Macroeconomic Policy Analysis

in Low Income Countries

THE EXTERNAL
SECTOR
4-Current Account

By Dr. Mark Ellyne

 The External Sector

Goals:
Understand the balance of payments
accounts;
How they reflect real and fiscal sector
activities ,and
Be able to forecast the key elements of
the BoP.

04/22/2023 2
 I. Balance of payments
conventions and relationships

4
 Balance of Payments Accounts
Current Account Capital & Financial Acct.
 Goods  Capital Account
 Imports (-)  Capital transfers
 Exports (+)  Acquisition/disposal of non-
produced nonfinancial assets
 Financial Account
 Services  Foreign direct investment
 Portfolio investment
 Income  Other investment, net
 loans
 Remittances & Compensation
of employees  Trade credit
 Errors & omissions
 Investment income
Change in Reserves
 Gold
 Current transfers  Foreign exchange
 Official  IMF position
 Private  Exceptional financing
04/22/2023 5
 BOP Accounting Conventions

Transactions with non-residents (currency

is not the issue)
Accounting in foreign exchange (US$ or
SDR) to avoid valuation issues
Current vs Capital transactions
∆Reserves flows are policy-related
Accrual accounting, not cash

7
 BOP Accounting
Conventions

Inflow of Forex (+) Outlfow of Forex (-)

 Export  Import
 Borrowing  Lending abroad
 Debt forgiveness  Debt service
 Reduction of  Increase of reserves
reserves

04/22/2023 8
 BOP Flows

Exports Imports
$ $
Capital Repayment of
Inflow debt

Domestic
Borrowing
economy Outward FDI
& lending

$
Foreign Reserves

9
 CAB + CFA + ΔRes = 0

CAB + CFA = Overall Balance = ΔNFA

Overall Balance = ΔRes = -ΔNFA
CAB = Current Account Balance
 CFA = Capital and Financial Account, excluding
the ΔReserves.
 ΔRes = Change in official reserves, where
negative implies an increase (i.e., outflow of
foreign exchange). ΔRes = -ΔNFA
10
 External Debt &
The Current Account
CAB = -[CFA+∆Res]
Most CFA flows are debt-creating flows. Even
FDI may be though of as a foreign liability
because it may be withdrawn at later data.
The change in foreign reserves (a foreign
asset) also affects the net debt of the country.

Thus: CAB ≈ Change in net external

indebtedness
11
Trends in Current Account Balance in SSA,
1981-2013

Current Account as a percentage of GDP (line)

Source: UNCTADstat and IFS

04/22/2023 12
 SA Current Account Balance

B. Current account and trade balance

% of GDP % of GDP
6 6
Current account Trade balance
4 4

2 2

0 0

-2 -2

-4 -4

-6 -6

-8 -8
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1
07 08 09 10 11 12 13 14 15
 BOP Accounting Questions

1. How is foreign aid of free wheat

accounted?
2. A company is creating an new oil field
and sends in a drilling rig; how is it
accounted?
3. An importer only pays after 90 days—
how is it recorded?
4. What might large errors and omissions
mean?
14
 What Are Foreign Reserves

Held by Central Bank (not MoF) as

deposits offshore
Reserves should be short-term liquid
assets
ΔRes = Change in net Foreign Assets of
Central Bank
Negative implies accumulation (i.e.,
outflow of foreign exchange)
15
 Foreign Reserves and Money

ΔRes = Change in net foreign assets of

the central bank (with opposite sign)
If NFA ↑ (Reserves increase)
=> ΔRes is negative
 The CB buys foreign exchange
for local currency
 Then Ms ↑

16
 Questions

1. If foreign reserves go up, is that good?

Does money come into the country or go
out?
2. Is a current account deficit good or bad?

17
National Accounting and BOP

GDP = C + I +(X-IM)gnfs
+ Transfers + Factor Income

GNDI = C + I + CAB

18
 Meaning of S-I Balance

(Y-C–I) = CAB = -CFA

 A CA deficit implies too much consumption

and investment relative to GDP.
 A CA surplus implies too little consumption
and investment relative to GDP.
 Within overall S-I balance, who is saving and
investing: government or private sector?

