VIII. A Medium-Term Macroeconomic Projection
Author:
John R. Karlik
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Mr. Michael W. Bell
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M. Martin https://isni.org/isni/0000000404811396 International Monetary Fund

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S. Rajcoomar https://isni.org/isni/0000000404811396 International Monetary Fund

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Charles Adair Sisson
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Language:
English
Print Publication Date:
26 May 1996
Keywords:
BOOK; government; net; policy; Sri Lanka rupee; savings-investment balance; gross investment; net credit; SDR exchange rate; Monetary base; Inflation; Commercial banks; Private investment
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Abstract

This chapter presents a framework for constructing a medium-term macroeconomic projection for Sri Lanka that is an extension of the framework presented thus far in these workshops. For several reasons, a medium-term projection is a useful addition to the one-year forecasts designed to gauge the impact of a given set of policy initiatives during the program year (1991).

1. A Framework for Medium-Term Projections

a. The uses of medium-term projections

This chapter presents a framework for constructing a medium-term macroeconomic projection for Sri Lanka that is an extension of the framework presented thus far in these workshops. For several reasons, a medium-term projection is a useful addition to the one-year forecasts designed to gauge the impact of a given set of policy initiatives during the program year (1991).

First, a medium-term projection helps to determine whether the policy package designed for 1991 is viable for the next several years, primarily in terms of the evolution of the balance of payments and external debt indicators.

Second, it is useful in assessing the appropriateness of adjustment measures. For instance, if a deterioration in the terms of trade is expected to be temporary, then the required adjustments can be less demanding than they would be otherwise.

Third, a medium-term projection can help set appropriate development goals for an economy. The following framework includes not only projections for the balance of payments and for debt servicing obligations but also a forecast of government operations and a monetary survey projected over 1991–95. Thus, given the external current account and the government’s saving-investment balance, an analyst can assess the implications for private sector resources and calculate private sector investment and saving requirements consistent with any target growth rate (Figure 8.1). The monetary survey and balance of payments projections can be used to evaluate the adequacy of the financing available from the banking system and abroad in light of private investment targets. The analyst can then determine whether the targets are too ambitious and need to be adjusted downward or whether structural changes (for example, to increase the productivity of investment or to alter the government’s role in the economy) will make even ambitious goals consistent with lower rates of private investment and saving.

Figure 8.1.
Figure 8.1.

Saving and Investment in the Medium–Term Forecasting Framework1

1 For a complete graphical representation of linkages among sectors, see Figure 2.2, “The Macroeconomic Accounts and Their Interrelations.”

Fourth, a medium-term framework enables the analyst to weigh the trade-offs among competing goals through sensitivity analysis and to determine, under alternative scenarios, how much must be sacrificed in one area in order to meet a target in another. Policymakers can then decide on the appropriate configuration of policies according to their own preferences.

b. The baseline scenario, the 1991 program scenario, and medium-term structural change

An important aim of the medium-term forecast is to determine whether (i) improvements resulting from the initiatives undertaken in the baseline and program scenarios will endure beyond 1991, or (ii) Sri Lanka’s macroeconomic situation will again deteriorate, perhaps because of factors the 1991 policy initiatives did not anticipate.1

The numerical projections shown in the tables are for illustrative purposes only; readers should substitute their own projections, making changes in methodology where appropriate. The 1991 balance of payments, fiscal, and monetary sector forecasts developed under the program scenario are to be substituted for the illustrative examples given. The same methodology used to forecast the program scenario for 1991 can then be used to extend the projections over the next four years, making it possible to determine whether maintaining the 1991 policy initiatives will yield a satisfactory outcome in 1992–95 with regard to real growth, inflation, external reserves, and foreign debt. Additional initiatives to promote structural change over the medium term will be required if the economy cannot maintain a satisfactory growth rate, if the program does not reduce inflation to an acceptable level, if reserves fall too low, or if the debt service and debt-to-GDP ratios persist in rising.

c. How the framework is organized

The framework consists of a set of interlinked tables. All of the calculations can be performed with a hand calculator; however, the sensitivity analysis is most easily performed with Lotus 1–2–3 (a diskette is available). The seven tables for Sri Lanka during 1990–95 are as follows:

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Table 8.1.

Sri Lanka: Medium–Term Framework (Targets, Constraints, External Environment, and Policy Tools), 1990–95

(In percentage change, unless otherwise noted)

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Source: IMF staff.
Table 8.2.

Sri Lanka: Export and Import Projections, 1990–95

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Source: IMF staff. PCH = Percentage change XUV = Export unit value ENSA = Exchange rate, SL rupees/SDR, annual average MUV = Import unit value XVOL = Export volume MVOL = Import volume WPI = Wholesale price index
Table 8.3.

