Deficit Reversals in Advanced Economies: Do Real Exchange Rates Matter?

Based on these criteria, the chapter identifies 42 episodes of large and sustained external deficit reversals over the past 40 years in advanced economies (Figure 3.1). The magnitude of the reversals ranges from the 2.7 percent of GDP adjustment in Italy beginning in 1981 to the 18 percent of GDP adjustment that began in Portugal in the same year. Moreover, 13 cases of large and persistent deficits were identified, including the most recent U.S. episode and Australia’s two-decade-long period of current account deficit starting in 1980, and are described in detail in Box 3.2. The rest of this section focuses on the reversal episodes.

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Episodes of Deficit Reversals and Large and Persistent Deficits¹

(1960–2006; current account deficit in percent of GDP)

The chapter identifies 42 episodes of large and sustained deficit reversals in advanced economies, 60 episodes in emerging markets, and 17 episodes in oil-exporting countries. Moreover, 29 cases of large and persistent deficits were identified in the entire sample.

Sources: IMF, International Financial Statistics; OECD, Economic Outlook (2006); World Bank, World Development Indicators (2006); and IMF staff calculations.¹See Appendix 3.1 for the definition of deficit reversals and large and persistent deficit episodes, and information on country group composition.²Change in current account deficit, in percent of GDP, from the trough to the end of the reversal episode.³The x-axis refers to the average current account deficit, in percent of GDP, during the episode. The y-axis refers to the number of years the large current account deficit was sustained.

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Box 3.1.

External Sustainability and Financial Integration

Despite massive net external borrowing, U.S. net foreign assets have remained broadly stable for the past five years as a share of GDP. This, together with the ease with which the United States has financed its large trade and current account deficits, has led to suggestions that in an increasingly financially integrated world such deficits are sustainable without the need for exchange rate adjustment. In particular, some point to the U.S. dollar’s role as a reserve currency and to the depth and liquidity of U.S. financial markets to explain high demand for U.S. assets, while others argue that intangible exports and assets make the U.S. external account much stronger than currently measured.¹

Over the medium term, external sustainability requires that a country’s net external position not increase or decrease without bound, relative to the size of the economy. To highlight how financial integration influences this requirement for sustainability, this box considers the cases of three countries that have run large and protracted current account deficits over the past few years—Australia, Spain, and the United States—and investigates the implications of these deficits for their net foreign asset positions. As the figure shows, these deficits had very different implications for the path of net foreign assets of the three countries: Spain’s net foreign liabilities increased substantially, relative to its GDP; the U.S. liabilities remained broadly stable despite its large current account deficit; and Australia’s experience fell in between. What accounts for these striking differences?

The balance of payments identity says that changes in net foreign assets (NFA) can originate from net external lending or borrowing (FL)—which, abstracting from statistical discrepancies and other factors such as reclassifications of claims or liabilities, is broadly equal to the current account balance (CA)—and changes in the value of external assets and liabilities due to fluctuations in exchange rates or asset prices (KG).² In turn, the current account is equal to the balance on goods, nonfactor services, and transfers (BGST) plus the investment income earned on assets ($i_t^A{A}_{t-1}$) minus the income paid out on liabilities ($i_t^L{L}_{t-1}$):

$\begin{array}{ll}NF{A}_t-NF{A}_{t-1}=F{L}_t+K{G}_t& \left(1\right)\\ F{L}_t\cong C{A}_t=BGS{T}_t+i_t^A{A}_{t-1}-i_t^L{L}_{t-1}.\end{array}$

Dividing both sides of the equation by GDP and rearranging terms, changes in a country’s net foreign asset position can be described as follows:

$\begin{array}{cc}nf{a}_t-nf{a}_{t-1}=bgs{t}_t+\frac{r_t^L-g_t}{1+g_t}nf{a}_{t-1}+\frac{r_t^A-r_t^L}{1+g_t}{a}_{t-1},& \left(2\right)\end{array}$

where lowercase letters denote ratios to GDP; $r_t^A$ and $r_t^L$ denote the nominal rate of return on foreign assets and liabilities, respectively—inclusive of the yields $i_t^A$ and $i_t^L$ and of capital gains; and g_t denotes the growth rate of nominal GDP. When the returns on external assets and liabilities are the same, equation (2) reduces to the standard debt accumulation equation. If this is the case, and if the rate of return is higher than the GDP growth rate, a debtor country will need to run a trade surplus to prevent its net external position from deteriorating. The equation also shows that in a world with much larger stocks of external assets and liabilities than a decade ago, differences in rates of return have potentially grown in importance as factors explaining the evolution of net foreign assets.

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External Imbalances: Australia, Spain, and United States

(Percent of GDP)

Sources: IMF, Balance of Payments Statistics Yearbook; and IMF staff calculations.

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Equation (2) helps us understand the differential experiences of Australia, Spain, and the United States. The table illustrates the role played by the three factors driving changes in net foreign assets in equation (2) between end-2001 and end-2005 (2006 for the United States).³

• Australia ran a trade deficit during this period, averaging 2 percent of GDP. The rate of return on its liabilities and the GDP growth rate were similar for this period, as were returns on assets and on liabilities. Consequently, the external position deteriorated in proportion to the size of the trade deficit.

• Spain ran a similar trade deficit of just over 2 percent of GDP, but the return on its external liabilities was much higher than the return on its assets. As a consequence, and despite a high growth rate, its net external position deteriorated much more sharply than did Australia’s position.

• The U.S. trade deficit averaged over 5 percent of GDP, more than twice as large as that of Australia or Spain. However, a very large positive differential between returns on external assets and on liabilities kept the external position from deteriorating at all.

Evolution of Net External Position

(In percent of GDP unless otherwise noted)

Source: IMF staff estimates.

Evolution of Net External Position

(In percent of GDP unless otherwise noted)

		United States (2001–06)	Australia (2001–05)	Spain (2001–05)
Changes in net foreign assets		3.4	-8.7	-19.8
Cumulative effects of: Trade deficit		-28.2	-8.5	-8.7
	Return—growth rate differential	1.5	1.0	3.1
	Asset-liability return differential	30.0	-1.4	-14.2
Differential in returns on assets and liabilities average (in percent)		8.0	-0.5	-3.5
Correlation with change in the real effective exchange rate (over 1995–2005)		-0.74	-0.54	-0.34

Source: IMF staff estimates.