04/22/2023 19
 The Twin Deficits

(S-I) can be divided into government

and private components.
Y - C – I = CAB
(Yg - Cg – Ig) + (Yp - Cp – Ip) = CAB
Gov. bal. pvt. sec. bal.

Fiscal deficit & Current account deficit are

often called the twin deficits
04/22/2023 20
 CAB and Foreign Savings

CAB = -(CFA+ ΔRes) = - Sf

The current account must be offset by
an equal and opposite position in the
CFA, which is foreign savings
SN - I = CAB = -(CFA+ ΔRes) = - Sf

04/22/2023 21
 Why do Countries Have
CA Surpluses and Deficits?
Deficit Surplus

o Excess consumption o Export boom

o Investment surge
o Commodity boom
o FDI surge
o Excess saving.
o Exchange rate
overvaluation o Exchange rate
undervaluation

04/22/2023 22
 Forecasting the BOP

Current account Capital and Financial

Account
 Trade  Foreign direct
 Services investment
Portfolio investment
 Factor incomes
Other Long-term
 Transfers capital
Disbursements
Repayments
 Short-term capital

04/22/2023 Dr. M J Ellyne 23

 Forecasting the BOP

No-policy-change scenario:
No change in the real exchange rate
(price elasticity=0), so no substitution
effect for quantity of imports and exports
demanded;
No change in donor and domestic
investment policies.

04/22/2023 24
 II. Projecting Current Account
Components

04/22/2023 25
 Projecting Trade Volumes

 In the absence of specific knowledge, we assume a

constant RER under a no-policy-change scenario.
Thus the quantity effect is all that remains.
(However, we could incorporate a
substitution/price effect if ∆RER ≠0)
Real Trade Balance:
∆NX/NX =∆X_R/X_R - ∆IM_R/IM_R - ∆RER/RER)
Quantity effect - price effect
(substitution)
26
 We Want to Projection
‘Nominal’ Trade Flows
If prices and quantities are known:
Valuei = ∑QiPi
Xt = QXt*PXt
IMt = QMt*PMt
or by growth rate
IMt/IMt-1 = [(1+%QMt)*(1+%PMt)]
 IMt = [(1+%QMt)*(1+%PMt)] Mt-1
Q growth P growth
04/22/2023 Dr. M J Ellyne 27
 Simple Import Forecast

 Oil Imports in 2012=1000 R

 Growth in oil prices = 3%
 Growth in GDP=5%
 Assume oil demand elasticity of 1.0
 What are oil imports in 2013?
(assuming no substitution effects)

04/22/2023 28
Need Quantity and Price Effect

Growth of Import value = Growth in import

quantity + Growth of import price

(1+%IM) = (1+%IM_R) * (1+%PM)

or
IM = IM_R*PM

Dr. M Ellyne – Macro Policy Analysis 29

Econometric Quantity Estimation

Import quantity demanded =

F{domestic demand, relative price}
IM_R = F{+Y, -RER}
= F{+demand, substitution}
log(IM_R) = α + β1log(Y)-β2log(RER)

demand elasticity price elasticity

30
 Defining Elasticities

Estimate elasticities from past:

Demand elasticity:
β1 = eY = %ΔIM_R/%ΔGDP_R
or assume ≈ 1

Price elasticity
β2 = eP = │%ΔIM_R/%ΔRER│<< 1
(Assume about .2 if %ΔRER known)
04/22/2023 31
 Price Elasticities Are Low
in Short-Run
Generally, most imports/exports are
relatively price inelastic in very short run
(.1 to .3, and negative for imports)
However, in the longer term (>4
quarters) can assume that sum of import
and export price elasticities ≥ 1. (Meets
Marshall-Lerner Conditions)

04/22/2023 32
 The Elasticity Approach-
No Substitution Effect
Volt= (1+eY *%DDemand)(1+eP*%DRel price)*Volt-1
Quantity Price
or Income or Substitution
Effect Effect

Quantity effect = (1 + eY*%DGDP_R)

