically become more expensive than the same goods produced externally Example 2: suppose that E decreases by 5%, p increases by 20% and p * by 10% (RER by about 5%); even if domestic currency becomes cheaper, domestic goods become more expensive than foreign goods 27 Real effective exchange rate (REER) Even if we have bilateral RERs for all trading countries, how can we aggregate (average) to obtain one single index? The real effective exchange rate (REER) of a currency is the weighted geometric average of bilateral real exchange rates of that currency against the currencies of selected countries or groups of countries i= 1, N a foreign country/economy w i weight of currency of country i t time index 28 14

Indicators of Competitiveness REER AND NEER developments often diverge [2010 = 100] 140 China 110 India 130 100 120 110 100 90 80 90 70 80 2010 2011 2012 2013 2014 2015 2016 2017 2018 105 100 95 90 85 80 75 70 65 60 2010 2011 2012 2013 2014 2015 2016 2017 2018 Sources: CEIC. Indonesia 60 2010 2011 2012 2013 2014 2015 2016 2017 2018 Thailand 115 110 105 100 95 90 85 2010 2011 2012 2013 2014 2015 2016 2017 2018 29 ASEAN4: diverging REER developments (2010 = 100) 125 120 115 110 105 100 95 90 85 80 2010 2010 2011 2012 2012 2013 2014 2014 2015 2016 2016 2017 2018 Indonesia Thailand Malaysia Philippines Sources: CEIC. 30 15

Indonesia: What is this Picture Telling Us? Exchange Rates: Indonesia (2010 = 100) 105 Appreciation 0.00013 100 0.00012 95 0.00011 90 0.0001 85 0.00009 80 0.00008 75 0.00007 70 2010 2011 2012 2013 2014 2015 2016 2017 2018 Sources: CEIC. NEER REER USD/IDR (Right Axis) 0.00006 31 REER: choice of weights Depending on the purpose of the analysis, one can use: Import weights: it emphasizes competition in domestic markets An average of direct and third market exports: it emphasizes competition in foreign markets Total trade weights linear combination of import, direct exports, and third market export competition See http://www.bis.org/publ/qtrpdf/r_qt0603e.pdf for an explanation of weighting systems 32 16

REER: choice of currencies How many currencies to include in index? o Require either direct import or direct export measures to exceed threshold (e.g., 1.0%) o Keep adding currencies until total import or total export coverage exceeds threshold (e.g., 95%) How often to update currency weights? o Every year? Once every 5 or 10 years? 33 Balassa-Samuelson effect Real exchange rate appreciation following productivity increase Suppose that labor productivity in the tradable sector rises: 1. Prices of traded goods are determined internationally: higher productivity will means higher profits 2. If the labor market is flexible, demand for labor increases and wages increases 3. Wages increase in the non-tradable sector because of wage equalization across sectors 4. Because there is no international competition, prices of non-tradable increase, and the overall price level also increases 5. ΔRER > 0 because of an increase in productivity of the tradable sector (because of a gain in competitiveness!) 34 17

So, when is REER appreciation bad? Suppose production costs of tradables increase due to: Rent extraction from the non-tradable sector Other sources of inefficiencies Wages increase without productivity gains (e.g., higher minimum wages) or administered prices In the non-tradable sector prices to recover higher costs Price-based REER However, because in the tradable sectors prices are fixed, profits are squeezed, and the tradable sector becomes less competitive 35 CPI-based REER Consumer Price Index (CPI) covers the basket of consumption goods Advantages o CPI series available for most countries; o Usually available at monthly frequency. Disadvantages o Basket updated only every 5 years or so; o Many items in basket are non-tradables; o Big differences in baskets across countries. Alternatives o PPI, WPI, GDP deflator, Unit Labor Cost (ULC) 36 18

Equilibrium exchange rates 37 Why care about equilibrium REER? A REER in disequilibrium may suggest macroeconomic policies that are suboptimal and/or not mutually consistent o Such policies may also have implications for the rest of the world Use of estimates of the equilibrium REER: o Establish a rate to which to peg o Make medium-term forecasts o Assess the sustainability of existing exchange rate policies o Consider global implications of exchange rates 38 19

What do we mean by equilibrium? When thinking about the equilibrium REER, should we focus on the short run (day-to-day) or the long run? FOREX markets are liquid and efficient, so nominal exchange rates should be in equilibrium Most approaches for assessing equilibrium exchange rates focus on medium-term equilibrium or norm. The REER is in equilibrium if it is consistent with internal and external balance: o o Internal balance: no output gap and no inflationary pressures External balance: current account is financed with a sustainable level of capital flows There is a need to consider the exchange rate together with other relevant policies 39 The IMF s External Balance Assessment (EBA) 40 20

What is EBA? A tool for analyzing current accounts and real exchange rates in a consistent multilateral framework Current account gaps must add to zero Separate panel regressions for RER and CAB. CAB can be converted to RER via estimated/assumed elasticity Includes fundamentals, financial and cyclical factors, and policies as explanatory variables Equilibrium means consistent with fundamentals and desirable policy setting. Not a forecast Regressions form basis of assessment but judgment enters as well 41 Current Account Approach Focus on the REER that is consistent with a sustainable current account (CA). The CA balance does not need to be zero in the medium-term equilibrium. It will depend on the level of savings and the return on domestic investment relative to investments abroad. 42 21

