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The macroeconomic balance approach addresses the requirements to achieve internal and external balances simultaneously. Under the macroeconomic balance (MB) approach the exchange rate are perceived to be in equilibrium when the associated underlying currant account coincide with the equilibrium CA position for each country. A key distinction of the MB approach from other approaches to assessing exchange rate is that it focuses explicitly on the current account—or more precisely on whether the outlook for current account at prevailing REERs is consistent with the CA norm. The notion of a CA norm masks its underlying substance as the norm implies consistency of the current account with the existing saving-investment balance, or, as it was presented in the early days of the MB approach, with the capital account.1 2.The fact that sum of current accounts for the world should equal zero enforces global consistency in the MB approach. In a multilateral framework, the sum of CA position implied by the configuration of equilibrium exchange rates is globally consistent, or, in practical application, that a simultaneous movements in all exchange rates from their prevailing to their equilibrium levels would not significantly affect the convergence of the global current account to zero. Thus, the equilibrium REER for each country under the MB approach should ultimately be consistent with the sum global all current accounts of all countries equal to zero. The deviation of the REER of an individual country from the equilibrium would signal then that the country does not contribute to the global macroeconomic balance. 3.The CGER MB approach consists of three steps.2 First, an equilibrium and multilaterally consistent relationship between CA balances and a set of fundaments is estimated with panel econometric techniques. Second, a CA norm is computed for the country under consideration based on the relationship estimated in step one as a function of the medium-term levels of fundamental for this country. Third, the REER adjustment that would close that gap between the CA norm and the UCA is calculated using the relevant elasticities. The coefficients estimated in stage one capture medium-term tendencies in the co-movements of the CAs with the underlying fundamentals in 54 developed and transition economies that represent  percent of global trade. It can be argued that this is a representative set of countries that are ultimately responsible for global balances, as economies with a larger international presence has larger multilateral effect of REER of other countries. 4. The coefficients in the CGER MB approach can not be applied directly applied to a LIC. The coefficients obtained in step one of the CGER estimations reflect co-movements of the CAs with the underlying fundamentals in developed and transition economies.
Isard and Mussa in Exchange rate Assessment (1998) for a historical discussion. Lee et al (2008).
2 Application of these coefficients to the medium-term values of fundamentals of a LICs with the view to estimate the CA norm would create an internal methodological conflict and would impair the interpretation of the results. Also, a direct estimation of the coefficients for a panel of LICs or their large groups (i.e. nonoill exporters and oil exporters) poses the problem of multilateral consistency as for a meaningful estimation of the CA norm the sum of CA in the panel should converge to zero. Finally, a direct estimate of the CA norm by relating is a certain set of fundamentals essentially collapses the MB approach into the ERER approach with the only difference that the CA, and not the REER is the dependent variable.3 5.Data requirements under the MB approach are essentially the same as under the ES approach. With the notable exception of the CA norm, all other variables needed for the estimations have already been discussed in section C. An important difference is that the MB is dynamic concept as it allows to estimate a time-bound trajectory of the exchange rate adjustment needed to bring the UCA in line with its norm, whereas the ES approach is essentially static addressing the question of what the exchange rate adjustment is needed today to bring the UCA in line with the benchmark NFAP. Therefore, the UCA evaluated under the ES approach at a fixed point of time (2007), under the MB approach should presented as an annual medium-term projection. In 2008-2013, the UCA differs from the baseline CA by the magnitude of temporary factors that affected it in 2005-2007 but still have visible impact in the medium term. Beyond the medium term, the UCA coincides with the baseline CA as the lagged effects of the temporary factors die off. Macroeconomic assumptions and elasticities needed to calculated the change in the exchange rate are the same as in the ES approach. Finally, the same sensitivity tests can be applied to the results. 