Rel. Price effect = (1 + eP*(%DRER)
→But we assumed DRER=0
04/22/2023 33
 Forecasting Import Value
= %QIM + %PIM
Value=Quantity*Price
IM = IM_R*PM
or
IMt = (1+%DIM_R)(1+%DPM)*IMt-1
=(1+ eY %DGDP_R)(1+%DPM)*IMt-1
Effective vol change + price change

04/22/2023 34
Forecasting Imports—Assumptions

%ΔM = (nominal value in $)

+ β0 *%Δ(GDP_R) Domestic Q demand
+ β1*%ΔPMt Import Price effect
- β2*%ΔRERt Competitiveness/subst
Estimate βs or Assume:
β0 ≈ 1
β1 = 1 β2 doesn’t matter

04/22/2023 Dr. M J Ellyne 35

 What is Real Import Elasticity
for ZAM?
LOGIMPORTS = -8.868 + 1.6158*LOGRGDP - 0.675*LOGRER
Dependent Variable: LOGIMPORTS
Method: Least Squares
Date: 08/13/16 Time: 14:49
Sample: 1994 2014
Included observations: 21

Variable Coefficient Std. Error t-Statistic Prob.

C -8.868232 2.883016 -3.076026 0.0065

LOGRGDP 1.615869 0.217106 7.442758 0.0000
LOGRER -0.675130 0.270095 -2.499606 0.0223

R-squared 0.966610 Mean dependent var 7.714289

Adjusted R-squared 0.962900 S.D. dependent var 0.832406
S.E. of regression 0.160332 Akaike info criterion -0.691578
Sum squared resid 0.462714 Schwarz criterion -0.542361
Log likelihood 10.26157 Hannan-Quinn criter. -0.659194
F-statistic 260.5448 Durbin-Watson stat 0.796057
Prob(F-statistic) 0.000000

36
 Historical Decomposition

Historically, we examine the change

in value and in price for a category of
imports or exports:

%Vol = (1+%Value)/(1+%Price)-1
then calculate:
Demand Elasticity = %Vol/%RGDP

04/22/2023 Dr. M J Ellyne 37

 Historical Decomposition
to Estimate Demand Elasticity

2011 2012 2013

1. Value of Imports (kwacha) -6,454.0 -7,926.0 -9,195.0
2. %Change value imports 37.0% 22.8% 16.0%
% change in Import price ( or Parnter's
1.5% -2.2% -0.9%
3. export prices)
%change volume imports =
35.0% 25.6% 17.1%
4. (1+%IM)/(1+%PM)
5 GDP_R growth (%) 6.3% 6.7% 6.7%
Elasticity of QM to GDP_R =
5.521 3.802 2.541
6. %QM/%GDP_R

38
 Forecast of Imports
• Estimate demand elasticity of import volume to GDPR based on trend or equal to
last year.
• Multiply by GDPR growth to determine growth of IM volume
• Estimate growth in import prices (from advanced economies export prices-WEO)
• Growth in prices+growth in volume = growth in value

2011 2012 2013 2014

1. Value of Imports (kwacha) -6,454.0 -7,926.0 -9,195.0 -10,005
2. %Change value imports 37.0% 22.8% 16.0% 8.8%
% change in Import price ( or Parnter's
1.5% -2.2% -0.9% -4.3%
3. export prices)
%change volume imports =
35.0% 25.6% 17.1% 13.7%
4. (1+%IM)/(1+%PM)
5 GDP_R growth (%) 6.3% 6.7% 6.7% 6.4%
Elasticity of QM to GDP_R =
5.521 3.802 2.541 2.141
6. %QM/%GDP_R

39
 Import Components

If appropriate, break down imports into 2

or 3 main categories, and forecast each
component separately:
 Oil and raw materials
 Consumer goods – link to Consumption
 Capital goods – link to Investment

04/22/2023 Dr. M J Ellyne 40

Always Check Nominal Import
Share of GDP - SA
IM_GENI
.40

.36

.32

.28

.24

.20

.16
90 92 94 96 98 00 02 04 06 08 10 12 14

41
 Export Function

X_R = f (+Yf; REER, capacity)

