L-6 Assessing the External Position IMF Singapore Regional Training Institute OT 18.52 Macroeconomic Diagnostics February 26 March 2, 2018 Presenter Yoke Wang Tok This training material is the property of the International Monetary Fund (IMF) and is intended for use in IMF courses. Any reuse requires the permission of the IMF
Part I Objectives Provide a broad overview of external sector issues, focusing on diagnostic tools Examine the current account from a savinginvestment perspective and a trade perspective. Explore the financial accounts seeking answers as to how the current account is financed. Part II Define the nominal and real effective exchange rate Estimating equilibrium real effective change rates 2
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
Part I: External Sector Assessment 5
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? How do we measure nominal and effective exchange rates? How do we assess competitiveness? Is the real exchange rate in equilibrium? -Concepts behind External Balance Assessment (EBA) -Measuring and Assessing Equilibrium Exchange Rate 6
Conceptual Framework External Sector Assessment Flows Stocks Current Account Capital & Financial Accts ER & Competitiveness 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 7
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? 8
Resources Available IMF - External Balance Assessment (EBA and EBA-lite) - Debt Sustainability Analysis (External DSA) : L7 - IMF Reserve Metric: L7 Other - Competitiveness Indicators (price and non-price) - Constant Market Share Analysis 9
Balance of Payments 10
Current Account The current account balance is the difference between exports and imports of goods and services plus net income plus net current transfers CAB=X M + Y f +TR f - Net income (Y f ) includes: - interest paid on foreign debt - interest received on foreign assets - profit remittances - reinvested earnings - labor income paid to nonresidents - Net current transfers (TR f ) includes: - official and private grants - worker remittances from/to abroad 11
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 - debt flows - equity flows Depending on presentation, can include reserves and errors and omissions Flows over time determine changes in the NIIP Usually very small CA +E&O = - (ΔFI + ΔRES) 12
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 (- RES) Errors and Omissions 13
Indonesia: Current Account Balance Billions of US$ 2013 2014 2015 2016 A. Current Account (Billions of US$) Current account balance (CAB) -29.1-27.5-17.7-21.3 Balance on Goods and Services -6.2-3.0 5.0 1.8 of which: Balance on Goods 5.8 7.0 13.3 12.3 of which: Balance on Services -12.1-10.0-8.3-10.6 Exports of goods and services (XGS) 205.0 198.8 170.6 170.8 Goods 182.1 175.3 148.4 147.5 o/w Oil 17.9 13.8 7.8 6.7 o/w Non-oil 164.2 161.5 140.5 140.8 Services 22.9 23.5 22.2 23.4 Imports of goods and services (MGS) 211.3 201.9 165.6 169.1 Goods 176.3 168.3 135.1 135.1 o/w Oil 40.4 37.7 20.9 19.1 o/w Non-oil 135.9 130.6 114.1 116.1 Services 35.0 33.5 30.5 33.9 Primary Income, Net (Y) -27.1-29.7-28.2-28.9 Income credit 2.6 2.1 2.8 3.5 Income debit 29.7 31.8 31.0 32.4 of which: Interest 1.4 1.2 1.0 0.0 of which: Other debit 28.3 30.6 29.9 32.4 Secondary Income, Net (TRF) 4.2 5.2 5.5 5.8 Memorandum Item: Primary current account balance (CAP) -27.7-26.3-16.6 14-21.3 Gross domestic product (in US$ billion) 914.6 890.6 859.0 941.0
Indonesia: Financial Account 2013 2014 2015 2016 Billions of US$ C. Financial Account* (Billions of US$) Financial Account -22.3-45.1-16.9-30.8 Direct investment, net (FDI) -12.2-14.7-9.9-11.1 Direct investment: Assets 11.1 10.4 9.3 10.3 Direct investment: Liabilities 23.3 25.1 19.2 21.4 Portfolio investment, net -10.9-26.1-16.7-21.6 Portfolio: Assets 1.3-2.6 1.0 1.4 Portfolio: Liabilities : Equity Securities -1.9 3.3-1.5 3.8 Portfolio: Liabilities : Debt Securities 14.0 20.2 19.3 19.2 Other investment, net 0.8-4.3 9.8 1.8 Other investment: Assets 3.4 3.4 11.2 0.6 Other investment: Liabilities 2.6 7.7 1.4-1.3 Change in international reserves (- = decrease) -7.3 15.2-1.1 9.6 Memorandum Item: Errors and omissions -0.5-2.3-0.3 0.0 Total debt inflows, net 16.6 27.9 20.7 17.9 Other Asset Flows (OAF) -38.9-73.0-37.5-48.7 Stock of International Reserves (Bil US$) 99.4 111.9 105.9 115.5 *Capital Account is close to zero and not shown 15
