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Lecture 7: Factors Affect Current Account CA Reversals for the Low-and Middle-Income Countries. Milesi-Ferretti, Gian Maria and Assaf Razin (1998), “Current Account Reversals and Currency Crises: Empirical Regularities,” CEPR Discussion Paper, No. 1921, or NBER Working Paper, No. 6620, and in P. Krugman (2000) (ed.) Currency Crises, U. of Chicago Press. Study sharp external adjustments in low-and middle-income countries. Facts: Sharp reductions in current account deficits (reversals), large nominal devaluations (currency crises) --- What factors help predict crises and reversal sand what factors explain macroeconomic performance after such events occur. Data: (105 low- and middle-income counties) --- 1970-1996 48 African Countries, 26 Asian Countries, 26 countries from Latin America and Caribbean and 5 European Countries Categories of the data: Macroeconomic variables: economic growth, real consumption growth, the rate of investment, the fiscal balance, the level of GDP per capita Financial variables: the ratio of M2 to GDP, the credit growth rate and the ratio private credit to GDP. External variables: current account balance (exclusive and inclusive of official transfers), the real effective exchange rate, the degree of real exchange rate overvaluation, the degree of openness to trade, the level of external official transfers as a fraction of GDP. Debt variables: ratio of external debt to output, the interest burden of debt as a fraction of GDP, the share of concession debt, short-term debt, public debt and multilateral debt in total debt and the ratio of FDI flows to debt outstanding. Foreign variables: the real interest rate in the United States, the rate of growth in OECD countries, and the terms of trade. Dummy variables: regional dummies, a dummy for the exchange rate regime, and an IMF program in place for at least 6 months during the year. Current account reversals 3 requirements: a. An average reduction in the CAD of at least 3 (5) percentage points of GDP over a period of 3 years with respect to the 3 years before the event.--- 125 (117) episodes in 69 (59) countries. Excluding reversals occurring within 2 years of a previous one, the total is 100 (77) episodes. b. The maximum deficit after the reversal must be no larger than the minimum deficit in the three years preceding the reversal. c. The average CAD must be reduced by at least one third. Empirical study: A. event-study methodology (follow Eichengreen et al., 1995) A Comparison of “Tranquil” (average) and “turbulence” periods ---- (deviation from tranquility). Variables: real exchange rate, terms of trade, foreign exchange reserves, real interest rate, consumption growth, fiscal deficit, and output growth. Except that no clear pattern for output growth characterized the period preceding or following (from t-3 to t+3) a reversal, the rest of variables show consistent patterns as predicted—worsen and improve. B. multivariate Probit analysis 3% average decline of the current account deficit between t and t+2 with respect to the period between t-1 and t-3 Reversal appear more likely for countries with high CAD, low foreign reserves, high GDP per capita, worsened terms of trade, high investment, high OECD growth, high US interest rate. Reversals appear less likely with pegged rate regime, high share of concessional debt and official international transfers. Current Account Reversals and Output Performance Focus on two issues: first, whether reversals are costly in terms of output and second, what factors determine a country’s rate of growth during a reversal period. OLS estimation: Dependent variable: average rate of output growth during the 3 years of the reversal period, as deviation from OECD average during the same period. Explanatory variables: all are dated prior to the reversal, including average GDP growth, investment, the CA balance, GDP per capital, ratio of external debt to GDP, real overvaluation of the real exchange rate, official transfers and US real interest rates. Reversal events seem to entail substantial changes in macroeconomic performance between the period before and the period after the crisis, but are not systematically associated with a growth slowdown (coefficient estimated of the average GDP prior to reversal is not significant). Predictors of Currency Crashes 4 definitions of currency crises: Crisis1: 25% depreciation (vis-à-vis dollar), and at least 10% higher than the depreciation the previous year.