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Macro - I Introduction to Financial Programming 1 Outline of the session 1. 2. 3. 4. 5. - Financial programming - Overview Real – Production Sector External Sector Monetary Sector Government Sector 2 Overview of financial programming A financial programming framework combines what is happening (or likely to happen) in each sector of the economy (real/production, government, monetary and external) over one period of time (usually a year). I allows to check for overall consistency. It is mainly based on accounting identities (not much economic theory there) that hold for any economy. • e.g. Y = C + I + G + (X – M) ; CA = I – S It also incorporates economic relationships that are not identities and depend on the behavior of individuals: • e.g. Impact of an appreciation of the currency on imports and exports ; impact of an interest rate increase on investment and saving ; ….. 3 Overview of financial programming A comprehensive financial programming framework is forward looking: The emphasis is on the current and the few next years. It may have longer horizon (up to 20 – 30 years when interested in medium-long term sustainability). However, looking at the past is also important to understand economic behavior of individuals: e.g. Impact of an appreciation of the currency on imports and exports ; impact of an interest rate increase on investment and saving ; ….. 4 Overview of financial programming Distinction between the four economic sectors: Sector « Table » Real Sector National Account External Sector Balance of Payments Governement Sector Government Financial Operation Monetary Sector Monetary Survey What happens in one given sector has real and financial implications on the 3 others. Policies (fiscal, monetary, structural) and shocks (internal or external) in a given sector have implications 5 on the others. Circular Flow of the Economy Daraban, Bogdan. "Introducing the Circular Flow Diagram to Business Students." Journal of Education for Business 85.5 (2010): 274-279. 6 Overview of financial programming Main linkages between sectors (not exhaustive) REAL SECTOR GENERAL GOVERNMENT Fiscal Accounts (local currency, flows) National Accounts (local currency, flows) Revenues Grants Private consumption General government consumption (Wages+Goods and services) Expenditures Current Capital Private investment General government investment Overall balance Financing Domestic financing (net) Banking system Nonbanking sector External financing (net) Exports of goods and nonfactor services Imports of goods and nonfactor services EXTERNAL SECTOR Balance of Payments (US Dollars, flows) CURRENT ACCOUNT Exports of goods and nonfactor services Imports of goods and nonfactor services Factor services (net) Transfers (net) Official Private CAPITAL ACCOUNT Direct investment Medium/long-term capital (net) Private sector (o/w banks) Centr. Government Short-term capital (net) Private sector (o/w banks) Centr. Government Overall balance Reserves (Change in net foreign assets) MONETARY SECTOR Monetary Authorities (local currency, stocks) Net foreign assets Net domestic assets: Net credit to governemnt sector Credit to banks Other items (net) Reserve money Currency Banks reserves Deposit Money Banks (local currency, stocks) Net foreign assets Banks' reserves Net domestic assets: Net credit to government sector Credit to nongovernment sector Other items (net) Liabilities to monetary authorities Private sector deposits 7 Overview of financial programming How and for what is this framework used in practice? 1 - Create baseline / forecast for the next years, that is "consistent" in the sense that the economic activity can be “financed”: - In case of a budget deficit: is domestic and/or external financing (debt or grants) likely to be available? - In case of a current account deficit in the BoP, is external financing (debt or grants or FDI …) or domestic financing (FX reserves) likely to be available? - Are government revenue forecasts consistent with the projected economic growth? - Is private investment forecast consistent with funding by the banking sector ….. This is an important reality check …..as both the baseline and/or forecast should be realistic! 