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Evolution of Net External Position

(In percent of GDP unless otherwise noted)

		United States (2001–06)	Australia (2001–05)	Spain (2001–05)
Changes in net foreign assets		3.4	-8.7	-19.8
Cumulative effects of: Trade deficit		-28.2	-8.5	-8.7
	Return—growth rate differential	1.5	1.0	3.1
	Asset-liability return differential	30.0	-1.4	-14.2
Differential in returns on assets and liabilities average (in percent)		8.0	-0.5	-3.5
Correlation with change in the real effective exchange rate (over 1995–2005)		-0.74	-0.54	-0.34

Source: IMF staff estimates.

Which factors can help explain differences in rates of return between external assets and liabilities?

• Relative currency and stock price movements play an important role. For example, in a country with liabilities denominated in domestic currency and assets in foreign currency, an unexpected exchange rate depreciation will raise the domestic currency return on assets. In a country with high net liabilities denominated in foreign currency, an unexpected depreciation would instead have unfavorable balance sheet effects, by raising the return on liabilities measured in domestic currency. Obviously, higher price increases in foreign stock markets relative to the domestic market would generate a favorable return differential.

• The composition of the external portfolio also matters. For example, since returns have on average been higher on equity instruments than on debt instruments, countries with a larger share of equity-type assets (FDI and portfolio equity) in total assets than of equity-type liabilities in total liabilities could have a favorable return differential.

These factors played an important role in the countries under consideration:⁴

• Exchange rate movements. Australia, Spain, and the United States have significant net external liabilities denominated in domestic currency but positive net foreign currency holdings. As a result, a currency depreciation will, other things being equal, raise domestic currency returns on external assets by more than returns on liabilities. During the period under consideration, the U.S. dollar depreciated in real effective terms, while the euro appreciated, consistent with the observed return differentials.⁵ The Australian dollar also appreciated, but its adverse effect on the domestic currency value of external assets was mitigated by widespread currency hedging.

• Relative stock price movements. Spain’s stock prices increased faster than stock prices of its financial trading partners, raising the return on Spain’s external liabilities, while the opposite happened for the United States. Australian stock prices also increased more rapidly than stock prices elsewhere, raising returns on Australian equity liabilities, but the effect on the overall return differential was muted by the higher weight of equity on the asset side of the balance sheet.

• Portfolio composition. During the sample period, the United States and Australia had a higher share of equity-type instruments (FDI and portfolio equity) in their asset portfolios (around 60 percent) than in their liability portfolios (around 40 percent), with Spain also showing a modest positive difference between the asset and liability share of equity instruments. In light of the higher returns on equity than on debt during the period under consideration, this composition effect helps explain the behavior of return differentials in Australia and especially the United States.

Of course the overall size of the net external position also matters—if overall returns rise, net external liabilities will increase faster in countries that start off with larger imbalances.

Should one extrapolate these trends for the future? Do the large favorable return differentials in the United States obviate the need for trade balance and exchange rate adjustment? Extrapolating these trends would be unwise—as specified in investment prospectuses, “past performance is no guarantee of future returns.” And return differentials would not indefinitely obviate the need for U.S. trade balance and exchange rate adjustment. More specifically:

• Return differentials induced by exchange rate movements require unexpected exchange rate depreciation period by period—hence, they are inconsistent with a stable exchange rate. The effect of exchange rate depreciation on return differentials in debtor countries with significant domestic currency liabilities can help the adjustment process, but it would disappear once the exchange rate stabilizes, or when investors require higher returns to compensate for exchange rate risk.

• Similarly, it is not realistic to project persisting differentials in stock returns (indeed, there is no evidence that the U.S. stock market has significantly underperformed world markets over the past three decades).

• Return differentials explained by differences in portfolio composition, risk, liquidity, and other factors may well persist, but they are likely to fall well short of those witnessed recently for the United States. For example, with the current differences in portfolio composition for the United States and Australia, a hefty 5 percent extra return on equity instruments relative to debt would imply a positive return differential between external assets and liabilities of about 1 percent. In addition, a return differential of 2 percent between U.S. FDI assets and liabilities would widen the overall return differential by about ½ percent. Under this illustrative scenario, the need for U.S. trade balance adjustment would be reduced by about 1½ percent of GDP, well short of the 6 percent adjustment that would be needed to stabilize the external position.

In sum, while international financial integration allows for a diversification of risk, with balance sheet effects cushioning external adjustment, it does not provide a permanent flow of “free lunches.” Changes in asset prices and returns can generate large valuation effects on a year-to-year basis, but would likely play a more modest role over a longer period. Hence, in a debtor country running a large trade deficit, a correction in the trade balance is eventually inevitable to ensure external sustainability. Of course, the point in time at which this correction will actually take place, its size, and the means through which it would occur would depend on the specific circumstances of the country as well as international macroeconomic and financial market conditions more generally.

Note: The authors of this box are Jaewoo* Lee and Gian Maria Milesi-Ferretti. 1 On the first point, see Caballero, Farhi, and Gourinchas (2006); on the latter, see Hausmann and Sturzenegger (2006). 2 There are differences across countries in the measurement of NFA—in particular, most countries (including Spain) estimate foreign direct investment (FDI) at book value, while others (including Australia and the United States) estimate it at market value. These differences will be reflected in the calculation of capital gains, and hence of rates of return. 3 Data on NFA for the United States in 2006 are based on staff estimates. If NFA was scaled by exports of goods and services, to reflect the different degree of trade openness between the three countries, the trends within countries would be similar, but net external liabilities would be lower in Spain than in the United States and Australia. 4 Measured return differentials can also be affected by other factors, such as the method for estimating FDI (see footnote 2 in this box), the riskiness of assets, and incentives for transfer pricing driven by differences in corporate tax policy. Box 1.2 in the September 2005 World Economic Outlook discusses the role of these factors in explaining differences between returns on U.S. FDI assets and liabilities. 5 The real effective depreciation of the U.S. dollar since early 2002 was much sharper vis-à-vis its “financial” trading partners than its commercial trading partners, thus increasing its effect on return differentials.

Examining the reversal episodes reveals the following common patterns:

• The current account deficit averaged 4 percent of GDP at the start of the adjustment, with an average correction of about 6 percent of GDP over a period of four to five years (Table 3.1).