6.This paper proposes a simple and transparent non-econometric method to evaluate the REER under the MB approach and applies it to WAEMU. A. Inverted DSA 7.Several features make DSAs particularly appropriate for the MB approach. First, DSA are focused on underlying policies, not only on sustainability of the debt. When the debt-to-GDP ratio is on a non-explosive path, the solvency condition is automatically met. In fact, the DSA assesses whether the policies summarized in the path for the primary fiscal balance and in the non-interest CA are consistent with a sustainable debt path. Second, DSAs looks at debt dynamics rather that at debt levels. Under the DSA, a country is solvent is the NPV of the non-interest CA is equal or exceeds the NPV of its external debt. Third, DSA capture the notion of the use of underlying, rather that the current, levels of key variables as it explicitly requires that the standard templates be adjusted to the circumstances of a particular country, for example by shortening or extending the averaging period and excluding non-representative and one-off events, which may distort the outcome. by CA as Finally, although produced by country teams, DSAs are based on macroeconomic
These and other difficulties are the reason that the MB CGER methodology for LICs is currently not available and there are very few applications in the literature Chinn and Ito (2005)
3 projections, which are derived from multilaterally consistent global assumptions and the latest WEO projections for oil prices, nonfuel commodity prices, interest rates, and exchange rates, which assures their multilateral consistency. 8.A standard DSA presents a number of scenarios, of which only the baseline is appropriate for the MB analysis. The baseline presents the evolution of keys macroeconomic variables, which is consistent with a sustainable level of external debt. In principle, the baseline scenario should reflect an unbiased projection of debt sustainability derived from a comprehensive and realistic macroeconomic framework prepared in conjunction with the debt analysis. The “alternative scenarios” included in a standard DSA are not appropriate for the MB approach, as they do not reflect a comprehensive and consistent alternative macroeconomic scenarios, but rather illustrate the impact on debt sustainability of a mechanic change in one (the lower level of concessionality scenario) and several (the historical scenario) variables. 9.The appropriateness of the baseline scenario for the under the MB approach depends on whether it reflects current policies. This can be deduced from the underlying assumptions, which usually clearly spelled out in the DSA. Since DSA are based on WEO projections for the global environment they by construction incorporate the assumption of unchanged current policies and unchanged REER, al lest for the 5-year WEO horizon. However, country-specific assumptions can include measure that are expected to be taken in the medium term, but have not been neither approved not inherently imminent. In practice, very rarely DSAs analyze debt sustainability conditional on assumptions of sharp shift in fiscal policies, rapidly scaled up aid, ort massive productivity growth, as any of such assumptions require explicit justification and may not pass the reality check. 10.The status of LICs in the HIPC process broadly ensures that DSA are indeed based on current policies. DSAs for pre-decision point countries are supposed to explicitly show that on current policies the trajectory of external debt is not sustainable and key macroeconomic variables deteriorate without a sizeable debt relief. For countries in the interim period, the baseline includes the interim debt relief, which is also representative of current policies as fiscal policies and CA projections, at least until the assumed completion point, factor in debt service payments reduced by the amount of the interim debt relief. Finally, for the post completion point countries, DSA already incorporate debt relief in the baseline scenarios and assume new debt accumulation at a certain reasonable rate discussed and agreed with the authorities today, i.e. they are again predicated on current policies. 11.For countries with unsustainable external debt, the baseline DSA scenario is not usable for the purposed of the ES approach. In these cases, a full-fledged alternative scenario based on an alternative macroeconomic framework but still on multilaterally consistent global WEO assumption is usually available as part of DSAs.
