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

L-6

Assessing the External Position

Presenter

Yoke Wang Tok

IMF − Singapore Regional Training Institute

OT 18.52 Macroeconomic Diagnostics February 26 – March 2, 2018

Objectives

Part I

• Provide a broad overview of external sector issues, focusing on diagnostic tools

• Examine the current account from a saving-investment 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

MDS2

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

MDS3

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

4MDS

Part I: External Sector Assessment

5

External Sector AssessmentKey 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

6MDS

Conceptual Framework

7

External Sector Assessment

ER & Competitiveness

Capital & Financial Accts

Current Account

External Balance Assessment

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

Reserves & Intervention

External Balance Sheet

Reserve Adequacy

Flows Stocks

External Sector AssessmentGuidance

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?

MDS8

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

MDS9

Balance of Payments

10MDS

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 (Yf) includes:- interest paid on foreign debt- interest received on foreign assets- profit remittances- reinvested earnings- labor income paid to nonresidents

- Net current transfers (TRf) includes:- official and private grants- worker remittances from/to abroad

MDS11

CAB=X – M + Yf +TRf

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

MDS12

CA +E&O = - (ΔFI + ΔRES)

Usually very small

Balance of Payments Accounts(usually in US$ or euros)

13

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

MDS

14

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 -21.3

Gross domestic product (in US$ billion) 914.6 890.6 859.0 941.0

A. Current Account (Billions of US$)

Indonesia: Current Account Balance

2013 2014 2015 2016

15

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

C. Financial Account* (Billions of US$)

Indonesia: Financial Account 2013 2014 2015 2016

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”

16MDS

Analyzing the Current Accountbasic frameworks

Savings-Investment (S-I) perspective

Trade perspective

17MDS

Analyzing the Current AccountBasic 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

18MDS

Savings-Investment PerspectiveCA link to national accounts

19

GDP = C + I + X – M

Current AccountGross NationalDisposableIncome

Domestic Demand

GNDI = C + I + X – M + Yf +TRf

GNDI – C – I = CAB

(SG – IG) + (SP – IP) = CAB

GNDI –DD = CAB

Fiscal Policy

S – I = CABor

MDS

Savings-Investment PerspectiveCA balance as inter-temporal choice

The current account balance seen from the perspective of the difference between savings and investmentmay 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.

20MDS

Savings-Investment PerspectiveCA 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

21MDS

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.

22MDS

Imports

+ +M = f (GDP, REER)

+ -M = f (GDP, Pm/PGDP)

M: Real ImportsGDP: Real GDPPm: Import deflatorPGDP: GDP deflatorREER: Real effective exchange rate (increase=appreciation)

Alternatives to GDP: absorption, GNI for aggregate imports; consumption, investment for disaggregated importsAlternatives 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.

23MDS

Exports

+ -X = f (PARGDP, REER)

+ +X = f (PARGDP, Px/PGDP)

X: Real exportsPARGDP: Trading-partner country GDPPx: 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.

24MDS

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.

25

EXPORTS Typical

Relative Price Elasticity: 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

IMPORTS Typical

Relative Price Elasticity: estimates

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

MDS

Capital and Financial AccountAdvanced 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

26MDS

Capital Flows to AMs and EMs

27MDS

SummaryIdentifying 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?

MDS 28

SummaryDifficulty 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

29MDS

SummaryHigher deficits can increase vulnerability

30MDS

SummaryIdentifying 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.

31MDS

Part II: Exchange Rates Assessment

32

Exchange Rates AssessmentOverview

• 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

MDS33

MDS34

Concepts of Exchange Rates & Competitiveness

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)

MDS35

1E

R

36

Bilateral Nominal Exchange Rate

Symbol Units Appreciation ofdomestic currency

Depreciation of domesticcurrency

E $/Dom(IMF) ↑ ↓

R Dom/$(Textbook) ↓ ↑

Domestic currency =DomForeign currency =$

37

Bilateral Nominal Exchange Rate Bilateral rates send conflicting messages about the nominal value of a country’s currency against the USD

60

80

100

120

140

160

180

China Japan Philippines Thailand Indonesia

Source: CEIC Data Co.

Appreciation

January 1999 = 100

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 the foreign country/economy• wi weight of currency of country i• t time index

MDS38

iw

ti

N

i

t ENEER )( ,

1

Real Exchange Rate

Neither E, nor R, nor the NEER indicate the relative (real) price ofgoods: 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:

MDS39

*

pRER E

p

RER = the real exchange rate

E = the nominal exchange rate

P= the domestic price level

P*= the foreign price level

The Real Exchange Rate

Consider

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

*

pRER E

p

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 selected countries or groups of countries

• i = 1,…N the foreign country/economy• wi weight of currency of country i• t time index

MDS41

iw

ti

N

i

t RERREER )( ,

1

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

43

Indicators of CompetitivenessREER AND NEER developments often diverge (1996 – 2011) [Jan 1996 = 100]

90

110

130

150

170

190

1996 1998 2000 2002 2005 2007 2009 2011 2014

NEER REER

China

60

70

80

90

100

110

120

130

1996 1998 2000 2002 2005 2007 2009 2011 2014

India

0

20

40

60

80

100

120

1996 1998 2000 2002 2005 2007 2009 2011 2014

Indonesia

Source: Haver Analytics

40

60

80

100

120

140

1996 1998 2000 2002 2005 2007 2009 2011 2014

Thailand

MDS44

ASEAN: diverging REER developments

80

85

90

95

100

105

110

115

120

125

Indonesia Thailand Malaysia Philippines

Real Effective Exchange Rates in ASEAN4(January 2011 = 100)

Source: IMF INS

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 performanceE.g. trade balance, export market shares, trade links

However, appreciation of REER over time does not necessarily indicate a loss of competitiveness (and vice-versa):

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

MDS46

47

Indonesia: What is this Picture Telling Us?

0,00006

0,00007

0,00008

0,00009

0,0001

0,00011

0,00012

0,00013

0,00014

50

70

90

110

130

150

170NEER REER USD/INR

Exchange Rates: Indonesia(Rebased, Jan 2010 = 100)

Sources: Haver; CEIC Data Co.

Depreciation of Local currency

MDS48

IMF methodology to estimate equilibrium REER

• Measuring and Assessing Equilibrium Exchange Rate

• Concepts behind External Balance Assessment (EBA)

• 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

Equilibrium and Internal/External Balance

• 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

Why Do We Care About Equilibrium REERs?

MDS51

IMF methodology to estimate equilibrium REER

• Measuring and Assessing Equilibrium Exchange Rate

• Concepts behind External Balance Assessment (EBA)

EBA: Overview

• EBA consists of :

a) CA regression approach

b)REER regression approach

c) ES approach

• Not intended to be a forecast.

52

EBA: Overview

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

CAit = (Cyclical/Temporary)it δ

+ α + (Fundamentals)it θ + P*it γ

+ (Pit - P*it) γ

+ (Residual)it

55

(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

(4) Residual, unexplained

(3)+(4) “Total EBA gap”

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)

Fundamentals

• 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.

Current Account Approach

Policy Gaps

• Policies of home country and trading partners can affect the external position

• Policy gaps: difference between actualpolicies and desirable policies

• Example: if the home country has a larger-than-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

EBA: Indonesia 2016

Source: IMF Article IV for Indonesia (2017)

• 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

MDS60

Key takeaways

The End

61