• Consistent with the literature on deficit reversals, the process of current account adjustment was generally accompanied by both a real depreciation of the domestic currency (an average 12 percent total real depreciation)⁷ and a slowdown of growth (an average 1½ percentage point decline in annual average GDP growth after the reversal compared with before the reversal). Figure 3.2 shows that the real currency depreciation has typically started in advance of the external adjustment.

• Deficit reversals tended to be preceded by a positive output gap, with the difference between actual and potential output peaking one year before the start of the adjustment and declining considerably afterward. This observation is consistent with the proposition that the slowdown in economic activity associated with deficit reversals is a consequence of the business cycle (Goldman Sachs, 2005). However, the size and persistence of the average swing in the output gap during a reversal episode suggests that while the business cycle may indeed have played a role in these episodes, it does not fully account for the output costs associated with the reversals (Edwards, 2005; and Freund and Warnock, 2005).

Table 3.1.

Summary Statistics of Episodes of Reversals¹

Sources: IMF, International Financial Statistics; OECD, Economic Outlook (2006); World Bank, World Development Indicators (2006); and IMF staff calculations.

¹Average values. Medians are in parentheses.

²Number of years between year 0, the trough (peak) year of the current account deficit (surplus), and year T (the end year of the episode). See Appendix 3.1 for further details.

³Average after the reversal (between year 1 and T, where 1 is the first year of the reversal and T is the year when the episode ends) less average before the reversal (between −T and −1).

⁴Maximum change in real effective exchange rate (REER) within the period surrounding the reversal (−T…T). An increase represents a real appreciation of a country’s domestic currency relative to its trading partners.

Table 3.1.

Summary Statistics of Episodes of Reversals¹

	Number	Current Account at Year of Reversal (percent of GDP)	Size of Adjustment (percent of GDP)	GDP Growth
				Duration of reversals (years)2	Average change (percent)3	REER: Total change (percent)4
Deficit reversals
Advanced economies	42	-4.1 (-3.5)	5.7 (4.9)	4.6 (4.0)	-1.4 (-1.0)	-12.2 (-12.5)
Preceded by large and persistent deficits	7	-6.9 (-6.2)	7.4 (6.9)	5.0 (4.0)	-0.2 (-0.9)	-10.2 (-6.2)
Surplus reversals
Advanced economies	36	2.4 (1.9)	5.0 (4.6)	4.7 (4.0)	0.6 (0.3)	15.6 (12.1)
Emerging markets	49	4.7 (3.2)	10.1 (9.1)	4.0 (4.0)	1.4 (1.2)	23.1 (16.6)
Oil exporters	15	18.9 (12.3)	20.7 (11.7)	4.4 (4.0)	-2.4 (-1.6)	71.6 (36.0)

Sources: IMF, International Financial Statistics; OECD, Economic Outlook (2006); World Bank, World Development Indicators (2006); and IMF staff calculations.

¹Average values. Medians are in parentheses.

²Number of years between year 0, the trough (peak) year of the current account deficit (surplus), and year T (the end year of the episode). See Appendix 3.1 for further details.

³Average after the reversal (between year 1 and T, where 1 is the first year of the reversal and T is the year when the episode ends) less average before the reversal (between −T and −1).

⁴Maximum change in real effective exchange rate (REER) within the period surrounding the reversal (−T…T). An increase represents a real appreciation of a country’s domestic currency relative to its trading partners.

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Table 3.1.

Summary Statistics of Episodes of Reversals¹

	Number	Current Account at Year of Reversal (percent of GDP)	Size of Adjustment (percent of GDP)	GDP Growth
				Duration of reversals (years)2	Average change (percent)3	REER: Total change (percent)4
Deficit reversals
Advanced economies	42	-4.1 (-3.5)	5.7 (4.9)	4.6 (4.0)	-1.4 (-1.0)	-12.2 (-12.5)
Preceded by large and persistent deficits	7	-6.9 (-6.2)	7.4 (6.9)	5.0 (4.0)	-0.2 (-0.9)	-10.2 (-6.2)
Surplus reversals
Advanced economies	36	2.4 (1.9)	5.0 (4.6)	4.7 (4.0)	0.6 (0.3)	15.6 (12.1)
Emerging markets	49	4.7 (3.2)	10.1 (9.1)	4.0 (4.0)	1.4 (1.2)	23.1 (16.6)
Oil exporters	15	18.9 (12.3)	20.7 (11.7)	4.4 (4.0)	-2.4 (-1.6)	71.6 (36.0)

Sources: IMF, International Financial Statistics; OECD, Economic Outlook (2006); World Bank, World Development Indicators (2006); and IMF staff calculations.

¹Average values. Medians are in parentheses.

²Number of years between year 0, the trough (peak) year of the current account deficit (surplus), and year T (the end year of the episode). See Appendix 3.1 for further details.

³Average after the reversal (between year 1 and T, where 1 is the first year of the reversal and T is the year when the episode ends) less average before the reversal (between −T and −1).

⁴Maximum change in real effective exchange rate (REER) within the period surrounding the reversal (−T…T). An increase represents a real appreciation of a country’s domestic currency relative to its trading partners.

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Advanced Economies: Key Indicators During Deficit Reversals¹

(Medians across episodes; t = 0 is the trough year of the ratio of current account deficit to GDP; x-axis in years before and after t = 0)

The real effective exchange rate (REER) starts depreciating around two years before the trough of the current account deficit. Total domestic demand growth is above that of trading partners before the reversal but falls below after the reversal. Output is above potential before the trough but the output gap widens and remains low afterwards.

Sources: IMF, International Financial Statistics; OECD, Economic Outlook (2006); World Bank, World Development Indicators (2006); and IMF staff calculations.¹See Appendix 3.1 for the definition of deficit reversals and information on country group composition.²An increase in the index represents a real appreciation while a decrease represents a real depreciation of a country’s currency relative to its trading partners.

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The magnitude of the exchange rate correction and of the GDP growth slowdown varies considerably across episodes. To shed light on this, the reversal episodes were ordered based on the average change in GDP growth after the reversal. Consistent with Croke, Kamin, and Leduc (2005), two groups of episodes were identified (Figure 3.3):

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Deficit Reversals in Advanced Economies: Episode Characteristics by Average Change in GDP Growth

(Medians across the two groups of episodes; asterisks show that the difference between the medians in the contractionary and expansionary deficit reversals is statistically significant at the 10 percent confidence level)

Total depreciation of real effective exchange rate (REER) is much higher in the expansionary reversals. These cases are also characterized by higher openness to trade and smaller current account deficits.