Sri Lanka: Debt and Debt Service Projections, 1990–95

(In millions of SDRs)

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Source: IMF staff.
Table 8.4.

Sri Lanka: Balance of Payments Projections, 1990–95

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Source: IMF staff.
Table 8.5.

Sri Lanka: Projections of Central Government Operations, 1990–95

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Source: IMF staff.
Table 8.6.

Sri Lanka: Saving and Investment Relationship, 1986–95 1

(As percent of GDP)

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Source: IMF staff.

Steps in construction of savings–investment relationship, as percent of GDP, 1991–95:

a. From balance of payments, external current account balance;

b. From government operations, government fixed investment;

c. From government operations, government savings = current revenue + grants – current expenditure – capital transfers;

d. Private savings–investment balance derived as residual;

e. Total investment requirement = target growth rate × ICOR;

f. Private gross investment requirement = total investment – government investment; and

g. Private saving derived as residual.

Question: Is implied private saving/GDP ratio achievable?

1/(S–I)p + (S–I)G = CAB

Table 8.7.

Sri Lanka: Monetary Survey, 1990–95

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Source: IMF staff.

The first table drives the remainder of the framework. If the framework is run in Lotus, and if the targets, constraints, or policy tools are changed, the tables and their outcomes will need to be recalculated accordingly. The targets in Table 8.1 are the desired growth and inflation rates. The constraint relates to the productivity of investment, as measured by the incremental capital-output ratio (ICOR).

Selected lines from the External Environment Table (Table 5.8) in Chapter V are reproduced in Table 8.1 as the primary components of the external environment.

The policy tools that can be adjusted in this framework are central government current revenue, current expenditure, capital expenditure, and net lending, as well as the Sri Lanka rupee/SDR exchange rate. In the example provided, it is assumed that the real effective exchange rate remains constant and that the SL rupee/SDR rate is depreciated annually by the percentage increase in wholesale domestic prices divided by the percentage increase in unit labor costs in trading partner countries.2 Anyone using the framework may substitute an alternative method of calculating a constant real effective exchange rate or may alter the price competitiveness of Sri Lanka according to preference. One test of policy asks whether, given world market price increases and a schedule of rupee depreciation (and consequently of increases in the prices of imported goods denominated in rupees), the growth of broad money is sufficiently restrained to accomplish the targeted progressive reduction in inflation. This proposition is tested in the lower portion of the monetary survey table (Table 8.7).

An intermediate target is the maximum interest rate commercial banks pay on 12-month deposits (FIDR). Over 1986–90, the fiscal and monetary authorities conducted public borrowing and monetary supply operations in a manner calculated to maintain the maximum bank deposit rate, on average, approximately 15 percent above the Consumer Price Index (CPI) inflation rate. In the example, this relationship is presumed to continue over 1991–95.

Table 8.2 presents the details of trade projections. The forecasts for exports are based on equation 5.8 in the balance of payments forecasting chapter and those for imports (initially) on equation 5.9. However, the import equation implies an unchanged average propensity to import, which seems implausible in the light of the tariff reductions and reforms scheduled for completion in early 1991, despite the rupee depreciation. Consequently, projecting imports requires the analyst to incorporate a subjective judgment that embodies a gradually rising import propensity. As noted in section 2, the analyst should insert the previously prepared trade projection under the 1991 policy scenario and apply the forecasting methodology used to develop that scenario to the 1992–95 projections. In this way, the sustainability of the 1991 policy scenario can be appraised over the medium term. The output in Table 8.2 determines the trade balance in Table 8.4, which presents the full balance of payments.

External debt outstanding and debt service are calculated in Table 8.3. Medium-and long-term debt are separated according to the terms—either concessional or nonconcessional—under which credits have been extended. Disbursements of each type of debt for 1991 can be taken from the balance of payments projection for that year. In the example, government and private medium- and long-term disbursements during 1991–95 grow gradually, continuing historical trends. The amortization of nonconcessional debt contracted during 1991–94 is assumed to be distributed equally over the next five years; concessional credits do not involve any amortization during the forecast period.

Interest rates on external debt are linked to actual rates in 1990, when the average rate on all nonconcessional debt (including short-term debt) was 8.8 percent, and to the projection for the U.S. dollar 6-month LIBOR (London Interbank Offered Rate) provided in the World Economic Outlook (WEO) for the external environment.3 Different fixed spreads over LIBOR are assumed for short- and long-term nonconcessional debt. The interest rate on concessional debt is assumed to remain unchanged from 1990. Interest payments are calculated separately in Table 8.3 on average concessional and nonconcessional debt outstanding each year, and the total appears under the current account portion of Table 8.4.