Demand, Substitution,…
where:
 REER in dom/for currency
 Yf foreign demand

04/22/2023 Dr. M J Ellyne 42

 Export Demand Elasticity

Export demand elasticities:

e = %ΔX/%ΔGDP_Rf
Y

ePX = %ΔX/%ΔREER

 Assume high demand elasticity (around 1)

 Substitution effect=0 for constant REER
04/22/2023 Dr. M J Ellyne 43
 Export Value

Value=Quantity*Price
X = X_R*PX
or
Xt = (1+%DX_R)(1+%DPX)*Xt-1
= (1+ eY %DGDP_Rf)(1+%DPX)*Xt-1

04/22/2023 Dr. M J Ellyne 44

Export Forecast Using Elasticities

%ΔX =
+ β0*%Δ(foreign demand) Demand
+ β1*%ΔPworldt World Price
+ β2*%ΔRERt Competitiveness

Where
β0 =eY ≈1; β1 =ep ≈ 1 , %ΔRERt = 0
04/22/2023 Dr. M J Ellyne 45
 Trade Balance

Xt = ∑X_Rt*PXt
IMt = ∑IM_Rt*PMt

Trade Bal = Xt - IMt

04/22/2023 Dr. M J Ellyne 46

Imports and Exports of Services

1. Assume services grow at same rate

as merchandise exports or imports;
or
2. Estimate elasticity of services to
exports/imports of goods and apply
to export growth
= %∆Xservices/%∆Xgoods

04/22/2023 Dr. M J Ellyne 47

 Foreign Grants

Public (foreign aid) and Private (NGOs)

Assuming grants are politically negotiated the
trends tend to persist and only change slowly
over time relative to GDP:
Foreign Grants to Government = Use
identifiable trend or else keep constant or
declining share of GDP; Can use share shown
in budget
Private transfers = Constant or declining share
of GDP
04/22/2023 48
 Interest Income

To calculate interest paid, we need to know the

future stock of debt (discussed next lecture)
Similarly, to calculate interest received, we
need to know the future stock of foreign
reserves (discussed next week)
We calculate the past effective interest rate on
foreign balances and hold it constant or use
the US dollar libor rate from WEO.

04/22/2023 49
 Wage Remittances (net)

Assume they grow at the same rate as

foreign growth (in dollar terms) if positive
Wt+1 = Wt (1+%Yf)
Or at the rate of domestic economic growth
if negative.

04/22/2023 50
 Trade Policies

Export-led growth - Characteristic of many

successful emerging markets. Includes
increased quantities and diversification.
 Import substitution vs export promotion.
Use of high tariffs and/or quantitative
restrictions to protect domestic industries.
Tariff Policy
What is impact on competitiveness (cost)?

51
 Protectionist Arguments
Cheap labor abroad makes us
uncompetitive.
High tariffs preserve employment.
Restricting imports can reduce prices.
Domestic protection keeps money at
home.
Countries need to protect infant industries.

52
Can Protectionist Policies Work

Yes, if
 Protected industry has the ability to be
competitive globally,
Protected industry aids vertical integration
Protection does not hurt export
competitiveness

53
 Potential Problems with
Import Substitution
Goals of Protection
Protect jobs
Raise fiscal revenue
Frequent Results
Raises price level of goods
Overvalues exchange rate
IM-subtitution industries drain resources from
export industries
Exports may become less competitive
54
End of Lecture 4

55
Macroeconomic Policy Analysis
in Low Income Countries

THE EXTERNAL
SECTOR
5-Capital and Financial
Account

By Dr. Mark Ellyne

 What Drives the Capital Flows

May be a policy-related flow, like

government borrowing for the public
investment programme; or
May be driven by financial incentives, like
the interest rate differential (or expected
future growth).