Sources: IMF, International Financial Statistics; OECD, Economic Outlook (2006); World Bank, World Development Indicators (2006); and IMF staff calculations.¹Contractionary deficit reversals are the 11 deficit reversals with the largest average decline in GDP growth (the bottom quartile in the sample ordered by the change in growth).²Expansionary deficit reversals are the 10 deficit reversals with the smallest average decline in GDP growth (the top quartile in the sample ordered by the change in growth).³Average of GDP annual growth rates in the period after the reversal (1 … T) less average annual growth rates in the period before the reversal (−T … −1).⁴Maximum change in REER within the period surrounding the reversal (−T…T). A decrease represents a real depreciation of a country’s currency relative to its trading partners.⁵“Before reversal” is the change in the variable between −T and 0. “After reversal” is the change in the variable between 0 and T.

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• A group of “contractionary” deficit reversals, characterized by a significant growth deterioration (a median 3½ percentage point slowdown). These episodes were also associated with a strong reduction in GDP growth relative to trading partners and a widening of the output gap, following a strong decline in investment rates.⁸ Relatively large initial external deficits and low openness to trade were also observed. In these cases, the degree of real effective depreciation was modest (median of about 8 percent), often reflecting limited flexibility of the exchange rate regime.⁹

• A group of “expansionary” reversals, in which growth did not slow down and in fact some pickup was generally observed (a median increase in GDP growth of about ¼ percentage point). These episodes were associated with both a larger-than-average total real depreciation (median of about 18 percent), which corrected a somewhat more overvalued currency and spurred export growth, and a strong increase in saving rates, associated with substantial fiscal consolidation, which allowed investment rates to be sustained much closer to their pre-reversal values.¹⁰

While the contractionary episodes conform to an adjustment occurring largely through a rebalancing of demand differentials with trading partners in the context of limited exchange rate flexibility, the expansionary episodes reflect a stronger role for relative price adjustment. In these cases, real depreciation played a key role by either offsetting an expenditure-reducing shock (e.g., fiscal consolidation) or correcting a competitiveness problem.

The main conclusions from this analysis of deficit reversals in advanced economies are that while changes in growth differentials clearly play a role in the adjustment, real depreciation can help smooth the impact of slowing domestic demand. Indeed, among historical episodes of deficit reversals in advanced economies over the past 40 years, there has been a clear trade-off between the growth slowdown after the reversal and total real effective exchange rate depreciation (Figure 3.4). Simple regression analysis suggests that a 10 percent total real effective depreciation has been associated with a ½ percentage point lower average decline in GDP growth after the reversal.

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Advanced Economies: Total Change in Real Effective Exchange Rate and Average Change in GDP Growth During Deficit Reversals

Depreciation in real effective exchange rate (REER) has helped reduce the output costs associated with a deficit reversal (the larger the depreciation of the currency, the lower the output costs of the reversal).

Sources: IMF, International Financial Statistics; OECD, Economic Outlook (2006); World Bank, World Development Indicators (2006); and IMF staff calculations.¹Maximum change in REER within the period surrounding the reversal (−T … T). A decrease represents a real depreciation of a country’s currency relative to its trading partners.²Average real GDP growth after the reversal (1 … T) less average real GDP growth before the reversal (−T… −1).

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Surplus Reversals: What Is the Role of Real Exchange Rate Appreciation?

This chapter identifies 36 episodes of large and sustained reversals of external surpluses in advanced economies, 49 episodes in emerging markets, and 15 episodes among oil exporters (Figure 3.5). Moreover, 20 cases of large and persistent surpluses were identified for all countries, including the two-decade-long current account surplus of Switzerland (see Box 3.2).

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Episodes of Surplus Reversals and Large and Persistent Surpluses¹

(1960–2006; current account surplus in percent of GDP)

The chapter identifies 36 episodes of large and sustained surplus reversals in advanced economies, 49 episodes in emerging markets, and 15 episodes in oil-exporting countries. Moreover, 20 cases of large and persistent surpluses were identified in the sample.

Sources: IMF, International Financial Statistics; OECD, Economic Outlook (2006); World Bank, World Development Indicators (2006); and IMF staff calculations.¹See Appendix 3.1 for the definition of surplus reversals and large and persistent surplus episodes, and information on country group composition.²Change in current account surplus, in percent of GDP, from the peak to the end of the reversal episode.³The x-axis refers to the average current account surplus, in percent of GDP, during the episode. The y-axis refers to the number of years the large current account surplus was sustained.

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The following common patterns emerged from the reversal episodes:

• At the start of the reversal, the current account surplus averaged 2½ percent of GDP for advanced economies, and had higher ratios to GDP for emerging markets and oil exporters (about 5 percent and 20 percent of GDP, respectively). The average size of the adjustment was also much larger in emerging markets and for oil exporters than in advanced economies, although the reversal occurred over a similar time frame—four to five years (see Table 3.1).

• Surplus reversals in advanced economies and emerging markets have been associated with both an acceleration of GDP growth and a real appreciation (see Table 3.1). In particular, in both advanced economies and emerging markets, real effective exchange rates appreciated strongly and real GDP growth tended to accelerate when the reversals occurred (Figure 3.6).

• While these findings indicate symmetry between surplus and deficit reversals, only for advanced economies was it possible to find some weak evidence of a trade-off between the increase in GDP growth after the reversal and real exchange rate appreciation. For emerging markets, a stronger real appreciation did not reduce the magnitude of the increase in output growth associated with the reversal.

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Key Indicators During Surplus Reversals¹

(Medians across episodes; t = 0 is the peak year of the ratio of current account surplus to GDP; x-axis in years before and after t = 0)

In both advanced economies and emerging markets, real effective exchange rate (REER) appreciates and GDP growth increases after the peak year of the current account surplus.

Sources: IMF, International Financial Statistics; OECD, Economic Outlook (2006); World Bank, World Development Indicators (2006); and IMF staff calculations.¹See Appendix 3.1 for the definition of surplus reversals and information on country group composition.²An increase in the index represents a real appreciation while a decrease represents a real depreciation of a country’s currency relative to its trading partners.