----the rate of depreciation increases from, say, 50 to 61 %. Crisis2: 25% depreciation, and at least a doubling in the rate of depreciation with respect to the precious year and a rate of depreciation the previous year below 40%. (in order to capture the high-inflation episodes) Crisis3: a 15% minimum rate of deprecation, a minimum 10% increase in the rate of depreciation with respect to the previous year and a rate of depreciation the previous year of below 10%. Crisis4: analogous Crisis3 plus the exchange rate be pegged the year before the crisis. 3-year window----------the recent Asian currency crashes are not in the sample. A. event-study methodology Prior to crisis: low foreign exchange reserves, weak terms of trade, CAD, real exchange rate appreciation B. multivariate probit analysis Estimate the probability of a currency crisis at time t+1 at a function of a set of explanatory variables at time t and of “external” factors at time t and t+1. The set of explanatory variables is similar to the one used for reversals. Warning signals: Low Foreign exchange reserves, real exchanger ate overvaluation, high US interest rate, weak terms of trade, low share of concessional debt, less openness, have no IMF program, and CAD (for the middle-income countries only)-----similar to Frankel and Rose (1996) Currency Crises and Output Performance OLS estimation Dependent variable: average growth rate in the 3 years following the crash Independent variables: average growth rate in the 3 years preceding the crisis, the growth rate the year of the crisis (deviation from the OECD average), The most robust predictor of output performance after a crisis appear to be the average growth rate before the crisis (significant estimated coefficient). However, growth tends to decline the year of the crisis (not significant). Countries more open to trade tend to grow faster after a currency crisis. Real exchange rate is not a good predictor of economic performance after a currency crash (differs from its role played at explaining output performance after reversals and in triggering currency crises) Currency crashes and reversals in current account imbalances have indeed different characteristics and have a different impact on macroeconomic performance. Crisis and Reversals: A Comparison 1st stylized fact: When crises precede or accompany reversals they tend to occur one or two years prior to a reversal. 2nd stylized fact: reversals are more likely to be preceded by currency crises in Latin America and the Caribbean than they are in Asia. Less than a third of all currency account reversals are preceded by a currency crisis. Problems of estimation: endogeneity and simultaneity problems that makes it difficult to give a “structural” interpretation to its findings. Current Account Adjustment in Industrialized Countries Freund, C. L. (2000), “Current Account Adjustment in Industrialized Countries,” Board of Governors of the Federal Reserve System, International Finance Discussion Papers, No. 692. To investigate: 1. When a typical adjustment begins and what it entails? 5% CAD 2. What factors trigger a current account reversal? Business cycle 3. How the current account adjusts? RER depreciation Finding: 25 episodes of 25 industrialized countries between 1980 and 1997 are studied. Current account reversal begins when the CAD is about 5% of GDP, and associated with slowing income growth and a 10-20% real depreciation. Real export growth, declining investment, and an eventual leveling off in both the net international investment position and the budget deficit-GDP ratio are also likely to be part of the adjustment. Current account reversals are largely a function of the business cycle. ------------------------------------------------------------------------------------------------------ The dynamics of current account adjustment Examine in the CA, the exchange rate, real income, the trade balance, saving and investment, the short-term interest rate, the budget balance, and the net international investment position in the ten year period surrounding the trough date. The data are from the World Bank World Development Indicators (WDI) and the IMF International Financial Statistics. Industrialized countries: 1997 per-capita income above $10,000, there are 25 countries. These countries accounted for 80% world trade in the 1990s 4 criteria as a reversal (similar to Milesi-Ferretti and Razin, 1998): a. b. The CAD exceeded 2% of GDP before the reversal The average deficit was reduced by at least 2% of GDP over 3 years (from the minimum to the 3 years average) c. The maximum deficit in the 5 years after the reversals was not larger than the minimum deficit in the 3 years before the reversal d. The current account was reduced by at least one third. From figures (median and average CA-GDP), the typical CA-GDP pattern shows a current account that continued to worsen for 4 to 5 years before it hit