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Assessing the External Position

The views expressed herein are those of the author and should not be attributed to the IMF, its Executive Board, or its management.

Bank Indonesia International Workshop and SeminarCentral Bank Policy Mix: Issues, Challenges, and Policies

Jakarta, 9-13 April 2018Rajan Govil

Objectives of the lecture

• Review of the Balance of Payment (BOP) Accounts

• Examine the current account from a saving-investment perspective and a trade perspective

• Nominal and Real Exchange Rates• IMF Approach to Exchange rate Assessment

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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

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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

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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?

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?

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Conceptual Framework

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External Sector Assessment

ER & Competitivenes

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

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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?

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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

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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

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Capital and Financial AccountThe 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

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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 investmentEquity

Debt

Other investment

Net international reserves (-ΔRES)Errors and Omissions

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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”

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Analyzing the Current Accountbasic frameworks

Savings-Investment (S-I) perspective

Trade perspective

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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

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Savings-Investment PerspectiveCA link to national accounts

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GDP = C + I + X – MCurrent AccountGross National

DisposableIncome

Domestic Demand

GNDI = C + I + X – M + Yf +TRf

GNDI – C – I = CAB

(SG – IG) + (SP – IP) = CAB(SG – IG) + (SP – IP) = CAB

GNDI –DD = CABGNDI –DD = CABFiscal Policy

S – I = CABS – I = CABor

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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.

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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 a excessively large CA surplus

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Savings-Investment PerspectiveCA drivers

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Trade Perspective

A more classic view considers the main drivers of the current account as:

- imports and exports- exchange rates and competitiveness

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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

Exchange rates: Concepts and measurement

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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

Bilateral Nominal Exchange Rate

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

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1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

(1999 = 100)

Thailand Indonesia Philippines Japan ChinaSources: CEIC

Appreciation

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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• wi weight of currency of country i• t time index• NEER up implies domestic currency appreciates

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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

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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

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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• wi weight of currency of country i• t time index

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Indicators of CompetitivenessREER AND NEER developments often diverge [2010 = 100]

Sources: CEIC.

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2010 2011 2012 2013 2014 2015 2016 2017 2018

China

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90

100

110

2010 2011 2012 2013 2014 2015 2016 2017 2018

India

6065707580859095

100105

2010 2011 2012 2013 2014 2015 2016 2017 2018

Indonesia

85

90

95

100

105

110

115

2010 2011 2012 2013 2014 2015 2016 2017 2018

Thailand

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ASEAN4: diverging REER developments

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105

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2010 2010 2011 2012 2012 2013 2014 2014 2015 2016 2016 2017 2018

(2010 = 100)

Indonesia Thailand Malaysia PhilippinesSources: CEIC.

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Indonesia: What is this Picture Telling Us?

Sources: CEIC.

Appreciation

0.00006

0.00007

0.00008

0.00009

0.0001

0.00011

0.00012

0.00013

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85

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100

105

2010 2011 2012 2013 2014 2015 2016 2017 2018

Exchange Rates: Indonesia(2010 = 100)

NEER REER USD/IDR (Right Axis)

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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

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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?

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Balassa-Samuelson effect

Suppose that labor productivity in the tradable sector rises:1. Prices of traded goods are determined internationally:

higher productivity will means higher profits2. If the labor market is flexible, demand for labor increases

and wages increases3. Wages increase in the non-tradable sector because of wage

equalization across sectors4. 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!)

Real exchange rate appreciation following productivity increase

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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

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CPI-based REER

• Consumer Price Index (CPI) covers the basket of consumption goods– Advantageso CPI series available for most countries;o Usually available at monthly frequency.

– Disadvantageso Basket updated only every 5 years or so;o Many items in basket are non-tradables;o Big differences in “baskets” across countries.

– Alternativeso PPI, WPI, GDP deflator, Unit Labor Cost (ULC)

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Equilibrium exchange rates

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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 pego Make medium-term forecastso Assess the sustainability of existing exchange rate policieso Consider global implications of exchange rates

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What do we mean by equilibrium?

• When thinking about the equilibrium REER, should we focus on the shortrun (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 Internal balance: no output gap and no inflationary pressures

o 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

The IMF’s External Balance Assessment (EBA)

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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

• 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.

Current Account Approach

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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

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• 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

Definition of Fitted Current Account

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• Adjust the Fitted CA for policy gaps

• This is a relevant concept for thinking about medium-run 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

Definition of Current Account Norm

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First stage is descriptive to understand determinant factors

Second stage normative evaluation based on information from the econometric results to estimate “policy gaps”.

Judgment is involved.

uPXXGDPCA

fc ++++= δγβα

PXXGDP

ACfc δγβα ˆˆˆˆ

ˆ+++=

Actual values

Fitted value

*ˆˆˆˆˆ

PXXnormGDP

ACfc δγβα +++=

Desirable policy levels

Norm

“What would the fitted CA be if policies were at desirable levels?”

Pol

icy

Gap

Estimations of Current Account Norm

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• 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:

Current Account ApproachStep by Step

ps Policy Ga Fitted CACA norm −=

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• 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

Current Account ApproachStep by Step

εε CAREER

REERCA Δ=Δ

ΔΔ=

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CA Gap, CA Norm, and the Policy Gap

= Actual - Norm

Real Effective Exchange Rate Gap

CA Gap/ Elasticity

Fitted – Policy gap =1.2.

3.

4.

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 (%GDP)

-5.0

(E) Current account gap = actual – norm (%GDP) = (D)-(C)

-2.0

(F) REER elasticity (ε) to current account -.2

(G) REER gap (percent) = (E)/(F) 10.0

CA balance in 2015

CA balance based on regression output

CA balance adjusted for policy gaps

(-)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

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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.

Policies to Achieve the Equilibrium

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IMF Assessment for Indonesia

Source: IMF Staff Report for Indonesia, February 2018

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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 interpretedwith 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

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Annex

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Normative Analysis for CA

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^

* *ˆ ˆ [ ( ) ' ] . ( ) 'C A C AC A gap P P Rgr resid P PY Y

γ γ= − − − = + −

Actual CA

EBA CA norm

Contribution of Policy gaps

γβα PXYAC ′+′+=

ˆ Let P*be the desirable values for thosepolicy variables. Then simply add and

subtract :

γγβα )'(''ˆ

** PPPXYAC −+++=

γ'*Pfrom the right hand side of equation

Contribution of Policy gaps

EBA CA norm

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Normative Analysis for CA

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• Total CA gap

• 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

• Analysis for the REER gap based on EBA-ERER is analogous

^

* *ˆ ˆ [ ( ) ' ] . ( ) 'C A C AC A gap P P Rgr resid P PY Y

γ γ= − − − = + −

Actual CA EBA CA normContribution of Policy

gaps

γ̂)'( *PP −

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*ˆˆˆˆˆ

PXXnormGDP

ACfc δγβα +++=

Computing the Policy Gap

•Policy Gaps include both domestic and world policy gaps

PXXGDP

ACfc δγβα ˆˆˆˆ

ˆ+++=

]ˆˆˆˆ[]ˆˆˆˆ[ˆˆ

*PXXPXXnormGDP

ACGDP

ACfcfc δγβαδγβα +++−+++=−

normCAfittedCAGapPolicy −=

( )*ˆ PPGapPolicy −= δ

Desirable levels of policy variables

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