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To shed further light on the relative role of GDP growth and real appreciation for emerging markets during surplus reversals, expansionary episodes (in which the surplus decline was accompanied by a strong increase in GDP growth) were distinguished from contractionary reversals (in which the surplus decline was accompanied by a substantial fall in GDP growth) (Figure 3.7):

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Surplus Reversals in Emerging Markets: Episode Characteristics by Average Change in GDP Growth

(Medians across the two groups of episodes; asterisks show that the difference between the medians in the contractionary and expansionary surplus reversals is statistically significant at the 10 percent confidence level)

Reversals of current account surpluses were characterized by an increase in investment in the expansionary reversals and an increase in consumption (decrease in savings) in the contractionary reversals.

Sources: IMF, International Financial Statistics; OECD, Economic Outlook (2006); World Bank, World Development Indicators (2006); and IMF staff calculations.¹Contractionary surplus reversals are the 13 surplus reversals with the largest average decline in GDP growth (the bottom quartile in the sample ordered by the change in growth).²Expansionary surplus reversals are the 12 surplus reversals with the smallest average decline in GDP growth (the top quartile in the sample ordered by the change in growth).³Average of GDP annual growth rates in the period after the reversal (1 … T) less average annual growth rates in the period before the reversal (−T … −1).⁴Maximum change in REER within the period surrounding the reversal (−T … T). An increase represents a real appreciation of a country’s currency relative to its trading partners.⁵“Before reversal” is the change in the variable between −T and 0. “After reversal” is the change in the variable between 0 and T.

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• In the expansionary cases, the surplus reversals were characterized by a strong acceleration in GDP growth relative to trading partners and a reduction of the output gap. The turnaround in the investment cycle and the strong increase in import volumes led to a rapid narrowing of the surplus.¹¹

• In the contractionary cases, the surplus buildup was associated with a period of faster growth relative to trading partners and a relatively undervalued currency. The reversal of these surpluses was then characterized by a more significant real appreciation and, especially, a sizable increase in domestic demand (in particular, consumption) accompanied by more expansionary monetary and fiscal policies. Still, GDP growth slowed somewhat during the reversal as the increase in domestic demand did not offset the smaller contribution to growth from net exports.¹²

Overall, an increase in domestic demand appears to play a key role in both types of surplus reversals—either from an increase in investment that drives the growth acceleration in the expansionary episodes or from an increase in consumption that marks the shift from net exports to domestic demand as the main engine of growth in the contractionary cases. Real appreciation seems to have played a larger role in the contractionary cases, in particular by correcting an initial undervaluation of the real exchange rate.

Surplus reversals in oil-exporting countries do not fit the above patterns, as the deterioration of the external position has occurred with both a substantial slowdown in GDP growth and a large total real appreciation of their currencies. For these countries, the initial buildup of external surpluses owes much to the positive terms-of-trade effect from a surge in commodity prices (Figure 3.8). In turn, this leads to an increase in domestic demand and inflation, which drives up the real value of the currency. While the sharp decline of the external surplus is related to the reversal of the terms-of-trade increase (causing a sharp decline in export revenues), the currency continues appreciating in real terms, as domestic demand growth and inflation are sustained even after the decline in the terms of trade.

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Oil Exporters: Surplus Reversals¹

(Medians across episodes; t = 0 is the peak year of the ratio of current account surplus to GDP; x-axis in years before and after t = 0)

Current account surpluses for oil exporters mainly reflect large shifts in the terms of trade.

Sources: IMF, International Financial Statistics; OECD, Economic Outlook (2006); World Bank, World Development Indicators (2006); and IMF staff calculations.¹See Appendix 3.1 for the definition of surplus reversals and information on country group composition.²An increase in the index represents a real appreciation while a decrease represents a real depreciation of a country’s currency relative to its trading partners.

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In sum, this analysis of surplus reversal episodes suggests that while surplus reversals for oil exporters have followed a decline of commodity prices, reversals in advanced and emerging market economies have been associated with some real appreciation of domestic currencies and, even more importantly, an increase in domestic demand.

How Responsive Are U.S. Trade Volumes to Exchange Rate Movements?

The analysis of the historical episodes suggests that changes in real exchange rates have been important in the reversal of external imbalances, with a clear role in helping to sustain growth during deficit reversals. The conventional wisdom for the United States, however, is that large exchange rate changes are needed because of the low price elasticities of trade volumes and the partial response of trade prices to changes in nominal exchange rates.

The case for elasticity pessimism can be illustrated by looking at the standard “workhorse” empirical trade model—relating the volume of exports and imports to real foreign and domestic incomes and relative export and import prices. A vast empirical literature exists on this model for the United States and elsewhere, with estimates of trade elasticities varying greatly depending on the methodology, time period, and choice of variables.¹³ A general result is that price elasticities tend to be quite small, especially in the short run, and at times too low to satisfy the Marshall Lerner condition.¹⁴ Thus, an exchange rate depreciation would weaken the trade balance as its negative effect on the terms of trade would outweigh its positive effect on trade volumes.

This chapter revisits the standard empirical trade model to correct for biases that may lower estimates of trade elasticities. To provide a benchmark for this exercise, the standard model has been re-estimated for the United States over the post—Bretton Woods period (1973–2006).¹⁵

The results of the estimation conform to the elasticity pessimism view. In particular, the long-run estimates of U.S. import and export elasticities are quite low—indeed too low to satisfy the traditional Marshall Lerner condition (Table 3.2). Moreover, the U.S. income elasticity of imports is about 0.5 higher than the income elasticity of the trading partners’ demand for U.S. exports (as in Houthakker and Magee, 1969). This suggests that foreign GDP growth would need to be about double that in the United States to start reducing the U.S. trade deficit from its 2005 level—a seemingly unrealistic condition as historically the United States has grown at about the same pace as the rest of the world.¹⁶

Table 3.2.

Standard Trade Model: Estimates of U.S. Trade Elasticities

Source: IMF staff calculations based on estimates in Appendix 3.2.

¹Price elasticities with respect to relative prices (RP).

²Price elasticities with respect to real effective exchange rate (REER). Increase in REER denotes real appreciation.

³The correction for vertical integration bias is based on estimates on the 1979–2006 sample.

Table 3.2.

