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External Balance in Low‐Income Countries

2010; University of Chicago Press; Volume: 6; Issue: 1 Linguagem: Inglês

10.1086/648710

2150-8372

Lone Engbo Christiansen, Alessandro Prati, Luca Ricci, Thierry Tressel,

Fiscal Policies and Political Economy

Previous articleNext article FreeExternal Balance in Low‐Income CountriesLone Christiansen, Alessandro Prati, Luca Antonio Ricci, and Thierry TresselLone ChristiansenInternational Monetary Fund Search for more articles by this author , Alessandro PratiInternational Monetary Fund Search for more articles by this author , Luca Antonio RicciInternational Monetary Fund Search for more articles by this author , and Thierry TresselInternational Monetary Fund Search for more articles by this author PDFPDF PLUSFull Text Add to favoritesDownload CitationTrack CitationsPermissionsReprints Share onFacebookTwitterLinked InRedditEmailQR Code SectionsMoreI. IntroductionThis paper investigates empirically the external balance of low‐income countries by offering a coherent analysis of determinants of medium‐ to long‐term real exchange rates, current accounts, and net foreign assets and highlighting factors that are more likely to be specific to these countries. The rise and persistence of large external imbalances in recent years have renewed interest in this area from an empirical and theoretical perspective and have also highlighted the need for a multipronged approach to the analysis of external balances on the basis of multiple indicators. In this paper, the simultaneous analysis of the three aforementioned indicators of external balance allows us to check the consistency of the results across indicators, an effort generally absent in the literature. The focus on low‐income countries aims at filling another gap. Although the literature on the determinants of the real exchange rate and of the current account is very vast, very few contributions focus specifically on low‐income countries or account for features that are quite specific to—or more important for—this set of countries. Our analysis emphasizes factors such as structural policy and institutional distortions, access to special external financing, and a larger macroeconomic sensitivity to exogenous shocks. For the purpose of the empirical analysis, extensive efforts were required to create a wide database, which is unique in terms of the set of indicators and countries covered.A large literature has based the analysis of medium‐term determinants of current accounts on the standard intertemporal approach to the current account emphasizing saving and investment decisions (see, e.g., Chinn and Prasad 2003; Lee et al. 2008).1 A more recent empirical literature has aimed at explaining the patterns of global imbalances that have widened over the past decade as a function of financial crisis, financial development and distortions, and institutional variables (Chinn and Ito [2007] and Gruber and Kamin [2007] and, from a theoretical perspective, Caballero, Farhi, and Gourinchas [2008], Mendoza, Quadrini, and Rios‐Rull [2009], and Gourinchas and Jeanne [2009]). Others have illustrated the role of labor market policies and exchange rate regimes in influencing the persistence and dynamics of the current account (Ju and Wei 2007; Chinn and Wei 2008) and the relationship between labor market, financial frictions, and fiscal policies in shaping the optimal current account responses to shocks (Blanchard 2007).The literature on real exchange rates is vast, and we cannot do justice to all contributions. Broad surveys are offered by Froot and Rogoff (1995), Rogoff (1996) and, for developing countries, by Edwards (1989), Hinkle and Montiel (1999), and Edwards and Savastano (2000).2 The traditional findings of Meese and Rogoff (1983) on the unpredictability of exchange rates at short horizons are still undisputed, and the literature has converged toward explaining the behavior of real exchange rates at medium‐ to long‐term horizons as a function of fundamentals (see, e.g., Engel and West 2005; Engel, Mark, and West 2008). Empirical analysis of long‐run real exchange rates is typically guided by steady‐state relationships in models involving the intertemporal and intratemporal allocation of resources between tradable and nontradable sectors (Montiel 1999; Obstfeld and Rogoff 1999; Ricci, Milesi‐Ferretti, and Lee 2008; Vegh, forthcoming).A growing literature has uncovered the medium‐term determinants of gross and net foreign assets, after the creation of the Lane and Milesi‐Ferretti database of external positions (for the latest version, see Lane and Milesi‐Ferretti [2007]). Lane and Milesi‐Ferretti (2002b) offer a theoretical and empirical discussion of long‐term determinants of the net foreign asset position. Faria et al. (2007) show that more open economies with better institutions have a greater equity share in external liabilities.Few studies have focused on