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 16
Analyzing the Current Account basic frameworks Savings-Investment (S-I) perspective Trade perspective 17
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 18
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 19
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. 20
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 excessively large CA surpluses 21
Trade Perspective A more classic view considers the main drivers of the current account as: - imports and exports - exchange rates and competitiveness In today s lecture we will discuss the determinants of exports and imports, but will leave a detailed presentation on exchange rates and competitiveness for later. 22
Imports + + M = f (GDP, REER) + - M = f (GDP, Pm/PGDP) M: Real Imports GDP: Real GDP Pm: Import deflator PGDP: GDP deflator REER: Real effective exchange rate (increase=appreciation) Alternatives to GDP: absorption, GNI for aggregate imports; consumption, investment for disaggregated imports Alternatives to CPI-based REER: WPI, PPI, or ULC-based REER, etc. Potential additional variables: international import prices, ER volatility, capacity utilization, trade policy variables, etc. 23
Exports + - X = f (PARGDP, REER) + + X = f (PARGDP, Px/PGDP) X: Real exports PARGDP: Trading-partner country GDP Px: Export price deflator (local currency) PGDP: GDP deflator Empirical work usually includes measures of partner activity as it can be significant, even for a small country. Additional variables: international export prices, ER volatility, capacity utilization, trade policy variables, etc. 24
Import and Export Elasticities The response of export and import volumes to price and income changes depends critically on elapsed time. Empirical work generally shows quite small short-term elasticity coefficients, with estimates increasing over longer time periods. EXPORTS Typical Relative Price Elasticity: estimates IMPORTS Relative Price Elasticity: Typical estimates ST (1 year) Commodities 0.1 to 0.7 Manufactures 0.5 to 1.0 LT (2 years) 0.5 to 2.0 Scale Elasticity 1.0 to 2.0 ST (1 year) -0.1 to -0.7 Commodities lowest Luxury goods highest LT (>1 year) -0.5 to -1.5 Income Elasticity 1.0 to 2.0 25
Capital and Financial Account Advanced and Emerging Market Trends Capital flows have grown over the past couple of decades in both size and volatility Capital flows to EMs are larger as a percentage of GDP than AMs Historically, EM flows have been largely FDI, but in the run up to the 2008 global crisis, portfolio and other investment (mainly bank-related) increased Debt flows have proven more volatile and riskier to the financial system than FDI and portfolio equity flows 26
Capital Flows to AMs and EMs 27
Summary Identifying BOP trends Potential drivers of current account changes: - competitiveness - domestic savings or investment - domestic or external cyclical factors - commodity prices Composition of capital and financial account: - reliance on debt vs. non debt flows - reliance on volatile vs. stable capital flows - reliance on fx reserves to finance BoP balance Are these effects temporary or persistent? How are stocks evolving: NIIP, external debt, reserves? Are domestic policy distortions contributing to CA? 28
Summary Difficulty of interpreting a current account deficit As we have seen, the interpretation of whether a current account deficit is desirable or is too high or too low can only be made taking into account a wider view of the macroeconomic situation and the cause of the deficit Nonetheless, countries with high current account deficits are in general more at risk in times of global uncertainty and risk aversion as shown in the following chart 29
Summary Higher deficits can increase vulnerability 30
Summary Identifying external imbalances Ultimately, question of appropriate size of CA balance is at the core of external sector analysis. Need to take into account: - Cyclical (temp) and structural (permanent) factors - Stability and sustainability of sources of capital and financial account flows (debt vs. non-debt) The External Balance Assessment Methodology (EBA) and the External Debt Sustainability Analysis (DSA) are useful tools for this. 31