8 Overview of financial programming 2 – Evaluating the likely impact of various economic policies on the economy. The baseline must be prepared under the hypothesis that economic policy will remain the same for the next few years. Policy scenario can then be performed in order to evaluate the impact on the economy of various policies: - Fiscal policy (e.g. change in government expenditure) - Budget financing (e.g. domestic borrowing vs external borrowing) - Monetary policy (e.g. an increase in short term interest rate to tame inflation) - ……. 9 Overview of financial programming 3 - Detect short term vulnerabilities - The framework helps assessing whether the economy is approaching a dangerous zone (low FX reserves, risk of “dollarization”, heavy reliance on short term and volatile external capital flows, level of investment too low or too high, high budget deficit ….). - By performing scenario analyses: “What if ….” - Investors are losing confidence in the economy: FDI and portfolio flows are lower than expected, prompting a depreciation in the currency that could lead to inflation …. - There is an Ebola epidemic in the country requiring higher government expenditures and a partial shutdown of the economy thus reducing economic activity, including private 10 income and government revenues …. Overview of financial programming 4 - Detect long term vulnerabilities (imbalances and unsustainable paths) Typical examples: -Government debt sustainability -External debt sustainability 11 Overview of financial programming - 4 sectors: - (i) Real – Production Sector ; (ii) External Sector ; - (iii) Government Sector ; (iv) Banking Sector - Examples are taken from IMF article IV reports (or equivalent) for three countries - - Tunisia (Tables 1 to 6, pages 24 to 30) - - Fiji (Tables 1 to 5, page 26 to 30) - - Ghana (Tables 1 to 4, pages 24 to 30) - IMF tables follow the same structure across countries, whereas figures – graphs are country specific (so as to emphasize the important issues for the country). 12 Standard content of IMF Article IV report Overview of financial programming 13 Overview of financial programming Other Country specific documents: • - Debt Sustainability Analysis (DSA) • For public debt • For external debt • - Financial Sector Assessment Program (FSAP) • Other publications: WEO (2/year) Fiscal Monitor (2/year) GFSR (2/year) + Early Warning Exercise (not public) 14 Outline of the session • • • • • - Overview of financial programming Real – Production Sector External Sector Monetary Sector Government Sector 15 Real – Production sector - Y = C + I + G + (X – M) - This accounting identity holds in value (current nominal currency) and in “volume” (real terms) - Y: GDP (Value added in the economy during one year) C: Private Consumption of goods and services I: Private Investment (of goods and services) (not necessarily by residents) G: Government Consumption + Government Investment (of good and services) - X: Export of goods and services - M: Import of goods and services - (X – M): “net exports” - 16 Real – Production sector - In the Financing Programming Framework, emphasis is on: - - real economic growth - nominal GDP - Investment / GDP - Inflation (CPI, and GDP deflator) - Exports and Imports (nominal values and contribution to growth). 17 Real – Production sector -Useful tool: decomposing real growth -- Demand side: based on Y = C + I + G + (X-M). -What is the contribution of net exports, of private consumption … to economic growth? -- Supply side: based on industry activities -What is the contribution of the oil industry, of the construction sector … to economic growth? -- Production function approach: -What is the contribution of inputs (equipment, labor) and total factor productivity (TFP) to economic growth? 18 Sectorial Accounts and Macroeconomic Interdependences - Real Sector (4/4) - Usually, not much information on the real sector in IMF article IV reports (see World Bank). - Basic information is available at the top and the bottom of the “Selected Economic Indicators”. - (Does not mean that real sector is not looked at carefully) - Usually, growth forecast comes from industry-byindustry forecasts (supply side) with some impact of government expenditure, and FDI on economic activity (demand side). 