low‐income countries with the notable exceptions of Edwards (1989) and Hinkle and Montiel (1999).3 In this paper, we argue that low‐income countries differ from other countries mainly along three broad dimensions, which simultaneously affect the current account, the real exchange rate, and the net external asset position: (i) structural policies or distortions, in particular those related to the capital account and the domestic financial system; (ii) exogenous shocks, in particular natural disasters (whose effect may depend on the degree of capital account openness) and terms of trade shocks; and (iii) official external financing (grants and concessional loans).We believe that these factors are particularly important for our sample of countries. First, low‐income countries face greater distortions—some of which are policy induced—than other countries. For example, capital account controls—which were prevalent for a large number of countries over the sample analyzed—may reduce the ability of low‐income countries to borrow in order to bring consumption and investment forward, as required by a lower level of development or the occurrence of negative shocks. Capital controls may therefore affect domestic demand, the current account, the net foreign assets, and the real exchange rate.4 Domestic financial liberalization, which occurred during the 1980s and the 1990s in many developing countries, may reduce borrowing constraints and boost investment, which would tend to lower the current account and the net foreign assets position and appreciate the real exchange rate. But financial liberalization may also raise private savings, which, everything else equal, would improve the current account and the net foreign assets position and depreciate the real exchange rate.Second, low‐income countries are in general more exposed to shocks than other countries and may—as a result of the lack of diversification of their production structure—experience larger macroeconomic consequences associated with these shocks (see, e.g., Easterly et al. 1993). For example, low‐income countries are exposed to frequent terms of trade fluctuations associated both with their exports (e.g., main crop or natural resources) and with their imports (e.g., oil). Such terms of trade fluctuations affect the real exchange rate and the current account through income and intra‐ and intertemporal substitution effects. Moreover, low‐income countries frequently experience natural shocks, such as droughts, floods, windstorms, and earthquakes, which have larger macroeconomic consequences than in high‐ and middle‐income countries—including on the external position. Finally, wars and violent political transitions between regimes have often occurred in the historical sample. Such events, by disrupting investment, consumption, and capital flows, can have a bearing on the current account and the real exchange rate at a relatively short horizon.Finally, capital flows are typically of a different nature in low‐income countries than in other countries. A large part of their foreign borrowing is in the form of official development assistance (grants or concessional loans). Such capital flows do not respond to market incentives and often do not need to be repaid, thus contributing to financing larger trade deficits over the medium term. Finally, aid flows have often been associated with the risk of Dutch disease as resource transfers and are expected to lead to more appreciated real exchange rates in the short run by increasing aggregate demand (Van Wijnbergen 1984). In the long run, however, the effect on the real exchange rate is uncertain, depending on the relative impact on the productivity of tradables versus that of nontradables (Torvik 2001).To anticipate some of the results for the indicators that are more important for low‐income countries, we find that domestic financial liberalization is associated with higher current account balances and net foreign asset positions, suggesting a positive effect on domestic savings. Capital account liberalization tends to be associated with lower current account and net foreign asset positions and more appreciated real exchange rates, as predicted by standard theories. Negative exogenous shocks tend to raise (respectively, reduce) the current account in countries with closed (respectively, opened) capital accounts pointing at the importance of capital account frictions in shaping intertemporal consumption‐smoothing decisions. Finally, foreign aid is progressively absorbed over time through net imports and is associated with a more depreciated real exchange rate in the long run, a result that may reflect larger productivity gains in the nontradable sector relative to the tradable one.The paper is organized as follows. Section II reviews the theoretical literature on the determinants of the external balances. Section III presents the results of the empirical analysis. Section IV presents conclusions.II. Determinants