The remaining items of the balance of payments projections provided in Table 8.4 require some explanation. Port, transportation, and insurance receipts and payments are fixed percentages of exports and imports, based on historical performance. Travel receipts are projected to grow annually by a given rate and travel payments by a fixed amount. Above a set amount, interest receipts are related to the size of the average annual gross stock of foreign exchange reserves. Profits and dividends and other services are expected to grow only modestly from the 1990 level. Private unrequited transfers are projected to continue growing through 1993; thereafter, Sri Lanka’s accelerating growth is expected to create some reverse migration and a modest downturn in private transfers. Net official transfers are seen as first declining somewhat and then stabilizing.

Medium- and long-term capital flow projections have been explained earlier in this section, with the exception of direct investment, which is projected to continue at historically low levels until the civil conflict is resolved and then to approach previous levels. Net private short-term inflows will drop initially from the unusually high 1990 level and then grow gradually.

In this example, which users should replace with their own balance of payments projections, the current account deteriorates from a deficit of 3 percent of GDP in 1990 to over 5 percent of GDP in 1992, primarily in response to an adverse movement in the terms of trade, and improves marginally thereafter to a 4 percent deficit in 1995. Net capital inflows grow gradually, but the debt service ratio peaks in 1992 and falls by about 3 percentage points by 1995. Nevertheless, a severe imbalance occurs, as illustrated by the movement in gross external reserves, which are exhausted in 1992.

The projection of central government operations presented in Table 8.5 is neutral, in the sense that revenues and current expenditures expand by the targeted real growth rate compounded by CPI inflation. Capital expenditures and net lending increase by nominal GDP. In proportion to GDP, changes are small and no reallocation decisions are evident. Over 1986–90, financing from the banking system to the central government averaged 1.4 percent of GDP; this relationship is maintained in the illustrative projection. As with the balance of payments, users should replace this neutral example with their own projection of government operations.

The saving-investment relationship that emerges from these sectoral projections is presented in Table 8.6. The detailed steps in constructing this table are listed in its lower portion. An estimated ICOR can be used to calculate the total investment requirement and hence the requirement for private investment and private saving. The ICOR estimates can be prepared in several different ways, sometimes with divergent results. The estimate used in the example is calculated in a manner that parallels its use. Over 1986–90, gross investment as a proportion of nominal GDP averaged 22.8 percent. From a base of SL Rs 114,846 million in 1985 at constant prices, real GDP grew at an average annual compound rate of 3.4 percent over 1986–90. Calculated as the quotient of these two percentages, the ICOR is 6.7 and is used for each year to derive nominal total gross investment as a percentage of nominal GDP. The ICOR is susceptible to change from structural measures. Users should alter this ratio based on their assessment not only of the impact of policy measures adopted under the program but of other factors, such as more stable social conditions and improved national security.

A monetary survey is presented in Table 8.7. Net foreign assets are derived from the overall balance of payments (as projected in Table 8.4) and from the projected SL rupee/SDR exchange rate. The year-end exchange rates for 1990–94 are the averages of annual average rates, as given in Table 8.2. The balance of payments outcome is assumed to be reflected exclusively in the net foreign reserve position of the monetary authorities; the net foreign assets of the commercial banks increase in rupees only as a consequence of depreciation of the exchange rate.

Net credit from the banking system to the central government reflects the assumption incorporated in the government operations table. Credit to public corporations increases by the same average annual compound rate as in 1986–90. Other items (net) is assumed to increase by the same percentage as broad money, net of the offset to the change in net foreign assets due to rupee depreciation, as explained in Chapter II, section 6.

Broad money is projected on the basis of the percentage increase in the demand for real monetary balances (determined according to equation 7.4), compounded by the CPI inflation rate. Actual real average M2 declined in 1990 to reach a level below the average for 1987. Consequently, equation 7.4 overpredicts the level of real average broad money for 1990. To avoid a persistent overprediction of nominal broad money in 1991–95, percentage changes in predicted real average levels, rather than predictions of levels, are used to project nominal broad money. The details of this calculation are presented in the lower portion of Table 8.7. Once nominal year-end broad money is calculated, domestic credit and credit to the private sector are derived as primary and secondary residuals, respectively. As with the examples of projections for other sectors, users should substitute their own monetary survey projections for 1991 and vary the forecasting techniques used.

Projected private (non-central government) investment is also compared with capital inflows and bank financing to public enterprises and the private sector; the results are presented in percentages of GDP. This comparison is an indicator, relative to the recent past, of whether government borrowing from the banking system tends to crowd out bank financing to the private sector.