Current Account Approach Think of possible determinants of the long-run S I balance, such as: Fiscal policy (a surplus contributes to saving); Productivity (high productivity countries lend to low productivity countries and have higher CA balances); Population dynamics (an expanding population draws down national savings); Country risk (riskier countries attract less capital inflows to finance CA deficits) 43 Definition of Fitted Current Account Estimate historical relationship between CA and relevant explanatory variables, such as structural fiscal deficit, stage of development index (e.g., per capita GDP), and demographic variables (e.g., dependency ratios) Based on the historical relationship, use current levels of fiscal deficit, per capita GDP, dependency ratio, etc. to derive the equilibrium current account 44 22

Definition of Current Account Norm Adjust the Fitted CA for policy gaps This is a relevant concept for thinking about mediumrun equilibrium We calculate the CA Gap as the difference between the actual CA and the CA norm The CA gap is then used to make an assessment about the REER Gap 45 Estimations of Current Account Norm Policy Gap First stage is descriptive to understand determinant factors CA = α + β X c + γ X f + δ P + u GDP CA ˆ Fitted value = ˆ α + ˆ β X ˆ c + γ X ˆ f + δ P GDP Actual values Second stage normative evaluation based on information from the econometric results to estimate policy gaps. Judgment is involved. Norm CA ˆ norm = ˆ α + ˆ β X ˆ X ˆ c + γ f + δ P GDP What would the fitted CA be if policies were at desirable levels? 46 Desirable policy levels * 46 23

Current Account Approach Step by Step Step 1: Determine desirable policy settings Step 2: Estimate and calculate Fitted CA using regression coefficients Step 3: Calculate the Policy Gaps Step 4: Calculate the CA norm: CA norm = Fitted CA Policy Gaps 47 Current Account Approach Step by Step Step 5: Calculate the CA gap (i.e., the difference between the actual CA and the CA norm) Step 6: Determine relationship (i.e., elasticity, ε) between the REER and the CA Step 7: Calculate the REER gap ε = ΔCA ΔREER ΔREER = ΔCA ε 48 24

CA Gap, CA Norm, and the Policy Gap 4. CA Gap/ Elasticity 3. = Actual - Norm Real Effective Exchange Rate Gap 2. Fitted Policy gap = 1. Example: Fictitious Country 2017 (A) Fitted current account balance (%GDP) -4.0 (B) Policy gaps (%GDP) -1.0 (C) Current account norm (%GDP)=(A)-(B) -3.0 (D) Actual current account balance -5.0 (%GDP) (E) Current account gap = actual norm -2.0 (%GDP) = (D)-(C) (F) REER elasticity (ε) to current account -.2 (G) REER gap (percent) = (E)/(F) 10.0 CA balance based on regression output CA balance adjusted for policy gaps CA balance in 2015 (-) CA improvement needed (+) CA deterioration needed (-) REER appreciation needed (+) REER depreciation needed Intuitively, when we adjust the fitted current account for policy gaps and compare it to the actual current account, we find that an improvement in the CA is needed (i.e., the deficit is too large). To reduce the CA deficit, we need a depreciation of the REER (since REER depreciation would increase exports, reduce imports) 50 25

Policies to Achieve the Equilibrium If the RER is not in equilibrium the adjustment can come through: Change in the nominal exchange rate E; Change in aggregate demand Structural reforms. If the adjustment is not made and the situation becomes worse, the adjustment may eventually come through a crisis and/or compression of real demand and output. 51 IMF Assessment for Indonesia Source: IMF Staff Report for Indonesia, February 2018 52 26

Key Takeaways Exchange rates are central to assess competitiveness and multilateral policy analysis REERs are a key input into the IMF s EBA analysis (a key element of IMF s Surveillance) but must be interpreted with care The IMF s EBA methodology seeks to evaluate a country s external position with a notion of medium-term equilibrium The EBA places emphasis on a broad set of macroeconomic and structural policies 53 Annex 54 27

Normative Analysis for CA CA ˆ = α + X β + P γ Y CA ˆ = α + X Y ^ CA * * [ ( )' ˆ]. ( )' CA CA gap = P P γ = Rgr resid + P P Y Y Actual CA ' β + P EBA CA norm * Let P*be the desirable values for those policy variables. Then simply add and subtract : * ' γ + ( P P EBA CA norm * P )' γ 'γ from the right hand side of equation Contribution of Policy gaps ˆ γ Contribution of Policy gaps 55 Normative Analysis for CA Total CA gap CA CA gap = Y Y P P γ = Rgr resid + P P Actual CA ^ CA * * [ ( )' ˆ]. ( )' EBA CA norm * ( P P )' γˆ policies contribution into deviation of CA from the norm i.e., policy adjustment (P P*) will contribute to CA CA norm Example: fiscal deficit reduction should improve CA REER misalignment computed using the CA gap ˆ γ Contribution of Policy gaps Analysis for the REER gap based on EBA-ERER is analogous 56 28

Computing the Policy Gap Policy Gaps include both domestic and world policy gaps CA ˆ GDP Policy Gap = CA fitted CA norm CA ˆ = ˆ α + ˆ β X c + ˆ γ X f + ˆ δ P GDP Desirable levels CA ˆ ˆ ˆ * of policy norm = ˆ α + β X ˆ c + γ X f + δ P variables GDP CA ˆ [ ˆ ˆ ˆ ˆ ] [ ˆ ˆ ˆ ˆ * norm = α + β X c + γ X f + δ P α + β X c + γ X f + δ P ] GDP ( P ) Policy Gap = ˆ δ P * 57 29