of External BalanceThis section mainly reviews the determinants of the real effective exchange rate and of the current account, with particular emphasis on factors that are important fundamentals for low‐income countries. Toward the end of the section we will discuss the more limited literature on the determinants of net foreign assets (which generally follows intuitions similar to the current account). The main emphasis will be on the theoretical arguments that can guide our empirical analysis, but we will also highlight the empirical contributions related to each conceptual argument, in order to ease comparison with our results. Potential determinants are grouped into four main categories: (i) main determinants already identified in the literature (macroeconomic policies, predetermined characteristics, and stage of economic development); (ii) structural policies, distortions, and institutions; (iii) shocks; and (iv) external financing.Economic theory underpins the relationship between the real exchange rate, the current account, and a number of macroeconomic variables. In principle, factors that affect the real exchange rate should also affect the current account: for example, factors influencing aggregate demand will generally affect both the current account and the real effective exchange rate. However, theoretical foundations for the empirical analysis of the real exchange rate have usually been derived from long‐run steady‐state analysis of models with tradable and nontradable goods in the presence of balanced trade.5 At the same time, empirical analysis of the current account has been underpinned by the intertemporal approach to the current account, often in single‐goods models, hence without a meaningful exchange rate (Edwards 1989; Hinkle and Montiel 1999; Obstfeld and Rogoff 1999; Vegh, forthcoming). In discussing the various determinants, we will highlight the possible joint effects.A. Macroeconomic Policies, Predetermined Characteristics, and Economic DevelopmentFiscal policy. In the absence of Ricardian equivalence, fiscal policy affects aggregate demand, national savings, and therefore the current account balance and the real exchange rate.6 Empirically, Chinn and Prasad (2003) and Lee et al. (2008) find that the fiscal balance is significantly and positively associated with the current account in pooled ordinary least squares (OLS) regressions.7 Fiscal policy affects also the real exchange rate through a composition effect in a multigood economy even in the presence of Ricardian equivalence (Obstfeld and Rogoff 1999). If government spending falls relatively more on nontraded goods than private consumption (which is often the case for government consumption), it will lead to an appreciation of the real exchange rate since the relative price of nontraded goods must increase in order to maintain internal and external balance (Hinkle and Montiel 1999; Vegh, forthcoming). Consistent with this prediction, the empirical literature tends to find a positive coefficient (see, e.g., De Gregorio, Giovannini, and Wolf 1994; Ricci et al. 2008).Net foreign assets. Countries with initially higher net foreign assets can afford higher spending (above income flow)—and therefore a lower current account—while remaining solvent (Obstfeld and Rogoff 1999, chap. 2). However, in economies with uncertain horizon, nonzero steady‐state current accounts are positively associated with steady‐state net foreign assets (see Lane and Milesi‐Ferretti [2002a], Chinn and Prasad [2003], and Lee et al. [2008] for consistent empirical evidence in pooled OLS regressions).8 Moreover, in steady state, higher net foreign assets allow higher consumption of both tradable and nontradable goods while remaining solvent, implying a more appreciated real exchange rate (Lane and Milesi‐Ferretti 2002a, 2004; Ricci et al. 2008). This relationship may not hold in low‐income countries experiencing debt relief: if an increase in debt is expected to benefit from debt relief in the future, lower net foreign assets resulting from the increase in debt may not be associated either with lower consumption needed to service external liabilities through trade surplus or with changes in the real exchange rate. The effect of such expectations cannot be disentangled in the data and would also be reflected in the coefficient of net foreign assets in current account and real exchange rate regressions.Demographics. Under the life cycle hypothesis, a higher share of inactive dependent population reduces national savings and the current account balance and therefore results in a more appreciated real exchange rate. In an overlapping generations model, a higher share of working‐age agents raises national savings, thus increasing the current account. Population growth and fertility have a negative effect on the current account and a positive one on the real exchange rate if they are correlated with the share of young inactive people in the