19 Real – Production sector Ghana, real sector Source: IMF, 2014, Article IV report, Ghana 20 Real – Production sector Fiji, real sector 21 Source: IMF, 2014, Article IV report, Fiji Real – Production sector Tunisia, real sector 22 Source: IMF, 2014, Country report, Tunisia Overview of financial programming Main linkages between sectors (not exhaustive) REAL SECTOR GENERAL GOVERNMENT Fiscal Accounts (local currency, flows) National Accounts (local currency, flows) Revenues Grants Private consumption General government consumption (Wages+Goods and services) Expenditures Current Capital Private investment General government investment Overall balance Financing Domestic financing (net) Banking system Nonbanking sector External financing (net) Exports of goods and nonfactor services Imports of goods and nonfactor services EXTERNAL SECTOR Balance of Payments (US Dollars, flows) CURRENT ACCOUNT Exports of goods and nonfactor services Imports of goods and nonfactor services Factor services (net) Transfers (net) Official Private CAPITAL ACCOUNT Direct investment Medium/long-term capital (net) Private sector (o/w banks) Centr. Government Short-term capital (net) Private sector (o/w banks) Centr. Government Overall balance Reserves (Change in net foreign assets) MONETARY SECTOR Monetary Authorities (local currency, stocks) Net foreign assets Net domestic assets: Net credit to governemnt sector Credit to banks Other items (net) Reserve money Currency Banks reserves Deposit Money Banks (local currency, stocks) Net foreign assets Banks' reserves Net domestic assets: Net credit to government sector Credit to nongovernment sector Other items (net) Liabilities to monetary authorities Private sector deposits 23 Outline of the session • • • • • • - Overview of financial programming Real – Production Sector External Sector Monetary Sector Government Sector Building scenarios + short assignment 24 External Sector - Very important sector in the financial programming approach. - The initial mandate (in 1944) of the IMF was to monitor Balance of Payment (BoP) imbalances, lend money to and design adjustment program for, countries facing BoP crisis. At that time, exchange rates were fixed (the so-called “Bretton Woods System”) and international capital flows very limited. - BoP crisis at the time happened when a country became unable to pay for its imports because of (near-)exhaustion of its foreign exchange reserves (often due to years of BoP deficits). - The usual IMF recommendation was to “finance” (i.e. borrow) a temporary problem, but to “adjust” to a permanent problrm (through a mix a devaluation and structural reforms) so as to reach long-term sustainability. 25 External Sector • What is a BOP ? • A statistical statement that systematically summarizes, for a specific time period (usually a year), the economic transactions of an economy with the rest of the world The accounts are based on the residency of the agents ; Transactions are valued at market prices ; Unit of account : the national currency or a stable foreign currency. 26 External Sector Balance of Payments: Analytical Presentation • Current Account Balance (CAB) • Trade Balance good and services (X – M) • Investment income • Transfers Private (including remittances) Official (including EU grants) • Capital and Financial Account Balance (CFAB) • Direct investment (net) • Portfolio investment (net) • Medium and long term loans • Short-term capital • Errors and Omissions • Overall balance = CAB + CFAB + Errors and Omissions 27 Foreign Aid in the BoP • Official Grants are registered as “Official Transfers” in the Current Account • Loans are registered as “Official Long-term Borrowing” in the Financial Account 28 External Sector CAB is always matched by a change in net claims on the rest of the world. CAB + CFAB = Change in FX reserves (i) A current account surplus is reflected in • an increase in claims on the rest of the World • and/or an increase in FX reserves (ii) A current account deficit is reflected in • an increase in country’s net liabilities with the rest of the world • and/or a decline in FX reserves 29 External Sector Ghana, external sector 30 Source: IMF, 2014, Article IV report, Ghana External Sector Tunisia, external sector Source: IMF, 2014, Country report, Tunisa 31 Fiji, external sector 32 Source: IMF, 2014, Article IV report, Fiji External Sector Current Account and the Real Sector Investment, Saving and the Current Account Gross Domestic Product GDP = C + I + GC + GI + (X-M) Gross National Domestic Income GNDI = C + I + GC + GI + (X-M) + YF + TRF YF : Factor income (net) TRF : Official and private transfers (net) GNDI – (C +GC) – ( I+ GI) = (X-M) + YF + TRF S – I= CAB 33 External Sector External debt External debt accumulation: Dt = (1+Rt-1) Dt-1 + Bt At D : stock of debt R : interest rate on debt B : new loans A : amortization of debt Inter-temporal Constraint: If a country is net debtor, it will have to run a current account surplus in the