Standard Trade Model: Estimates of U.S. Trade Elasticities

	Estimated over 1973–2006				Estimated over 1986–2006
	Without correcting for biases		Correcting for aggregation bias	Correcting for vertical integration bias3	Without correcting for biases
	RP1	REER2	RP1	RP1	RP1	REER2
Imports
Price elasticity	-0.69	0.37	-1.45	-1.48	-0.82	0.48
Income elasticity	2.03	2.46	1.68	0.64	1.86	2.46
Exports
Price elasticity	0.02	-0.49	-0.26	…	-1.06	-0.60
Income elasticity	1.85	1.82	1.60	…	0.76	1.97

Source: IMF staff calculations based on estimates in Appendix 3.2.

¹Price elasticities with respect to relative prices (RP).

²Price elasticities with respect to real effective exchange rate (REER). Increase in REER denotes real appreciation.

³The correction for vertical integration bias is based on estimates on the 1979–2006 sample.

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Table 3.2.

Standard Trade Model: Estimates of U.S. Trade Elasticities

	Estimated over 1973–2006				Estimated over 1986–2006
	Without correcting for biases		Correcting for aggregation bias	Correcting for vertical integration bias3	Without correcting for biases
	RP1	REER2	RP1	RP1	RP1	REER2
Imports
Price elasticity	-0.69	0.37	-1.45	-1.48	-0.82	0.48
Income elasticity	2.03	2.46	1.68	0.64	1.86	2.46
Exports
Price elasticity	0.02	-0.49	-0.26	…	-1.06	-0.60
Income elasticity	1.85	1.82	1.60	…	0.76	1.97

Source: IMF staff calculations based on estimates in Appendix 3.2.

¹Price elasticities with respect to relative prices (RP).

²Price elasticities with respect to real effective exchange rate (REER). Increase in REER denotes real appreciation.

³The correction for vertical integration bias is based on estimates on the 1979–2006 sample.

Before looking at two possible sources of mis-specification of the standard empirical model, two caveats should be made about these results. First, the traditional Marshall Lerner condition is based on the assumption of complete pass-through of exchange rate movements to import prices. In the context of limited exchange rate pass-through, however, a U.S. dollar depreciation could still improve the nominal trade balance even with the low trade price elasticities estimated in the standard empirical model. The reason is that with partial pass-through, a U.S. dollar depreciation reduces the U.S. terms of trade by less than when exchange rate movements are fully transmitted to trade prices, making it easier for an improvement in real net exports to generate an adjustment in the nominal trade balance (Box 3.3).

Second, restricting the sample to the past two decades yields higher estimates of the U.S. trade price elasticities. This finding is consistent with the view that globalization is likely to have increased the responsiveness of trade volumes to changes in real exchange rates (Obstfeld, 2002). In particular, the increasing importance of outsourcing and of trade in intermediate products should induce firms to respond more strongly to changes in relative prices by switching between domestic and imported inputs, or by shifting tasks across borders.

Does the Standard Empirical Trade Model Underestimate the Response of Trade Volumes to Relative Prices?

The U.S. trade equations estimated above represent a basic, “stripped-down” version of the standard empirical trade model. Several efforts have been made over the years to improve upon this model and find more plausible values for trade elasticities in the long run. This subsection explores two particular variations on the standard empirical model, both of which yield larger estimates of long-run trade price elasticities and smaller (and less divergent) estimates of income elasticities of imports and exports, thus providing some ground for greater elasticity optimism.

First, low measured long-run price elasticities of U.S. trade volumes may reflect an aggregation bias. It is well known that estimates of trade price elasticities using microeconomic data (that is, at the level of individual goods or sectors) yield a wide range of values across sectors and goods, most of which are much higher than the range typically found in the macroeconomic literature.¹⁷ The large heterogeneity in these estimates raises the possibility that trade elasticities estimated on the basis of aggregate data could be different from the average of sector- or goods-specific estimates. For example, goods with relatively low price elasticities could be exposed to stronger price variations and thus exert a dominant effect on the estimated aggregate price elasticities, which would then underestimate the average response of trade volumes to relative prices (Goldstein and Khan, 1985; and Orcutt, 1950).

Box 3.2.

Large and Persistent Current Account Imbalances

The size and persistence of the U.S. current account deficit has raised concerns about the possibility of an abrupt and disorderly adjust-ment.¹ However, as a number of observers have argued, large and protracted external imbalances may be a reflection of investors’ decisions to allocate their savings toward the most profitable uses.² Even if a correction is eventually required, large and persistent deficits may not need to end in a more severe adjustment than do shorter-lived imbalances.

This box discusses the experiences that countries have had with large and persistent current account imbalances, focusing on current account deficits for advanced economies and on current account surpluses for advanced economies, emerging markets, and oil exporters. It first examines 13 episodes of large and persistent deficits in advanced economies, especially their experience with deficit reversals. It then examines 20 episodes of large and persistent surpluses for all countries in the sample, looking for common patterns during these episodes.³

Large and Persistent Current Account Deficits in Advanced Economies

While the criteria chosen to identify large and persistent current account deficits—a deficit amounting to more than 2 percent of GDP for more than five years—may seem undemanding, the actual current account deficit across the 13 episodes identified for the advanced economies averaged about 5 percent of GDP and lasted about 11 years. Seven of these episodes eventually ended with a reversal, while the remaining six are still ongoing (Australia, Greece, New Zealand, Portugal, Spain, and the United States).⁴

On average, during the 13 episodes of large and persistent current account deficits, GDP growth tended to be slower and consumption growth faster than outside these periods (for both variables, the difference between the crosscountry medians is statistically significant at 10 percent or better; see first figure). Moreover, these episodes were characterized by faster growth in private credit and a stronger stock market performance. Taken together, these findings appear consistent with an intertempo-ral smoothing view of current account imbalances—that the persistent external deficits were an optimal response to a permanent increase in productivity.⁵

If these deficits reflect appropriate saving and investment decisions, one could expect their reversal to occur smoothly and without a large growth slowdown (driven by the return of investment and saving ratios to their new long-run levels). Indeed, the experience with the reversal of large and persistent current account deficits in advanced economies shows that the correction of these deficits has not been characterized by a larger decline in GDP growth or by a greater real effective exchange rate depreciation than the other reversal episodes identified and discussed in the main text (see Table 3.1).⁶ Moreover, reversals after large and persistent deficits, on average, occurred over a similar time frame as the other reversal episodes (between four and five years). These results suggest that the adjustment of large and persistent current account deficits in advanced economies have generally reflected macroeconomic developments within the economy, rather than following externally driven events where the size and persistence of the current account deficit itself has precipitated the adjustment (see also Debelle and Galati, 2005).⁷

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Advanced Economies: Key Indicators of Large and Persistent Deficits¹

Sources: IMF, International Financial Statistics; OECD, Economic Outlook (2006); World Bank, World Development Indicators (2006); and IMF staff calculations.¹“Within” refers to the cross-country median of the average value of the variable during episodes of large and persistent imbalances. “Outside” refers to the cross-country median of the average value of the variable for the same countries but in different periods. Asterisks show that the difference between the two medians is statistically significant at the 10 percent confidence level.