population. These predictions are confirmed empirically in the analysis of the current account (see, e.g., Lee et al. 2008), of the real exchange rate (see Rose, Supaat, and Braude 2009), and of net foreign assets (see Lane and Milesi‐Ferretti 2002b).Stage of development and economic growth. Neoclassical theory predicts that countries at an early stage of development should import capital and borrow against their future income to finance their investment needs and smooth out consumption, given high marginal utility of consumption (Obstfeld and Rogoff 1999). Similarly, fast‐growing countries with higher expected productivity gains should invest more, implying a deterioration of the current account.9 Finally, high productivity growth in the tradable sector relative to the nontradable sector should be associated with a more appreciated real exchange rate (Balassa‐Samuelson effect): an increase in productivity in the tradable sector relative to the nontradable sector, with respect to trading partners, will lead to higher wages in the tradable sector (whose price is given in world markets if the country is small) and subsequently put upward pressure on wages and prices in the nontraded sector. Choudhri and Khan (2005) and Ricci et al. (2008) find that a 10% increase in the productivity of tradables relative to nontradables tends to appreciate the real exchange rate by about 1%–2% on average. Moreover, higher income will result in an upward pressure on prices of nontraded goods relative to traded goods, as traded goods are priced on the international market, leading to a real exchange rate appreciation.10 However, a good measure of relative productivity is not easily available in low‐income countries. Therefore, this paper uses real GDP per capita as a proxy variable, as in most of the literature. As this variable may not accurately capture the relative productivity effects—on the contrary, it averages out productivity in tradables and nontradables—the expected sign on this proxy is not clear.B. Policy Distortions and InstitutionsDomestic financial reforms. A more developed financial system facilitates investment and helps attract foreign capital, thereby lowering the current account balance and appreciating the real effective exchange rate.11 A more developed financial system may also improve the current account balance and depreciate the real exchange rate if it stimulates domestic savings (McKinnon 1973; Edwards 1995).12 Gourinchas and Jeanne (2009) model an open economy in which both investment and saving decisions are distorted by "wedges" affecting the return to capital. Their model predicts that financial liberalization can have ambiguous effects on the external position of a developing country: a reduction of the saving distortion tends to reduce capital inflows by increasing domestic savings, but a reduction of the investment distortion tends to increase capital inflows by raising capital scarcity.13 Empirical analysis has usually relied on measures of financial development as a proxy for the degree of financial liberalization and has found at best weak effects on the current account (Chinn and Ito 2007; Gruber and Kamin 2007).Capital account openness. Neoclassical theory predicts that, over the development process, capital account liberalization should be associated with a deterioration of the current account (capital inflows) and a real exchange rate appreciation in developing countries, and with an improvement of the current account (capital outflows) and a real exchange rate depreciation in advanced countries (Lucas 1988; Edwards 1989).14 Moreover, a more open capital account allows countries to borrow against future income and therefore to run a lower current account balance when hit by a temporary negative income shock (Vegh, forthcoming). However, Kraay and Ventura (2000) show that, if the marginal unit of wealth is invested in the same way as the average unit of wealth, transitory positive income shocks will lead to a current account deficit (surplus) in countries with negative (positive) net foreign assets.Institutions. Broad institutional characteristics such as the quality of property rights and contract enforcement can have first‐order effects on the current account balance and capital flows. Countries with better institutions may be more able to attract a steady flow of foreign capital as a result of lower expropriation risks and therefore can sustain lower current account balances and net foreign asset positions (Alfaro, Kalemli‐Ozcan, and Volosovych 2007; Gruber and Kamin 2007). However, in countries with better institutions, the political process may produce exchange rate policies less likely to favor overvalued real exchange rates and therefore result in higher current account and net foreign asset positions. The same outcome may arise from better institutions generating an environment more conducive to saving.Trade reforms. The effect of trade reforms on the current