57
Exchange Rate Asset Price Theory

Interest Rate Parity -

An Asset Approach
to Capital Flows

58
 Domestic vs Foreign Assets

Compare asset earnings in a single

currency

Arbitrage: If it is possible to earn more

interest in a comparable bond in SA than
in the USA then money should flow into SA
and affect the expected future exchange
rate to offset that interest differential

59
Covered Interest Parity (CIP)

Convert 1 Rand to US$ and

invest at ius =1/St*(1+ius)
Convert back to Rand at forward rate, F:
=1/St*(1+ius)*Ft
This will be equal to
investing in Rand at iza
1/St*(1+ius)*Ft ≈ (1+iza)
Otherwise arbitrage will be profitable
Spot (NER) and Forward in Rand/$ 60
 Testing Covered Interest Parity

IF: Ft/St ≈ (1+it)/(1+ift)

Log(F) – log(S) = log(1+it)- log(1+ift)
f s i if
THEN: f- s = a + b (i – if)
Test if a=0 and b=1
Evidence holds
Forward premium=interest rate differential
S and F in domestic/foreign currency
Applicable to open capital markets where assets are perfect substitutes 61
 Uncovered Interest Rate Parity
Under rational expectations, the interest rate differential
similarly reflects the relationship between the spot rate and the
expected/future spot rate:
E{St+1}/S = (1+i)/(1+if)
Or
E {%∆St+1} ≈ it - ift

Expected % change in XR = interest rate differential

And if markets are efficient:
Et {XRt+1} = XRt+1 = Ft + εt
S in domestic/foreign currency
62
 Testing UIP

Under rational expectations:

E {%∆St+1} = ∆St+1
E {%∆St+1} = it - ift = ∆St+1

Then: %∆St+1 = a + b (i – if)

Test if a=0 and b=1
Evidence does not support

63
 Why UIP Does Not Usually Hold

 Infinite number of factors can come into play

that determine the future exchange rate.
 Interest differential is predominately used for
setting the forward rate used by banks.
 Transactions costs are relatively large.
 Testing with data is difficult because of the
timing of the data, ie. average monthly, end of
period, …

64
 The Exchange Rate and
Interest Rate Policy
E{St+1}/St -1 = i – if
What happens if negative news influences
expectations of S?
What happens if central bank raises i?

S=NER in domestic/foreign currency = R/$

Decrease = appreciation

65
5-Forecasting the Capital Account
Capital & Financial Acct.
 Capital Account
 Capital grants
 Financial Account
 Foreign direct investment
 Portfolio investment
 Other investment, net
 Loan disbursement
 -Amortization
 Trade credit, net
 Errors & omissions
Change in Reserves
 Foreign exchange
 IMF position

04/22/2023 Dr. M J Ellyne 66

 Capital Grants

These are largely project grants to

government*
Function of domestic policy as well as
foreign donors’ ability to pay.
See if Capital Grants/GDP$ is constant or
predictable
*records acquisitions and disposals of nonfinancial assets, such as
land sold to embassies and sales of leases and licenses, as well as
capital transfers (i.e., the provision of money without anything of
economic value being supplied inreturn).

04/22/2023 Dr. M J Ellyne 67

 Foreign Direct Investment:

See if there is identifiable short-term trend

or policy, otherwise
assume to be a constant or decling share
of GDP.
Work on net FDI, assuming that outward
FDI is small

68
 Portfolio Investment

Only significant in emerging markets and a few

others (Zambia, South Africa)
Base projection on share of GDP
Keep in mind if there is a significant difference
in the real interest rate differential vs USA:
Δ[rsa-rus] = Δ(isa-πsa)- Δ(ius-πus)
[= Δ(isa-ius) + Δ(πus-πsa)]
 What is the impact of a positive change in the
real interest rate?

04/22/2023 69
 L-T Loan Disbursements

 Government foreign borrowing must be

reflected in BOP.
 Government has target level of public capital
investment, part of which is financed
externally and remainder is borrowed
domestically. Can assume foreign borrowing
is a constant or declining share of GDP.
 Private loans: Project as share of GDP; but
may be zero for most LICs

04/22/2023 70
 Amortization

 Base the future amortization rate (=a)

on the past amortization rates,
a = Amortt-1/Debtt-1;
or
 Assume 20 year amortization rate
Amortt+1 = .05 Debtt

04/22/2023 Dr. M J Ellyne 71

 Calculating the Stock of
External Debt
Must keep track of stock of debt (at end
of period):
Dt+1= Dt +Disbursementt+1 - Amortt+1 –
Forgivenesst+1
Calculate Dt+1/GDPt+1 ratio

Dt = Debt at end of period t

04/22/2023 72
 Amortization Exercise?