its minimum and then began adjusting, taking another 3 to 4 years to return to near zero. Exchange rate The real depreciation began one year before the CA hit its trough and continuing depreciation for 3 years, with an overall real depreciation of about 20%----J curve. Another evidence: currency crisis do not help predict current account reversals. Currency crisis uses the Frankel and Rose (1996) indicator from 1980-1995, and identifies 21 currency crises, which occurred in 10 of the 25 industrialized countries. Domestic income growth Income growth peaks about 2 years before the deficit reaches its trough, is lowest in the first year of recovery. About 4 to 5 years after the deficit is minimized, income growth returns to its pre-deficit level.----current account is cyclical. Interest Rates Real interest rates increased by about 2% in the final 3 years the CA deteriorated, and then came down by about 3 % in the first 3 years the CA reversed.(hump-shaped short-rate path)------------cyclical. Twin Deficits? The deterioration in the current account was not in general associated with an expansion in the budget deficit. The Trade Balance In the previous years, the trade balance worsened by about 1% to 2% of GDP; and in the following 3 years, the trade balance improved by about 4% of GDP. In the first 2 years, the recovery was assisted by a decline in the import-GDP ratio. But, the surge in real export growth in the second and third year of recovery was responsible for most of the improvement in the trade balance over the adjustment period. Savings and Investment The current account decline seems to be associated more with a decline in national savings than with an increase in investment; the improvement in the current account comes primarily through reduced investment------CAD was largely demand driven. The Net International Investment Position The net international investment position (NIIP) was declining as the current account worsened. However, there are few episodes shown that the reversal of the current account associated with a reversal in the NIIP. Alternative Theories of Adjustment The current account reversals in Canada, Denmark, and Norway were accomplished without a real or a nominal depreciation, and in Singapore the reversal took place with neither a depreciation nor a slowdown in GDP growth. Canada: the effective exchange rate indices are misleading because they conceal a large depreciation of the Canadian dollar w.r.t. to U.S. dollar (1976-1986 34% depreciation against USD). Canadian adjustment took place primarily vis-à-vis the Unite States, Canada’s episode remains consistent with traditional theory. Norway: the CAD was the result of an oil price shock (1986). Denmark: in 1987, the decline in capital inflows in conjunction with the monetary tightening reduced domestic demand sufficiently that the current account improved while the exchange rate remained unchanged. Singapore: the adjustment is consistent with the intertemporal story; the current account was in deficit because net income was expected to grow relative to other counties. Difference and similarity of the current account adjustment: Similarity: significant real depreciation Difference: Industrialized countries: GDP growth, the net foreign asset-GDP ratio and the government budget balance have significant explanatory power. Developing countries: relative income, financial deepening, and terms-of-trade effects. Possible explanation: in developing countries may be driven largely by foreigners willingness to invest and other external factors, while current account imbalances in large economies are more likely to be driven by domestic growth. Medium-Term Determinants of Current Accounts (Menzie Chinn and Eswar Prasad, “Medium-Term Determinants of Current Accounts in Industrial and Developing Countries: An Empirical Exploration,” 2000, IMF Working Paper, WP/00/46, March., or Journal of International Economics, 2003, 59, 47-76) 18 industrial and 71 developing countries (African Countries), cover the period 1971-95. CA X it it GDP it X: The government budget balance; Relative income (to US); Dependency ratios; Average GDP growth; Terms of trade volatility; Measures of capital controls; Degree of openness; And financial deepening Non-overlapping 5-year averages of the data for each country----medium term rather than short-term perspective. No distinguish between the effects of temporary and permanent shocks and among different sources of shock. Cross-Section Results Government budget balance (+) Net foreign assets (NFA)--Initial condition: average value of the first 5-year (+?) Stage of development relative per capital income and its square (+, -?) as a country moves from a low to