account and the real exchange rate is theoretically ambiguous (Edwards 1989). Trade reforms that are temporary (or perceived as temporary) may worsen the current account by reducing the price of imported goods relative to domestically produced goods (intratemporal substitution effect). The intertemporal effect is ambiguous: the current account should improve as a result of the income effect, but a lower price for today's consumption relative to future consumption negatively affects the current account balance (Ostry 1990).15 The effect of trade liberalization on the real exchange rate depends on whether income or substitution effects dominate. As trade is liberalized, the increase in real income resulting from lower import prices tends to appreciate the real exchange rate.16 However, trade liberalization may also shift demand away from nontraded to traded goods, resulting in a depreciation. A similar result would arise from the direct effect of liberalization (say tariff reduction) on the reduction of the domestic price of tradables. The evidence is generally in favor of the latter effect (see Goldfajn and Valdes 1999; Ricci et al. 2008).Price controls and black market premium. Administered prices keep prices below the market level and are therefore associated with a more depreciated real exchange rate (see evidence in Ricci et al. [2008]). However, price controls may also take the form of a marketing board pushing domestic prices up, which would therefore be associated with a more appreciated real exchange rate. Finally, a black market rate that is more depreciated than the official exchange rate (i.e., a positive black market premium indicating expectations of a devaluation of the official rate) is likely to be associated with a more appreciated real exchange rate (based on the official rate, which is the prevalent basis for measuring real exchange rates) for given fundamentals.C. ShocksTerms of trade. The effect of an improvement in the terms of trade is uncertain and mainly depends on whether the substitution or the income effect dominates. An improvement in the terms of trade arising from an increase in the price of exports raises the current account, as part of the positive income shock is saved to smooth out consumption over time, and appreciates the consumer price index–based real exchange rate as the increase in domestic demand (associated with the income effect) bids nontraded goods' prices up (Ostry 1988; Edwards and Ostry 1992). However, an improvement in the terms of trade arising from a decrease in the price of imports may also result in a worsening of the current account and a real depreciation if agents substitute imported goods for domestically produced goods or for future imported goods (Obstfeld and Rogoff 1999; Vegh, forthcoming). If imports are used as intermediate inputs in production, the last effect on the real exchange rate would be compounded, as domestic goods produced with those imports would tend to experience a decline in price. Overall, evidence shows a positive effect on the real exchange rate from a terms of trade improvement (see Ostry and Reinhart 1992; Chen and Rogoff 2003; Cashin, Céspedes, and Sahay 2004; Ricci et al. 2008; for an analysis of the separate effect of import and export prices, see Christiansen and Tokarick [2009]).Natural disasters. A negative income shock positively affects the current account balance if national savings increase, or if investment falls relative to savings, as a consequence of the shock. However, the current account could worsen if the country can smooth consumption out by borrowing on international financial markets (Obstfeld and Rogoff 1999). Thus, we expect the effect of natural disasters to depend on the degree of capital account openness.17 When considering the long‐run relationship between the real exchange rate and its fundamentals, we may expect shocks not to play any role, since it is likely that they have only temporary effects.D. External FinancingOfficial aid. In the short run, a surge in aid could push up domestic prices and induce a real exchange rate appreciation since supply has a limited ability to respond to an increase in aggregate demand financed by aid. In the long run, however, the effect of aid on the real exchange rate is theoretically ambiguous, since aid flows may cause an increase (decrease) in the productivity of the nontraded goods sector relative to the productivity of the traded goods sector, hence leading to a real exchange rate depreciation (appreciation).18To empirically estimate the impact of aid on the current account, aid must be broken down into its two main components (grants and concessional loans), given that they are accounted for in different parts of the balance of payments (the former enters the current account and the latter the financial account). Also, to the extent that aid flows are usually redistributed to private agents through government expenditures and are not