4 B. Derivation of the CA norm 12.A proxy for the CA norm can be derived directly from the DSA baseline scenario. A standard DSA calculates two variables directly relevant for the evaluation of the CA norm— the debt stabilizing non-interest CA and the primary fiscal balance. These are the CA and primary balance required to keep the debt-to-GDP ratio constant if all other relevant variable included in the DSA remain at their last year level. The level of these variable explicitly addresses the country’s solvency condition, i.e. establishes the level of the non-interest CA and primary balance needed to keep its external debt constant as a share to GDP. 13.The CA norm can be extracted by inverting a standard DSA. A DSA answers the question whether the level country’s external debt is sustainable and what it the resulting level of CA deficit and primary balance a country can afford to run in the medium and long run to help preserve debt sustainability. An inverted DSA answers a reverse question—what level of the CA and the primary balance are needed to stabilize the debt-to-GDP level at certain sustainable level. For a given time-path of reserve accumulation and non-debt creating capital account flows, the CA that stabilizes external debt at non-explosive and sustainable path may be viewed as a dynamic CA norm. 14.SeveralFigure 1. Debt-accumulating country complications arise with such derivation of the CA norm. First, since the CA is financed not only by debt creating inflows, but also by non-debt creating inflows, selecting Debt the debt creating flows that would stabilize external debt, my not be sufficient to ensure sustainability of the CA. However, in the case of most LICs, WAEMU included non-debtFigure 2. Debt-reducing country creating flows represent relatively minor and a relatively stable share in terms of GDP of all balance of payment flows, in particular in the projected period. In WAEMU, such flows so Debt not exceed 2.5 percent of GDP and does not change much through the projected period. CA norm Therefore, such flows may be treated as a constant at a steady state. Second, the DSA uses as Baseline CA an input the baseline CA from the macroeconomic framework. Therefore the CA reflects the ` assumptions of the framework but does not includes no feedback from the DSA. Third, the T DSA inevitably reflects the overall debt situation, with differs baseline CA used in theime Baseline CA substantially in countries with a sustainable level of external debt and countries with a large CA norm debt overhang. Finally, the norm level, but not the trajectory, will be different for debt-debtaccumulating countries (Figure 1) and debt-reducing countries (Figure 2). WAEMU includes T ime both.
Percent of GDP
Percent of GDP
15.The CA norm can be derived by inverting a standard DSA in three steps. First, identify a DSA scenario with a sustainable debt profile. For post-debt relief countries this is usually the baseline scenario. For pre-debt relief countries, this is usually an alternative scenario derived from an alternative macroeconomic framework, which includes debt relief needed to achieve sustainability. Second, calculate the CA balance that stabilizes the debt-to-
5 GDP ratio4. The DSA template provides all needed variables, although it calculates the noninterest CA that stabilizes the debt-to-GDP ratio. By adding back the projected interest payments and subtracting the change in external debt for the relevant year one can arrive at the CA needed to keep external debt constant in terms of GDP. Third, since the current account can be financed by both debt-creating and non-debt-creating flows, add to the CA calculated in the previous step all non-debt creating flows, assuming they are roughly stable as a share to GDP. 16. Application of the three step approach to WAEMU allowed to establish the CA norms. Current baseline DSA scenarios were used for post debt relief WAEMU countries with highly sustainable debt levels (Benin, Burkina Faso, Mali, Niger and Senegal). Alternative DSA scenarios derived from a comprehensive alternative macroeconomic frameworks were used for pre-debt relief countries (Cote-d’Ivoire, Guinea Bissau, and Togo). For the purposes of the estimation of the CA nor, the first group was treated as debtaccumulating group of countries. The second group was heterogeneous as external debt of Cote d’Ivoire (the largest WAEMUU economy) is not substantially above the sustainability levels and in fact converges to sustainability under the baseline scenario in the long run. Debts of Guinea-Bissau and Togo are clearly unsustainable and they were treated as a group of debt-reducing countries. Debt-stabilizing CA was derived by weighting debt-stabilizing CAs of individual countries by their relative PPP-based GDP shares in the WAEMU region. Finally, non-debt creating flows were added to arrive to the CA norm. 17.The resulting CA can be interpreted as a dynamic CA norm for a country. This derived CA norm is multilaterally consistent as it is based on WEO global economic assumptions. The norm is derived from a coherent macroeconomic framework for the country and thereof is consistent wit its fundamentals. It also reflects external stability because it is derived from the CA needed to stabilize external debt and debt-creating flows. Finally, the norm also reflects domestic stability because it is consistent with a sustainable primary fiscal balance. 18.The dynamics of the medium-term and long-term CA norms are distinctly different. As should be expected in the medium term, the CA nor does not exhibit any particular trend (Figure 3), hovering in the range of 4 to 5 percent of GDP. In the long run, the CA norm clearly indicates a reduction in the CA deficit (Figure 4), suggesting that overall lower CA deficit is needed to ensure along term macroeconomic stability.
Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year.