an intermediate stage pf development, they import capital and run CA deficit. Once developed, CA surplus to pay off accumulated external liabilities and export capitals. Demographic profile of the population: relative dependency ratios (-) (young and old Dependency ratios)—relative to the respective sample averages across all countries. Financial deepening (M2/GDP): a measure of the depth and sophistication of the Financial system induces more saving (+, for developing countries but not in Industrial countries) Terms of trade (TOT): more volatile TOT tends to save more for precautionary reasons. On the other hand, multinationals tend to diversify their production base across countries with volatile TOT in order to have the flexibility to exploit TOT movements. (+, For developing countries, -, for industrial countries.) The growth rate of aggregate output: (permanent or temporary) also considering the liquidity constraint, and productivity increase as GDP growth, and induces investment increases. No obvious net effects (?) Openness ratio: (-, among developing countries), attractive to foreign capital. Capital control: (+, for industrial countries; for developing countries, not significant) Causality(?), ex. lessens CA deficit by using capital control. Panel Estimates Net foreign assets (NFA)--Initial condition: average value of the first 5-year(+?): countries that have tended to run CA deficits, and built up a stock of NFL have better access to capital markets. Stage of development relative per capital income and its square (-, +) for developing countries. Financial deepening (M2/GDP): a measure of the depth and sophistication of the Financial system induces more saving. Private saving is the channel through which financial deepening influences the CA. Calderon, Cesar, Alberto Chong, and Norman Loayza (1999), “Determinants of Current Account in Developing Countries,” The World Bank. Glick, Reuven, and Kenneth Rogoff (1995), “Global versus Country-Specific Productivity Shocks and the Current Account,” Journal of Monetary Economics, pp. 159-192. Reisen, Helmut (1998), “Sustainable and Excessive Current Account Deficits,” OECD Development Center, Technical Papers, No.132. Foreign Direct Investment (FDI) is special with its macroeconomic implications: 1. FDI is largely determined by non-cyclical consideration, governed by long-term profitability expectations, it is less subject to sudden shifts in investor sentiment. 2. The Harberger externality does not apply to FDI. (Supply schedule of the FDI is upward sloping, and is likely to produce positive external spillovers.) 3. FDI inflows exert less upward pressure on the real exchanger arte, minimizing the risk of “Dutch disease.” FDI is likely to crowd in domestic investment, to the extent that it is “green field” investment, it will stimulate a corresponding movement in the demand for foreign exchange by stimulating imports. 4. In the absence of financial sector and foreign exchange distortions, foreign direct investment can improve the current account balance. The positive direct and indirect effects of FDI on national saving actually leads to an improvement in the current account in the long run. Terms of Trade Shocks and the Current Account (Paul Cashin and Jogn McDermott, NBER, WP/98/177) Three-good model: importable, exportable, and nontradable. Countries consume both importables and nontradables. (numeraire is exportable) TOT: relative price of importables in terms of exportables.(up, deteriorate) Real E : the relative price of exportables in terms of nontradables.(up, depreciation) Adverse transitory TOT shock: #Harberger-Laursen-Metzler (HLM)---income effect. #Interatemporal and intertemporal substitution effects.—TOT effects Intertemporal substitution: elasticity ( ) , makes current imports and current consumption more expensiver relative to future, raising general level of prices.(consumption-tileting effect, saving up) Intratemporal substitution: elasticity ( ) , make importable more expensive than consumption of nontradables, casuing agents to substitute into nontradables, raise the relaitve price of nontradables.(real exchange rate effect, saving up) How far the TOT shock will affect CA deficit, depends on the intratemporal and intertemporal sbstitution effects. The higher, the CA deterioration is the smaller. In general, developed countries (rich consumers) tend to have a higher intertemproal elasticity of substitution than do developing countries (poor consumers). --- much more open in capital market (note: intertemproal elasticity of substitution is the inversoe of relative risk aversion) ##Estimation of the intertemproal elasticity of substitution, Ct Rt et where R is real interest rate.