CPI inflation is calculated according to equation 4.15, using the projections of import prices in rupees and broad money, in order to determine whether the outcome of the illustrative projections meets the initial inflation target.

d. Structural change

The growth path set out in the example is ambitious, but similar rates have been attained by many of Sri Lanka’s neighbors. The investment and savings requirements would be lower if the productivity of investment could be raised and the ICOR gradually reduced over the forecast period. Such a structural transformation might be achieved, in part, by privatizing public corporations in the agricultural sector, subjecting them to a hard budget constraint, setting export targets for them, and linking employee compensation to profitability. Opening the manufacturing sector further to competitive market forces, creating stable expectations for private investors (domestic and foreign), and financial sector reform would also help. Resolution of the civil conflict would be a major step toward a more propitious investment outlook. Finally, any measures that increased the productivity of investment would improve the external current account.

The projected monetary survey should also take into account any expected reforms of the financial system, as well as the impact of any change in interest rate policy on the way the financing of the government budget deficit is undertaken. Such reforms could alter the initial outcome for credit from the banking system, which would help determine whether the available bank credit and financing from abroad are sufficient to support a level of investment consistent with an increasing real growth rate.

These are a few of the possible structural reform initiatives that analysts must weigh when using this framework; there may be other reforms in the fiscal and external sectors. By selecting alternative forecasting techniques and making reasonable adjustments to the calculations, analysts can integrate their subjective judgments into the calculations.

2. Limitations of the Framework

The framework presented here is simplified in many respects. In particular, it does not include all the possible linkages between central government operations and the national income accounts or the balance of payments. Increases in nominal GDP are determined by combining targeted real growth and inflation, regardless of the level of government expenditure or tax rates. Moreover, government current expenditure, which includes interest payments on external debt, is assumed not to vary with the exchange rate. Because the procedure has been simplified, applying it is tantamount to assuming that some type of private expenditure replaces in full any reduction in government consumption or investment outlays, that cuts in other types of current government expenditures offset increases in official interest payments abroad, and that reduced government crowding out of private activity compensates for any tax increases. Given an overall ICOR that may decline in response to structural reforms which raise the productivity of investment, the sum of private and government gross investment must be consistent with the targeted real growth rate. Private investment may replace government capital expenditure, but users can determine if such a shift is desirable.

In part because of these simplifications, which serve as computational shortcuts, this framework differs from an econometrically estimated model. Few models exist for a developing country like Sri Lanka, and their utility is limited in the presence of structural reform. This forecasting framework highlights some behavioral and accounting consistency requirements across sectors and also requires analysts to attempt to quantify the impact of structural reforms.

3. Exercises

  • a. In the illustrative projections provided for 1991–95, what problems are evident in the balance of payments, the management of external debt, central government operations, private (nongovernment) savings-investment balances, and the functioning of the banking system as summarized in the monetary survey?

  • b. Are the growth and inflation targets specified in Table 8.1 achieved in the example?

  • c. Modify the growth target. Do the individual sector problems identified in question (a) intensify or ease? Why?

  • d. Return the growth series to the values in the example and modify the inflation series. Do the individual sector problems identified in question (a) intensify or ease? Why?

  • e. Using the growth and inflation targets in the example, select a policy tool or structural reform in each sector to help correct the particular problem identified for that sector. Experiment with these tools and reforms, first individually and finally using all of them together. Are these initiatives mutually supportive? How successful is the technique of using them all together? What trade-offs do you notice?

  • f. Substitute the baseline 1991 projection for a sector of your choosing in the original set of illustrative projections. Alter the 1991 growth and inflation rates to conform to your own baseline. What impact does this substitution have on other sectors?

1

The baseline could have been forecast over 1992–95 also, but given an unsatisfactory 1991 outcome (in the absence of any policy changes), such an exercise is not essential. However, a medium-term projection of the 1991 baseline forecast would be appropriate if for any reason the deterioration during that year appeared to be temporary.

2

The IMF’s Information Notice System (INS) uses the ratio of domestic consumer prices to a trade-weighted average of consumer prices in partner and competing countries, because consumer price indexes ere available monthly, with relatively short time lags. The approach taken here is oriented toward the relative costs of production at home and abroad.

3

The WEO published semi-annually by the IMF, is the basis for the external environment projections, including interest rates, as detailed in Table 5.8 of the balance of payments workshop.

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Cover Financial Programming and Policy
Financial Programming and Policy
The Case of Sri Lanka
ISBN:
9781557755797
Publication Date:
26 May 1996
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781557755797.071
Pages:
291
  • Figure 8.1.
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    Figure 8.1.

    Saving and Investment in the Medium–Term Forecasting Framework1

Figure 8.1.

Saving and Investment in the Medium–Term Forecasting Framework1