future. A country is solvent when the present discounted value of future CA balances is not less than current external debt. An analysis of solvency requires • Forecasting future CA balances • Assumptions about future policies The current stance of policies is sustainable if they do not lead to 34 insolvency. External Sector External debt External debt sustainability o The external debt is sustainable if future debt service obligations can be met without rescheduling debt or seeking debt relief. o In their debt sustainability analysis, the IMF and the WB use various indicators / threshold to assess external debt sustainability Indicator Threshold Present value of debt / GDP 50% Present value of debt / Exports 200% Present value of debt / revenue 300% Debt service / exports 25% Debt service / revenue 22% 35 External Sector Foreign Exchange Reserves Foreign Exchange Reserves and the exchange rate regime: • Under fixed exchange rate, RES is determined by the net demand or supply of foreign exchange. • Under pure float, RES = 0 CAB = – CFAB Role of FX Reserves • Financing (temporary) BOP deficits • Supporting an exchange rate peg • Sustaining confidence in the domestic currency and the economy 36 External Sector Foreign Exchange Reserves FX Reserve Adequacy Usefulness of FX reserves •Reserves act as an insurance cover to smooth (i.e. finance) temporary fluctuations in capital flows (rather than having disruptive changes in domestic absorption). •A high level of reserves gives confidence and reduces incentives for speculation. FX reserves: return and cost •FX reserves have a financial return (depending on the global interest rate) •FX reserves have an opportunity cost (investing in the economy) •… can complicate Monetary Policy (more on that when 37 discussing the monetary sector) External Sector Foreign Exchange Reserves FX Reserve Adequacy Traditional indicator : Reserves in months of imports = Gross international reserve at end-period / average monthly import bill ( 3) Large and volatile international capital flows have reduced the relevance of the traditional indicator. The capital account crises of the late 90s made clear that the appropriate level of reserves cannot be assessed without reference to the capital account. 38 External Sector Foreign Exchange Reserves FX Reserve Adequacy Additional indicators for reserve adequacy focus on ‘financial vulnerability’ include • Exchange rate regime and the credibility of authorities’ policies • Openness of the economy (to trade and capital flows) • Variability and volume of foreign exchange transactions • Country’s access to short-term borrowing facilities • Maturity structure of liabilities (ability to cover short term debt (less than one year)) 39 External Sector Foreign Exchange Reserves Role of short-term debt and capital flight From: IMF, Assessing Reserve Adequacy (2011). 40 External Sector Foreign Exchange Reserves 41 External Sector External Reserve adequacy, Tunisia Source: IMF, 2014, Country report, Tunisa 42 External Sector External Reserve adequacy, Ghana Source: IMF, 2014, Article IV report, Ghana 43 Main linkages between sectors (not exhaustive) REAL SECTOR GENERAL GOVERNMENT Fiscal Accounts (local currency, flows) National Accounts (local currency, flows) Revenues Grants Private consumption General government consumption (Wages+Goods and services) Expenditures Current Capital Private investment General government investment Overall balance Financing Domestic financing (net) Banking system Nonbanking sector External financing (net) Exports of goods and nonfactor services Imports of goods and nonfactor services EXTERNAL SECTOR Balance of Payments (US Dollars, flows) CURRENT ACCOUNT Exports of goods and nonfactor services Imports of goods and nonfactor services Factor services (net) Transfers (net) Official Private CAPITAL ACCOUNT Direct investment Medium/long-term capital (net) Private sector (o/w banks) Centr. Government Short-term capital (net) Private sector (o/w banks) Centr. Government Overall balance Reserves (Change in net foreign assets) MONETARY SECTOR Monetary Authorities (local currency, stocks) Net foreign assets Net domestic assets: Net credit to governemnt sector Credit to banks Other items (net) Reserve money Currency Banks reserves Deposit Money Banks (local currency, stocks) Net foreign assets Banks' reserves Net domestic assets: Net credit to government sector Credit to nongovernment sector Other items (net) Liabilities to monetary authorities Private sector