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Large and Persistent Current Account Surpluses in Advanced Economies and Emerging Market Countries

As in the deficit episodes, the average size and duration of the episodes of large and persistent current account surpluses were well above the thresholds required—at least 2 percent of GDP for at least five years. In particular, across the eight episodes of large and persistent current account surpluses identified for the advanced economies, the current account surplus averaged about 6 percent of GDP and lasted on average about 12 years. Across the 12 episodes identified for emerging markets and oil exporters, the current account surpluses averaged about 9 percent of GDP and lasted six years on average.

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Key Indicators of Large and Persistent Surpluses¹

Sources: IMF, International Financial Statistics; OECD, Economic Outlook (2006); World Bank, World Development Indicators (2006); and IMF staff calculations.¹“Within” refers to the cross-country median of the average value of the variable during episodes of large and persistent imbalances. “Outside” refers to the cross-country median of the average value of the variable for the same countries but in different periods. Asterisks show that the difference between the two medians is statistically significant at the 10 percent confidence level. REER stands for real effective exchange rate, PPP for purchasing power parity, and CGER for Consultative Group on Exchange Rate issues. See footnote 8 in Box 3.2 for more information.

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The experiences during the eight episodes of large and persistent current account surpluses in the advanced economies identified in the chapter again appear consistent with the intertemporal smoothing view of current account imbalances. In particular, these cases were associated with slower growth in consumption and a weaker performance of the stock market during the episodes (see second figure).

A key characteristic of the 12 episodes of large and persistent current account surpluses in emerging markets and oil exporters has been a relatively undervalued real effective exchange rate (see second figure).⁸ Moreover, these episodes have been characterized by faster accumulation of foreign reserves, faster export growth, and slower consumption growth. However, for these variables, the difference with the averages outside these periods is not statistically significant. Interestingly, GDP growth was not faster on average when these countries experienced a large and sustained surplus, suggesting that currency undervaluation is not likely to result in permanently higher growth.⁹

Note: The main author of this box is Roberto Cardarelli. 1 See, among others, Roubini and Setser (2004). 2 See, among others, Backus and Lambert (2005). 3 Clearly, the relatively small number of large and persistent episodes of external imbalances suggests caution in drawing general conclusions from these patterns. 4 See Appendix 3.1 for a list of all episodes. 5 Following an increase in productivity, expected future income increases more than current income, as the capital stock takes time to adjust. At the same time, consumption ratios increase in anticipation of higher future income. Both lower saving rates and higher investment ratios lead to a deficit in the current account balance (Ghosh and Ostry, 1995). 6 See also Freund and Warnock (2005) for a similar finding. 7 The findings that the nature of capital flows does not seem to vary prior to a current account adjustment for advanced economies (Debelle and Galati, 2005) and that the extent of the adjustment in advanced economies (the changes in GDP and currency values) does not seem to be related to the level of foreign debt (Freund and Warnock, 2005) are consistent with this interpretation. 8 The difference in medians is significant at a 10 percent or better confidence interval for the two measures of currency misalignment shown in the figure, namely, the residuals from the regressions of real exchange rates on PPP-adjusted relative per capita incomes (from Johnson, Ostry, and Subramanian, 2007) and the deviation of real exchange rates from the medium-term equilibrium values estimated by the Consultative Group on Exchange Rate issues. 9 Johnson, Ostry, and Subramanian (2007) document the role of currency undervaluation in past growth episodes in developing countries.

Second, measured long-run import price elasticities may be biased by vertical integration. Conventional empirical estimates of U.S. import price elasticities do not recognize that goods imported into the United States often are produced using intermediate goods exported from the United States (the share of U.S.-made intermediate goods in U.S. imports is estimated at about 30 percent).¹⁸ Thus, data on U.S. imports used in econometric estimates can be interpreted as the sum of two components, the imported foreign value added and the U.S. exports of intermediate goods. As a result, measured U.S. import price elasticities will also be the sum of two components, the “true” price elasticity of imports and the effect of exchange rates on U.S. exports of intermediate products. As real exchange rate depreciation will reduce the demand for imports but increase the demand for U.S. intermediate exports, ignoring vertical integration will cause the measured import price elasticities to be underestimated.¹⁹

Box 3.3.

Exchange Rate Pass-Through to Trade Prices and External Adjustment

The extent to which changes in nominal exchange rates pass through to changes in export and import prices—in short, exchange rate pass-through—affects the role of exchange rates in the process of external adjustment through two channels.¹ First, a limited pass-through at home and abroad can mute the expenditure-switching effect of exchange rate changes on trade volumes, as it forestalls movements in relative trade prices. Second, different degrees of pass-through at home and abroad affect the impact of exchange rate movements on the domestic terms of trade—the ratio between domestic-currency-denominated export and import prices—with a high pass-through at home and abroad associated with a worsening of the domestic terms of trade. It is the combination of the two effects, that is, the response of nominal trade balances, that ultimately matters for external adjustment.

Against this background, this box first reviews the available empirical evidence on exchange rate pass-through. It then discusses the implications of this evidence for nominal external adjustment. Finally, it draws some implications on the potential for a depreciation of the U.S. dollar to spur a change in the U.S. trade imbalance.

Evidence on Exchange Rate Pass-Through

A vast body of research shows that exchange rate movements are only partially transmitted to import prices—on average for OECD countries between 1975 and 2003, only 64 percent of the change in exchange rates has been transmitted to import prices after one year (see the table). Moreover, pass-through into prices at the border varies considerably across sectors—being lower for highly differentiated manufacturing products—and across countries, likely reflecting differences in the sectoral composition of imports as well as in market size. In particular, the United States tends to have a much lower pass-through to import prices than do other advanced economies—about 0.5—while smaller, more open economies have rates closer to one.² This difference may be related to the stronger domestic competition for imported goods in the United States and may also reflect the international use of the dollar in invoicing export and import transactions (Goldberg and Tille, 2005).