intermediated by the domestic financial system, their effect on the external position is independent of the impact of domestic financial liberalization. Conceptually, and as a first‐order approximation, aid flows can be modeled as exogenous transfers.Grants. Countries receiving a steady flow of grants are able to sustain a lower trade balance in the medium term. Given that grants are accounted for in the current account section of the balance of payments, the current account should remain unchanged if a grant fully finances a deterioration of the trade balance. If, on the contrary, part of the grant is saved in the form of international reserves, the current account will improve.19Concessional loans. Concessional loans allow financing of a lower current account in the medium term. Moreover, debt on concessional terms poses a measurement issue as it creates a gap between the nominal and the present market value of net foreign assets.20 This paper examines the effect of net foreign assets when accounting for the present value of public and publicly guaranteed debt.21 This valuable correction of course has limitations since, given data availability, the additional effect from expected future debt relief cannot be accounted for.The literature on net foreign assets is more limited, in part because the empirical analysis was impaired by the lack of good data until recently (see Lane and Milesi‐Ferretti [2007] for a second edition of their data set). Lane and Milesi‐Ferretti (2002b) offer a theoretical and empirical discussion of the main determinants for advanced economies and developing countries. First, public debt tends to reduce net foreign assets, similarly to the effect of budget deficits on the current account. Second, a higher share of dependent population implies the need to run down savings (and thus reduce net foreign assets) in order to consume more. Third, the relation between income and net foreign assets is more uncertain. A positive relation is suggested by the standard development model in which poor countries borrow and rich countries lend but can also be derived in models with habit formation or nonlinearities in the utility function. However, a negative relationship with income may arise as a result of limited access to international markets or a high desire for precautionary saving in developing countries. Finally, richer countries tend to invest more in equity (see Faria et al. 2007), which is more likely to offer a higher long‐term return and result in higher net foreign assets.III. Empirical ResultsA. DataThe exercise required an extensive data‐gathering and cleanup exercise. We constructed a data set containing 134 countries over the period 1980–2006 for various indicators. Countries used in the main analysis were classified on the basis of their income group. Our low‐income country sample (see app. Table A1) comprises "low‐income" or "lower‐middle‐income" countries according to the World Bank classification and excludes emerging markets to make the sample as homogeneous as possible (China, Colombia, India, Indonesia, Pakistan, and Thailand). "High‐income" and "higher‐middle‐income" countries (in the World Bank classification), including the six countries above, were mainly used as a comparator group of high‐income countries. A summary statistic of the main data is provided in appendix Table A2. A description of all variables is provided in the appendix. The number of low‐income countries entering the regressions varies across specifications based on data availability for the specific indicators, but the largest low‐income country set (used in the trading partner calculations and in regressions with standard fundamentals) includes 59 low‐ and lower‐middle‐income countries.B. Analysis of Medium‐Term Current AccountsThis subsection analyzes the medium‐term relationship between the current account and a set of fundamentals. Following the existing literature, the estimations consist of an unbalanced panel of nonoverlapping 4‐year averages over the period 1981–2005, with six observations for most countries.1. Benchmark Current Account Regressions for Low‐Income Countries22Our preferred current account regressions for our sample of low‐income countries are reported in Table 1. In addition to country fixed effects, the regressions include traditional variables (see, e.g., Chinn and Prasad 2003; Chinn and Ito 2007; Lee et al. 2008) such as the fiscal balance, demographic variables (the old‐age dependency ratio, population growth), the initial net foreign asset position, the oil trade balance, and variables related to the stage of development (GDP per capita relative to the United States and real per capita GDP growth). Most notably, the ratio of the fiscal balance to GDP in relation to trading partners and population growth remains strongly significant in our sample of low‐income countries with the expected sign.Table 1. Medium‐Term Determinants of the Current Account: Main ResultsVa