deposits 44 Outline of the session • • • • • • - Overview of financial programming Real – Production Sector External Sector Monetary Sector Government Sector Building scenarios + short assignment 45 Monetary Sector Structure of the Financial System Financial System (Financial Survey) Banking System (Monetary Survey) Monetary Authorities (Balance Sheet of the MA) Other Financial Institutions (Consolidated Balance Sheet of OFI) Commercial Banks (Consolidated Balance Sheets of Commercial Banks) 46 Monetary Sector Monetary Authorities Functions: • Issue currency • Hold the country’s foreign reserves • Oversee the monetary system, supervise banks and monitor financial stability • Serve as lender of last resort to the system Balance Sheet: 47 Monetary Sector Commercial Banks Functions • Provide financial intermediation to savers and investors/borrowers. • Affect money supply and liquidity in the economy (through their deposit taking and lending behaviors). • Help transmit monetary policy from the monetary authorities to the economy Liabilities Balance Sheet Assets Net foreign assets Reserves Required reserves Excess reserves Deposits Demand (DD) Time and savings (TD) Foreign currency (FC) Liabilities to MA Domestic credit Claims on government Claims on other domestic sectors Other items (net) Other less liquid liabilities 48 Monetary Sector The Monetary Survey The Monetary Survey is the consolidated balance sheet for the entire banking system (Commercial Banks and Monetary Authorities). Present, in a timely fashion, data on monetary and credit developments for the entire banking system. Data are available at quite high frequency (monthly). Assets Liabilities Net foreign assets (NFA) Broad Money (M2) Narrow Money (M1) Currency in circulation (CY) Demand Deposits (DD) Quasi-Money (QM) Time and savings deposits (TD) Foreign currency deposits (FC) Net Domestic Assets (NDA) Net Domestic credit (NDC) Net claims on government (NCG) Claims on the Private Sector (CPS) Other items (net) (OIN) 49 Monetary Sector Balance of payments and Money supply In the Monetary Survey : M2 = NFA - NDA The change in money supply is equal to the change in the net foreign assets in the banking sector minus the change in net domestic credit. In the BoP : Change in FX reserves = CAB + CFAB = NFA The external sector (through changes in foreign exchange reserves) has an impact on Money Supply. 50 Monetary Sector • Monetary aggregates • Mo (Monetary base= currency in circulation + reserves of commercial banks at the CB ); • M1 (currency, checkable (or demand) deposits); • M2 (M1 + savings deposits, time deposits, money market funds); • M3 (M2 + special time deposits) The Monetary base is controlled by the Central Bank M1, M2, and M3 are not fully controlled by the CB Money Multiplier = M2/Mo Money Velocity = GDP/M2 51 Monetary Sector Ghana, Monetary survey Source: IMF, 2014, Article IV report, Ghana 52 Monetary Sector Tunisia, Monetary survey Source: IMF, 2014, Country report, Tunisia 53 Monetary Sector Fiji, Monetary survey 54 Source: IMF, 2014, Article IV report, Fiji Main linkages between sectors (not exhaustive) REAL SECTOR GENERAL GOVERNMENT Fiscal Accounts (local currency, flows) National Accounts (local currency, flows) Revenues Grants Private consumption General government consumption (Wages+Goods and services) Expenditures Current Capital Private investment General government investment Overall balance Financing Domestic financing (net) Banking system Nonbanking sector External financing (net) Exports of goods and nonfactor services Imports of goods and nonfactor services EXTERNAL SECTOR Balance of Payments (US Dollars, flows) CURRENT ACCOUNT Exports of goods and nonfactor services Imports of goods and nonfactor services Factor services (net) Transfers (net) Official Private CAPITAL ACCOUNT Direct investment Medium/long-term capital (net) Private sector (o/w banks) Centr. Government Short-term capital (net) Private sector (o/w banks) Centr. Government Overall balance Reserves (Change in net foreign assets) MONETARY SECTOR Monetary Authorities (local currency, stocks) Net foreign assets Net domestic assets: Net credit to governemnt sector Credit to banks Other items (net) Reserve money Currency Banks reserves Deposit Money Banks (local currency, stocks) Net foreign assets Banks' reserves Net domestic assets: Net credit to government sector Credit to nongovernment sector Other items (net) Liabilities to monetary authorities Private sector deposits 55 Outline of the session • • • • • - Overview of financial programming Real – Production Sector External Sector Banking Sector Government Sector 56 Government Sector • General government comprises all government units • Central government • State governments (in federal countries) • Local governments • The public sector also includes corporations and quasi-corporations controlled by the government units. These corporations are not part of the Government sector (but there can be public liabilities for the Government). 