Part II: Exchange Rates Assessment 32
Exchange Rates Assessment Overview Exchange rates are central to external sector analysis. Overvalued ER - loss in price competitiveness: - Slower growth and lower employment - Unsustainable current account deficit. BOP crisis? Undervalued ER: Growth above potential Overheating and inflationary pressures Excessive BOP surplus over-accumulation of costly reserves Depressed real wages and consumption 33
Concepts of Exchange Rates & Competitiveness 34
Nominal Exchange Rate 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.: 1.27 Singapore Dollar = 1 US$) E: price of one unit of the domestic currency expressed in units of the foreign currency (e.g.: 0.78 US$ = 1 Singapore Dollar) E 1 R 35
Bilateral Nominal Exchange Rate Symbol Units Appreciation of domestic currency Depreciation of domestic currency E $/Dom (IMF) R Dom/$ (Textbook) Domestic currency =Dom Foreign currency =$ 36
Bilateral Nominal Exchange Rate Bilateral rates send conflicting messages about the nominal value of a country s currency against the USD 180 January 1999 = 100 China Japan Philippines Thailand Indonesia 160 140 120 100 80 Appreciation 60 Source: CEIC Data Co. 37
Nominal Effective Exchange Rate Neither E nor R indicate how the currency of a country moves relative to the currencies of all its trading partners 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 w i t t N ( Ei, t i 1 NEER ) the foreign country/economy weight of currency of country i time index w i 38
Real Exchange Rate Neither E, nor R, nor the NEER indicate the relative (real) price of goods: given prices in local currencies and the exchange rate, does 1 bag of Thailand-produced rice exchange for 1 bag of U.S.-produced rice of the same type? We need to use the real exchange rate (RER): nominal exchange rate times the ratio of the price levels: p RER E p * RER = the real exchange rate E = the nominal exchange rate P= the domestic price level P*= the foreign price level 39
The Real Exchange Rate Consider RER p E p * Example 1: suppose that E is fixed; if p increases more than p * (RER ) goods produced domestically ( Thailand ) become more expensive than the same goods produced externally (the U.S. ): there is less incentive to buy / produce these goods domestically 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 becomes more expensive than foreign goods
Real Effective Exchange Rate Even if we have bilateral RERs for all trading countries, how can we aggregate (i.e., average them) 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 N ( RERi, t i 1 selected countries or groups of countries REER ) t w i i = 1, N the foreign country/economy w i weight of currency of country i t time index 41
Why REER? Why is such an adjustment sensible for competitiveness assessment? A nominal depreciation matched by a positive inflation differential with trading partners leaves relative prices of domestic and foreign goods, expressed in a common currency, unchanged Similarly, a nominal depreciation matched by a rising cost differential gives exporters no additional edge over foreign competitors
Indicators of Competitiveness REER AND NEER developments often diverge (1996 2011) [Jan 1996 = 100] 190 170 China NEER REER 130 120 110 India 150 130 110 100 90 80 70 90 1996 1998 2000 2002 2005 2007 2009 2011 2014 60 1996 1998 2000 2002 2005 2007 2009 2011 2014 120 100 Indonesia 140 120 Thailand 80 100 60 40 80 20 60 0 1996 1998 2000 2002 2005 2007 2009 2011 2014 Source: Haver Analytics 40 1996 1998 2000 2002 2005 2007 2009 2011 2014 43
ASEAN: diverging REER developments 125 120 Real Effective Exchange Rates in ASEAN4 (January 2011 = 100) Indonesia Thailand Malaysia Philippines 115 110 105 100 95 90 85 80 Source: IMF INS 44
45 Choice of Price or Cost Index Aggregate Price Index based measures Consumer price index Wholesale or producer price index Export unit values GDP deflator Unit labor cost (ULC) based measures REERs based on CPIs and ULCs most common IMF publishes REERs based on CPIs for almost all countries and ULC-based REERs for most industrial countries