If stock of debt is $1800 in 2012 and

average maturity is 20 years, how
much will be repaid in 2013?
If government borrows $100 in 2013,
what is new stock of debt at end-
2013?
=1800 – 1800/20 + 100 = 1810

04/22/2023 73
 Interest on Government Debt
Calculate the average ‘effective’
interest rate on government debt or
use libor+.5%
it-1$avg = Interestt-1/ExDebtt-2
Apply last period’s interest rate to debt
this period
Interest costt+1 = i$avg*Debtt
04/22/2023 74
 Interest Exercise

If stock of debt is $1800 in 2012

average maturity is 20 years,
government borrows $100 in 2013,
and current US$ libor is 1%.
How much interest will be paid in
2013?

04/22/2023 Dr. M J Ellyne 75

 Other S-T Capital

Other S-T private flows are generally due

to banking flows and trade credits and
might be thought of as working capital.
Thus, one strategy is to keep them as
constant share of $GDP or of
exports/imports
They are very difficult to predict.

04/22/2023 76
 Errors & Omissions

This is the balancing item for historical

data after all other data are recorded.
There can be no future E&O (=0)
If E&O has been consistently large in the
past, then treat it as part of S-T capital
flows for the future.

04/22/2023 77
 Change in Foreign Reserves

 The change in foreign reserves is equal to

the negative of the overall balance.
IMF disbursements and repayments are
part of Change in Reserves, ie IMF
finances part of BOP deficit
Check to see if there is any trend in the
overall balance, i.e. is it sustainable?

04/22/2023 78
 Stock of Foreign Reserves

Foreign $Reservest+1
= Foreign Reservest
+ Change in Reservest+1

Calculate Import Cover in months

= Foreign Reserves/(Imports/12)

04/22/2023 Dr. M J Ellyne 79

 Foreign Reserves Exercise

If foreign reserves at end-2014 are

US$825 million and the overall BOP
balance is -US$125 million in 2015, what
is the level of foreign reserves at end-
2015?
How much interest is earned on foreign
reserves:
= i$libor*Foreign Reservest-1

04/22/2023 80
 Implications of Projected BOP

If future projections for the “no-policy-

change” scenario indicate declining
reserves, what does this mean in regard to
the exchange rate? How could it be fixed?
What would be the meaning of strongly
rising foreign reserves?

04/22/2023 81
 Is the BOP Sustainable?

Can the current account be sustainably

financed by the capital account?
Do foreign reserves (stock) in months of
imports gnfs remain sustainable (is at least
3 months)?
Is Debt/GDP stable and <50%
Is Debt service/exports is stable or falling

04/22/2023 82
Exchange Rate Regimes

Fixed (to another currency)

.
.
.
(Independently) Floating

83
 Implications of Floating Rate

Free float – Central bank controls money

supply or the interest rate and does not
intervene in foreign exchange market, i.e.,
does not buy or sell foreign reserves.
Managed float with no predetermined
path – Central Bank may intervene in
foreign exchange market, but no exchange
rate target.

84
Fixed Exchange Rate Regimes

 A Fixed exchange rate between a

country's currency and an "anchor
currency,"
 Automatic convertibility guaranteed
by central bank
 A long-term commitment to the peg

85
 How to Hold a Peg?

At equilibrium, the foreign exchange

inflows cover the foreign exchange outflow
at the fixed exchange rate
What happens if a shock temporarily
raises the demand for foreign exchange?
Where does the extra foreign exchange
come from?

86
 Implications of Peg

Exchange Rate remains fixed but no

control over the level of foreign reserves
(NFA) changes (which means loss of
control over money supply)
i.e., Central Bank choses control over
exchange rate as opposed to money
supply

87
Alternative Exchange Rate Regimes

(From most fixed)

Arrangements with no separate legal
tender (e.g. dollarization) – loss of
monetary policy (e.g. Zimbabwe)

88
Declared Exchange Rate Regimes-
2011
No. of independent currencies – 13
Currency Boards – 12
Pegged – 43
Crawl like peg - 15
Managed float - 35
Independent float – 31
Source: IMF AREAER, 2011

91
 Impossible Trinity

In an environment of free capital mobility,

it is either possible to maintain a fixed
exchange rate or an independent
monetary policy, but not both.