57 Government Sector Source: Government Finance Statistics (GFS). IMF 58 Government Sector Source: GFS Manual, IMF, 59 2001 Foreign Aid in the Gov. Operations Aid Grants are registered “above the line” Foreign Loans are registered as Foreign financing 60 Ghana: Authorities budget scenario Government Sector 61 Source: IMF, 2014, Article IV report, Ghana Government Sector Government Expenditures have a direct impact on the production sector in the short run - Government consumption: (Wages and Salaries, Consumption of Good and services) - Government investment (transaction in non-financial assets) -Y = C + GI + I + GI + (X – M) However, Government consumption and investment can partially crowd out private consumption and investment. This is the fiscal “multiplier” debate: -If multiplier = 1; 1 euro of gov. expenditure translate (one the short run) into 1 euro of additional GDP -If multiplier is below 1, the effect is smaller (crowding out) -If multiplier is above 1, ….well, GDP increase by more than & euro. - The long run impact of government expenditures depends on the 62 nature of expenditure Government Sector Government financing operations also have an impact on the economy in the short run: - Taxes (more or less the same discussion than that about fiscal multiplier) - Deficits: - Financed by the domestic banking sector = increase in Net Domestic Assets …..so it has an impact on money supply, unless the banking sector reduces credit to the private sector (less private sector investment and consumption) - Financed by the domestic private sector : total impact depends on the behavior of private sector (less consumption and more saving ? Less investment ?) - Financed by external borrowing increase long term external vulnerability …but has less impact in the short run A good financial programming framework must take these constraints 63 and potential impacts into account. Government Sector In the longer run: Budget deficit and borrowing add to pubic debt. Public debt sustainability needs to be assessed. This will be discussed in Macro II. 64 Government Sector Fiji, Government sector Fiscal figures 65 Source: IMF, 2014, Article IV report, Fiji Government Sector Fiji, Government sector Source: IMF, 2014, Article IV report, Fiji Public debt 66 Government Sector Tunisia, Government sector Source: IMF, 2014, Country report, Tunisia 67 Government Sector Ghana, Government sector Source: IMF, 2014, Article IV report, Ghana Fiscal figures 68 Government Sector Ghana, Government sector Source: IMF, 2014, Article IV report, Ghana Public debt 69 Main linkages between sectors (not exhaustive) REAL SECTOR GENERAL GOVERNMENT Fiscal Accounts (local currency, flows) National Accounts (local currency, flows) Revenues Grants Private consumption General government consumption (Wages+Goods and services) Expenditures Current Capital Private investment General government investment Overall balance Financing Domestic financing (net) Banking system Nonbanking sector External financing (net) Exports of goods and nonfactor services Imports of goods and nonfactor services EXTERNAL SECTOR Balance of Payments (US Dollars, flows) CURRENT ACCOUNT Exports of goods and nonfactor services Imports of goods and nonfactor services Factor services (net) Transfers (net) Official Private CAPITAL ACCOUNT Direct investment Medium/long-term capital (net) Private sector (o/w banks) Centr. Government Short-term capital (net) Private sector (o/w banks) Centr. Government Overall balance Reserves (Change in net foreign assets) MONETARY SECTOR Monetary Authorities (local currency, stocks) Net foreign assets Net domestic assets: Net credit to governemnt sector Credit to banks Other items (net) Reserve money Currency Banks reserves Deposit Money Banks (local currency, stocks) Net foreign assets Banks' reserves Net domestic assets: Net credit to government sector Credit to nongovernment sector Other items (net) Liabilities to monetary authorities Private sector deposits 70 Thank you 71