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Mr. Alessandro Prati, Mr. Luca A Ricci, Lone Engbo Christiansen, Mr. Stephen Tokarick, and Mr. Thierry Tressel

Abstract

This paper empirically investigates the external balance of low-income countries (LICs) by offering a coherent analysis of determinants of medium- to long-term real exchange rates, current accounts, and net foreign assets, and by emphasizing factors that are more likely to be specific to LICs.1 The rise and persistence of large external imbalances in recent years have renewed interest in this area from both empirical and theoretical perspectives, and have also highlighted the need for a multi-pronged approach to the analysis of external balances based on multiple indicators. In this paper, the simultaneous analysis of the three indicators of external balance allows the consistency of the results across indicators to be checked, an effort generally absent in the literature. The focus on LICs aims at filling another gap. Although the literature on the determinants of the real exchange rate and of the current account is vast, few contributions focus specifically on LICs, or account for features that are specific to—or more important for—this set of countries. This analysis emphasizes factors such as structural policy and institutional distortions, access to special external financing, and a larger macroeconomic sensitivity to exogenous shocks. The empirical analysis required extensive efforts to create a wide database, covering a unique set of indicators and economies.

Mr. Alessandro Prati, Mr. Luca A Ricci, Lone Engbo Christiansen, Mr. Stephen Tokarick, and Mr. Thierry Tressel

Abstract

This chapter reviews the determinants of the real effective exchange rate and of the current account, with particular emphasis on factors that play an important role for lower-income countries. Toward the end of the chapter, the more limited literature on the determinants of net foreign assets (which generally follows similar intuitions as for the current account) is discussed. The main emphasis of this review is on the theoretical arguments that guide the empirical analysis, but it also highlights the empirical contributions related to each conceptual argument to ease comparison with the results of this analysis. Potential determinants are classified into four main groups: (1) main determinants identified in the literature; (2) structural policies, distortions, and institutions; (3) shocks; and (4) external financing.

Mr. Alessandro Prati, Mr. Luca A Ricci, Lone Engbo Christiansen, Mr. Stephen Tokarick, and Mr. Thierry Tressel

Abstract

This chapter analyzes the medium-term relationship between the current account and a set of fundamentals. Following the existing literature, the estimations consist of ordinary least squares or fixed-effect regressions for an unbalanced panel of nonoverlapping, four-year averages over the period 1981–2005 with six observations for most countries.2 The variables in the regressions are generally stationary. Also, the current account needs to be stationary for the intertemporal budget constraint to hold (Ghosh and Ostry, 1997).

Mr. Alessandro Prati, Mr. Luca A Ricci, Lone Engbo Christiansen, Mr. Stephen Tokarick, and Mr. Thierry Tressel

Abstract

This chapter investigates the long-run relationship between the real effective exchange rate and a set of fundamentals. The estimation relies on an unbalanced panel of annual data covering 1980–2006. Panel unit root tests show the unit root nature of the variables involved in the estimation, apart from the natural shocks (Table 4.1). Panel cointegration tests have been performed for the benchmark regressions of interest (columns 3 in Tables 4.2 and 4.3) and reject the null of no cointegration.2 Under the assumption of I(1) cointegrated variables, dynamic ordinary least squares (DOLS) with fixed effects regression provides—from the coefficients of the variables in levels—an estimate of the long-run cointegrating relationship between the real exchange rate and the set of fundamentals. As part of the DOLS specification, in addition to the variables in levels, the analysis introduces changes in right-hand-side variables and—given the short length of the sample—one lead and one lag of these changes.3

Mr. Alessandro Prati, Mr. Luca A Ricci, Lone Engbo Christiansen, Mr. Stephen Tokarick, and Mr. Thierry Tressel

Abstract

This chapter empirically investigates the net foreign assets position of low-income countries. The estimation relies on an unbalanced panel of annual data covering 1980–2006. As with the real exchange rate, panel unit root tests confirm the unit root nature of the variables involved in the estimation (see Table 4.1 in Chapter 4); and panel cointegration tests performed for the benchmark regressions (Table 5.1, column 1) reject the null hypothesis of no cointegration (see discussion of these tests in Chapter 4). Similar to the real exchange rate regressions, the panel cointegration estimation is based on dynamic ordinary least squares with fixed effects. In addition to determinants identified in the literature (public debt, demographics, and income per capita), the analysis considers the role of policy distortions (capital account and domestic financial liberalization) and of the quality of institutions.2

Mr. Alessandro Prati, Mr. Luca A Ricci, Lone Engbo Christiansen, Mr. Stephen Tokarick, and Mr. Thierry Tressel

Abstract

This chapter sets out the details of a methodology that can be used to calculate export supply and import demand elasticities without using econometrics. There is a long tradition in estimating trade elasticities (see Stern, Francis, and Schumacher, 1976; and Khan and Goldstein, 1985, for surveys) and the magnitude of the estimates varies widely (in some instances the signs of the estimates are contrary to theory). Most estimates in the literature are based on empirical work done on advanced economies. Many fewer studies focus on developing countries given the generally poor quality of data on trade volumes and prices in these countries, as well as the sometimes volatile behavior of economic variables.

Mr. Alessandro Prati, Mr. Luca A Ricci, Lone Engbo Christiansen, Mr. Stephen Tokarick, and Mr. Thierry Tressel

Abstract

Chapters 1 and 2 of this paper discussed the macrobalance approach, which is one method a researcher can use to determine the extent to which a country’s current account balance deviates from its long-run, sustainable value. Once the magnitude of any change in the current account is estimated, one would then like to know how changes in a country’s exchange rate would close any gap between the level of the actual current account and its long-run sustainable value. Changes in exchange rates alter prices and trade flows, and Chapter 6 described this relationship—elasticities of demand and supply for exports and imports. This chapter describes how those trade elasticities can be used to estimate how a change in a country’s exchange rate affects its trade balance—a key component of its current account. The chapter also explains the conditions that must be satisfied in order for various types of exchange rate changes to have desired impacts on the trade balance. In particular, under what circumstances will a depreciation improve the trade balance and the current account? In general, it will depend on the values of the trade elasticities. This chapter also presents estimates of how changes in exchange rates affect the trade balances of about 150 countries, using the elasticity values discussed in Chapter 6.

Ms. Catherine A Pattillo, Mr. Andrew Berg, Mr. Gian M Milesi-Ferretti, and Mr. Eduardo Borensztein

Abstract

Recent years have witnessed an increase in the frequency of currency and balance of payments crises in developing countries. More important, the crises have become more virulent, have caused widespread disruption to other developing countries, and have even had repercussions on advanced economies. To predict crises, their causes must be clearly understood. Two competing strands of theories are reviewed in this paper. The first focuses on the consequences of such policies as excessive credit growth in provoking depletion of foreign exchange reserves and making a devaluation enevitable. The second emphasizes the trade-offs between internal and external balance that the policymaker faces in defending a peg.

Mr. Eduardo Borensztein, James M. Boughton, Anandarup Ray, Bahram Nowzad, Robert Wade, and Alan A. Tait

This paper examines the policy implications of structural changes in financial markets. Domestic financial markets have become less segmented, and the major financial centers more integrated. At the same time, the structural changes in financial markets have improved efficiency by lowering intermediation costs, increasing the ability to hedge financial risks associated with currency, interest rate, and price volatility and opening up access to new sources of savings. The widespread application of computer and telecommunications technology to financial markets has permitted markets to process a significantly larger volume of transactions.