REER and Competitiveness Analyzing REER trends provides insights into price competitiveness -> export performance E.g. trade balance, export market shares, trade links However, appreciation of REER over time does not necessarily indicate a loss of competitiveness (and viceversa): 1) Export performance can also be influenced by non-price factors: quality, allocation of resources, etc. 2) REER appreciation can be consistent with the equilibrium REER appreciation 46
Indonesia: What is this Picture Telling Us? 170 150 130 Exchange Rates: Indonesia (Rebased, Jan 2010 = 100) NEER REER USD/INR 0,00014 0,00013 0,00012 0,00011 110 0,0001 90 70 50 Depreciation of Local currency 0,00009 0,00008 0,00007 0,00006 Sources: Haver; CEIC Data Co. 47
IMF methodology to estimate equilibrium REER Measuring and Assessing Equilibrium Exchange Rate Concepts behind External Balance Assessment (EBA) 48
Equilibrium and Internal/External Balance The REER is in equilibrium if it is consistent with internal and external balance: Internal balance: no output gap and no inflationary pressures External balance: current account is financed with a sustainable level of capital flows
Why Do We Care About Equilibrium REERs? Economic impact External balance is important for economic stability competitiveness Overvaluation of a currency may induce global investors to speculate on a devaluation REER expectations may affect borrowers decisions about borrowing in national/foreign currency International/domestic politics
IMF methodology to estimate equilibrium REER Measuring and Assessing Equilibrium Exchange Rate Concepts behind External Balance Assessment (EBA) 51
EBA: Overview EBA consists of : a) CA regression approach b)reer regression approach c) ES approach EBA: Overview Not intended to be a forecast. 52
EBA: Overview Two stages: 1. Positive (descriptive) analysis using regressions in order to understand the CA and REER. 2. Normative analysis, where Norm = the level consistent with fundamentals and desirable policy settings CA and REER gaps interpreted as consequences of distortions and policy gaps Broader set of factors policies, cyclical conditions and global capital market conditions http://www.imf.org/external/np/res/eba/index.htm
Broader Analysis Policies Reserves/FX intervention Safety nets (public health expenditure) Capital controls Monetary policies Financial policies Fundamentals Resource temporariness Growth forecast Cyclical conditions Global capital market conditions
Decomposition of the CA CA it = (Cyclical/Temporary) it δ + α + (Fundamentals) it θ + P * it γ + (P it - P * it) γ (1) Cyclical/temporary component: Subtract this from CA to compute cyclically adjusted CA. (2) Desirable norm : Determined by fundamentals and desirable settings of domestic and foreign policies (3) Policy gap or policy distortions : Deviations of actual policies from desirable settings, both domestic and foreign + (Residual) it (4) Residual, unexplained (3)+(4) Total EBA gap 55
Fundamentals 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)
Current Account Approach Derive the Current Account (CA) Gap Once the CA Gap is known, calculate the REER that is needed to close the gap 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.
Policy Gaps Policies of home country and trading partners can affect the external position Policy gaps: difference between actual policies and desirable policies Example: if the home country has a largerthan-desirable fiscal deficit, national savings is likely to be lower than desirable leading to an imbalance Issue: identifying desirable policies requires A LOT of judgment; easy to disagree
Source: IMF Article IV for Indonesia (2017) EBA: Indonesia 2016
Key takeaways Analyzing recent trends in the BOP can reveal weaknesses in different parts of the economy Examining CA developments from the trade perspective yields insights into a countries competitiveness Studying the CA from the savings-investment perspective forces one to consider the sources of financing Large CA deficits are not necessarily a concern but it does matter how it is financed and whether it is temporary or permanent Exchange rates are central to external sector analysis. Under- or overvaluation of exchange rates could be symptoms of internal or external imbalance The EBA methodology is used for assessing current accounts and exchange rates in a multilaterally consistent manner 60
The End 61