93
 Given Capital Mobility?

If the exchange rate is fixed to a partner

currency (like Namibia $ to rand), can you
change the local interest rate to manage
the domestic economy?

94
 Policy Choice for
Inflation Control
Capital Mobility

Fixed Exchange
Independent
Monetary Policy, r < or > Rate, or
monetary union

Both aim at
inflation control

95
 Alternative Policy Anchors

Inflation Targeting means using the

interest rate to fight inflation, while leaving
the exchange rate to float.
alternatively
Fixing the exchange rate to a low inflation
partner currency locks in the inflation to
that of the partner and requires similar
interest rates; e.g. EU or Zimbabwe

96
Can we set both the interest rate
and exchange rate?
In a highly controlled economy with a
closed capital account and the current
account mostly under government control
(for imports and exports), it could be
possible to set your own exchange rate
and own interest rates since the interest
will not affect capital flows. (e.g. North
Korea, former USSR, China?)

97
 What Are Exchange Controls

Payment restrictions (for foreign

exchange) on current account and/or
capital account transactions
Aimed at residents and/or
nonresidents
Aimed at inflows and/or outflows

99
 Reviving Capital Controls
to Manage Crises
IMF has recently expressed concerns
about orderly liberalisation of capital
controls by systemically important
emerging markets, like China and India.
Fund embraces “Capital Flow Measures,”
including capital controls and prudential
measures on a temporary basis, to
dampen the impact of capital flows.

100
 What You Should Know

 Structure of balance of payments

accounting
 Linkage to real sector
 Be able to project the BoP accounts
 And diagnose BOP problems

101
 What You Should Know

Understand the components of the capital

and financial account, and what drives
capital flows and how to estimate such
flows.
Difference between fixed and floating
exchange rate regimes

102
 Additional Issues

Global imbalance
Is China manipulating its currency?

103
 The Global Imbalances Issue

The exchange rate should adjust to ensure the

tendency toward current account balance, so
country’s current account balance cycles
around 0 for stability.
Sustained deficits (or surpluses) for long
periods indicate some other serious structural
problem.

2012/16/27 104
 Persistent Current Account
Surpluses And Deficits are a Problem

2012/16/27 105
To 10 Surplus Countries
(IMF)

106
Top 10 Deficit Countries
(IMF)

107
 Implications of
Current Account Balance
Current account Deficit → capital account
borrower, or debtor
(and vice versa: Surplus → Creditor)
Deficit → Currency depreciates
[Surplus → Currency appreciates]

 But what about China and USA?

2012/16/27 108
 China - USA Symbiosis

China has large surpluses so its currency

should appreciate
China loans USA large amounts of money
(by buying US government treasury bills)
to continue trade imbalance without
adjusting
And, China’s exchange rate is fixed to
US$

2012/16/27 109
 Is China Adjusting
US$ bn Res/GDP
3,500 China: Foreign Reserves 0.60

3,000
0.50

2,500
0.40

2,000
Reserves/GDP 0.30
1,500 (left) $ Reserves
(right) 0.20
1,000

0.10
500

0 0.00
1980 Q1 1982 Q4 1985 Q3 1988 Q2 1991 Q1 1993 Q4 1996 Q3 1999 Q2 2002 Q1 2004 Q4 2007 Q3 2010 Q2

2012/16/27 110
 Is China Adjusting?

US$/Yuan China: Exchange Rate, US$/Yuan

(Down=Depreciation)
0.80

0.70

0.60

0.50

0.40

0.30

0.20

0.10

0.00
1980 Q1 1982 Q4 1985 Q3 1988 Q2 1991 Q1 1993 Q4 1996 Q3 1999 Q2 2002 Q1 2004 Q4 2007 Q3 2010 Q2

2012/16/27 111
 Is China Helping or Hurting Us?

Persistent large surplus → exports are too

cheap?

Who receives the benefits?

2012/16/27 112