Figure 3. WAEMU: medium-term CA norm
0 -1 -2 -3 -4 -5 -6 2007 2008
Figure 4. WAEMU: long-term CA norm
(Percent of GDP) 0 2007 2012 2017 2022 2027
(Percent of GDP)
2009 2010 2011 2012 2013
-1 -2 -3 -4 -5 -6 -7
19.Two characteristics of these CA norms are worth mentioning. First, the norm is a projected trajectory of the CA, which may no be necessarily an optimal trajectory. For postdebt relief countries, which can in principle afford accumulate new external debt to the threshold of sustainability at a faster pace than in the baseline, the CA norm may be too low, as these countries can afford higher CA deficits. For pre-debt relief countries, which need to reduce external debt at least to the sustainability threshold, this trajectory my be too high as these countries may need to run lower CA deficits or even surpluses. Second, the CA norm changes over time. This reflects mainly accumulation or reduction of debt-creating and nondebt creating liabilities in each year, as well as the fluctuations of the underlying CA. However, after temporary factors die out and the underlying CA converges to its long-term baseline projections, the dynamics of the norm starts reflecting mainly the assumption on debt-creating flows. 20.The remaining steps to calculate REER misalignment are essentially the same as under the ES approach discussed in the previous section, with two caveats: • The MB approach uses both the actual (2007) and projected (2008-2027) values of the UCA, whereas the MB approach focuses only on the 2007 UCA. The medium-term projections of the UCA deviates from the baseline CA, as during the next five years temporary factors are still active and affect CA. The long-term projections of the UCA coincide with the baseline CA as all temporary factors die off (Figure 5). Export and import elasticities are assumed the same for the medium 2027 2013 -3 2007 and long term. Although this is a -4 strong assumption, as elasticities in -5 the long run should be generally -6 -7 higher, it can be addressed by way of -8 a sensitivity test. In any case, Baseline Underlying applying for consistency the elasticities used in the ES approach, the Marshall-Lerner condition is met as the sum of price elasticities is greater that unity.
Figure 5. WAEMU: baseline and underlying current accounts
Percent of GDP
7 21.Finally, applying the elasticity to the gap between the CA norm and the underlying CA allows to establish the degree of REER misalignment for each projected year. Distinction between medium-term and long term can be again made to usefully capture the dynamic characteristics of the MB approach. In the medium term, although numerically the REER can be viewed as overvalued, the misalignment does not exceed on average 5 percent and is erratic from year to year. The magnitude of misalignment fluctuates drastically from 8 percent in 2007 to 0.2 percent in 2008, then increases and falls again. Figure 6. WAEMU: Medium term REER misalignment
10 5 0 2007 -5 -10 Underlying CA CA norm 2008 2009 2010 2011 2012 2013 (Percent left scale, percent of GDP right scale) Overvaluation
22.In the long run, accumulated misalignment accumulates and becomes clearly pronounced. On current trends and with current policies, REER overvaluation may exceed 10 percent in 2013 and continue growing thereafter reaching 15 percent. Figure 7. WAEMU: Long-term REER misalignment
(Percent, left scale; percent of GDP, right scale) 15 10 5 0
2007 2012 2017 2022 2027
Overvaluation CA norm
-5 -10 Underlying CA
23.Therefore, based on the MB approach there are early indications that the REER follows the trend, which may eventually misalign it with fundamentals. In the medium term, the MB approach points only to a modest overvaluation of 1-5 percent, which is at the margin of the confidence intervals and can not be established beyond reasonable doubts. However, in the long run the compounding exchange rate overvaluation may become substantial and misalign the REER with fundamentals by 10-15 percent presenting a risk for external stability.
9 24.References Exchange Rate Assessments: CGER Methodologies Author/Editor: Lee, Jaewoo ; Milesi-Ferretti, Gian Maria ; Ostry, Jonathan David ; Prati, Alessandro ; Ricci, Luca Antonio Series: Occasional Paper No. 261 Methodology for Current Account and Exchange Rate Assessments Author/Editor: Isard, Peter ; Faruqee, Hamid ; Kincaid, G. Russell ; Fetherston, Martin Series: Occasional Paper No. 209 Published: December 28, 2001 Exchange Rate Assessment: Extension of the Macroeconomic Balance Approach Author/Editor: Isard, Peter ; Faruqee, Hamid Series: Occasional Paper No. 167 Published: July 24, 1998
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