- Alessandro Prati, Luca Ricci, Lone Engbo Christiansen, Stephen Tokarick, and Thierry Tressel
- Published Date:
- March 2011
©2011 International Monetary Fund
Production: IMF Multimedia Services Division Typesetting: Julio R. Prego
External Performance in Low-Income Countries / Alessandro Prati … [et al.] –
Washington, D.C. : International Monetary Fund, c2011.
p. ; cm. — (Occasional paper ; 272)
Includes bibliographical references.
1. Balance of payments – Developing countries. 2. Foreign exchange rates — Developing countries. 3. Balance of trade — Developing countries. I. Prati, Alessandro, 1961– II. International Monetary Fund. III. Series: Occasional paper (International Monetary Fund) ; no. 272.
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Assessments of exchange rate misalignments and external imbalances have become more prominent in the daily work of the International Monetary Fund, with frequent application to virtually every country. However, undertaking an external assessment for low-income countries (LICs) remains challenging because they have received limited attention in the literature—in part because of lack of data—and methodologies developed for advanced economies and emerging markets cannot be automatically applied to LICs. LICs are likely to be characterized by different policies, heavier distortions in the financial sector, lower access to official external financing, higher sensitivity to exogenous shocks, and different composition of external trade. While an earlier IMF Occasional Paper (Lee and others, 2008) summarizes methodologies available for an external assessment in advanced economies and emerging markets, this paper extends the analysis to LICs.
More precisely, this paper offers estimates of the relationship between the real effective exchange rate, the current account, and the net external assets position and a set of fundamentals in the medium to long term, with particular emphasis on LICs. The lack of attention paid to these countries has often been justified by data limitations, which led us to build a large database, unique in the set of indicators and number of countries it covers. Despite extensive data-collection efforts, this study still lacks wide coverage for many indicators, thus highlighting the need for further efforts to improve data production and quality control.
We find that the same broad set of economic fundamentals coherently explains the three external indicators in LICs. We also find that medium-term determinants of LICs’ external balances are somewhat different from standard determinants found in the literature. In addition to standard determinants, aid flows (grants and concessional loans), domestic financial liberalization, the removal of capital account controls, shocks (terms of trade, natural disasters), demographic measures, and the quality of institutions have a significant impact on the indicators of external balances of LICs. The results are generally consistent across methodologies and—for standard economic indicators—are mainly in line with the existing literature. The paper also derives a new measure of trade elasticities, which is important in gauging the coherence of exchange rate assessments based on the three external indicators.
The main results for LICs are innovative and interesting. Domestic financial liberalization tends to be associated with higher current account balances and net foreign assets positions, suggesting a positive effect on domestic saving. Capital account liberalization tends to be associated with lower current account and net foreign assets 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, open) 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 tends to be associated with a more depreciated real exchange rate in the long run, a result that may reflect larger productivity gains in the nontradable relative to the tradable sector (however, given that government consumption is controlled for in the regression and has a positive coefficient, the overall effect of aid on the real exchange rate, including the channel via government consumption, would be smaller in absolute value or may even be positive).
This paper is the result of an IMF Research Department project on external performance in low-income countries. Peter Pedroni has been an impressive consultant for the project, and the authors are grateful for the invaluable help he offered through extensive support, discussions, and advice. The authors are also grateful to Oya Celaysun for her views on issues related to the net foreign assets in LICs. We benefited from discussions with and comments from Andy Berg, Olivier Blanchard, Nicolas Courdacier, Atish Ghosh, Michael Klein, Nelson Mark, Peter Montiel, Jonathan D. Ostry, Antonio Spilimbergo, Kenneth West, other colleagues at the IMF, and participants in the 2009 National Bureau of Economic Research International Seminar on Macroeconomics. Freddy Cama and Murad Omoev offered excellent and patient research assistance. We are grateful to Ibrahim Levent and his team at the World Bank for kindly sharing the net present value calculation for debt indicators (the World Bank does not guarantee the accuracy of the data and accepts no responsibility for any consequence of their use). The authors are grateful to Aygul Evdokimova, Tracey Lookadoo, and Cristina Quintos for administrative assistance and to Joanne Blake and David Einhorn for editing and coordinating production of the publication.
The opinions expressed in this paper are those of the authors and do not necessarily reflect the views of the national authorities, the IMF, or IMF Executive Directors.
In memory of our friend and colleague Alessandro Prati, who passed away on June 21, 2009. His intellectual depth was and will remain a vast source of inspiration to all of us. His careful analysis, sharp intuition, and relentless curiosity guided the search for most of the new results offered in this paper, and for many more insights that remain on the research agenda.