While there is broad consensus on the fact that pass-through to U.S. import prices is lower than in most other economies, it is not clear whether pass-through has declined in advanced economies over the recent past, with several studies reaching different conclusions depending on the methodology and data used.³ For emerging markets, pass-through coefficients have declined considerably in recent years, following the decline in inflation rates, and are now comparable to those in advanced countries (Frankel, Parsley, and Wei, 2005; and IMF, 2006).

The literature on pass-through of exchange rate movements into domestic-currency-denominated export prices is considerably less extensive. Most studies assume pass-through coefficients for exports derived as the average of the coefficients of pass-through to import prices of partner countries. For the United States, this gives an export pass-through of about 0.8.

Exchange Rate Pass-Through into Import Prices After One Year

Source: Campa and Goldberg (2005) unless otherwise noted.

¹Campa and Goldberg (2005).

²Faruqee (2006).

³Faruqee (2006); Campa and Goldberg (2005); and Otani, Shiratsuka, and Shirota (2006).

⁴Campa and Goldberg (2005). Average of Australia, Canada, Denmark, New Zealand, Norway, Sweden, Switzerland, and the United Kingdom.

⁵Frankel, Parsley, and Wei (2005).

⁶Average of the estimates above with low and high estimates for Japan.

Exchange Rate Pass-Through into Import Prices After One Year

Country
United States1	0.42
Euro area2	0.81
Japan3	0.53–1.00
Open advanced economies4	0.60
Developing countries and emerging markets5	0.66
Average excluding the United States6	0.66–0.77
Average including the United States6	0.61–0.70
Average for OECD countries1	0.64

Source: Campa and Goldberg (2005) unless otherwise noted.

¹Campa and Goldberg (2005).

²Faruqee (2006).

³Faruqee (2006); Campa and Goldberg (2005); and Otani, Shiratsuka, and Shirota (2006).

⁴Campa and Goldberg (2005). Average of Australia, Canada, Denmark, New Zealand, Norway, Sweden, Switzerland, and the United Kingdom.

⁵Frankel, Parsley, and Wei (2005).

⁶Average of the estimates above with low and high estimates for Japan.

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Exchange Rate Pass-Through into Import Prices After One Year

Country
United States1	0.42
Euro area2	0.81
Japan3	0.53–1.00
Open advanced economies4	0.60
Developing countries and emerging markets5	0.66
Average excluding the United States6	0.66–0.77
Average including the United States6	0.61–0.70
Average for OECD countries1	0.64

Source: Campa and Goldberg (2005) unless otherwise noted.

¹Campa and Goldberg (2005).

²Faruqee (2006).

³Faruqee (2006); Campa and Goldberg (2005); and Otani, Shiratsuka, and Shirota (2006).

⁴Campa and Goldberg (2005). Average of Australia, Canada, Denmark, New Zealand, Norway, Sweden, Switzerland, and the United Kingdom.

⁵Frankel, Parsley, and Wei (2005).

⁶Average of the estimates above with low and high estimates for Japan.

Pass-Through and Nominal Trade Adjustment

An important implication of the incomplete exchange rate pass-through to import prices is that the traditional Marshall Lerner condition—which states that for an exchange rate depreciation to increase the nominal trade balance, the sum of the export and import price elasticities must be greater than one (η_x+ η_m> 1)—no longer holds.⁴

Indeed, the Marshall Lerner condition is based on the assumption of complete pass-through to import prices at home and abroad.⁵ With complete pass-through, an exchange rate depreciation is fully transmitted to a country’s domestic terms of trade, since, as expressed in domestic currency, import prices increase by the full amount of the depreciation while export prices remain constant (though they decrease in foreign currency).⁶ In this case, the nominal trade balance improves only if the expenditure-switching effect from the changes in relative prices is sufficiently strong, that is, if the sum of trade price elasticities is larger than one. Moreover, if trade volumes respond more slowly than prices, the improvement will come with a lag and the trade balance will initially deteriorate (J-curve effect).

With zero pass-through at home and abroad, however, an exchange rate depreciation still improves the nominal trade balance even if price trade elasticities are low—and the traditional Marshall Lerner condition is not satisfied. In this case, expressed in domestic currency, import prices do not move with the exchange rate depreciation while export prices increase, as they are held constant in the currency of the destination market.⁷ In this environment, the exchange rate depreciation improves the nominal trade balance, thanks to more favorable terms of trade, even though the expenditure-switching channel on trade volumes is neutralized as relative trade prices do not change with the exchange rate.

The empirical evidence suggests that the pass-through environment for the United States is a combination of the two cases described above—with low pass-through of exchange rate changes into U.S. import prices and higher pass-through into foreign-market prices of U.S. exports. Hence, both U.S.-dollar-denominated export and import prices tend to be relatively insensitive to movements of the U.S. dollar (Goldberg and Tille, 2005).

In this context, a U.S. exchange rate depreciation is likely to improve the trade balance even if the trade price elasticities are low, as limited pass-through to the terms of trade reduces the burden of the adjustment on export and import volumes. Specifically, considering a pass-through to U.S. import prices of 0.5 and a pass-through to the foreign-market price of U.S. exports of 0.8,⁸ a 10 percent depreciation of the U.S. dollar would imply a 0.3 percent deterioration in the U.S. terms of trade. Even with the low U.S. trade price elasticities estimated in the standard empirical trade model (see Table 3.2), a depreciation of the U.S. dollar would narrow the trade deficit. This reduction would be mainly associated with stronger export volumes, following the decline in the foreign-currency-denominated price of U.S. export goods. However, as U.S. imports exceed exports by about 50 percent, this scenario would lead to only a partial narrowing of the trade deficit in the absence of other changes, such as a decline in the domestic demand for imports or an increase in foreign demand for U.S. products.

Overall, the main implication from this analysis is that given the particular pass-through environment for the United States, a U.S. dollar depreciation could contribute to some narrowing of the U.S. trade deficit even if trade price elasticities are relatively low. This contribution would take the form of an improvement in the real trade balance, with the terms of trade deteriorating less than with full pass-through.

Note: The author of this box is Cedric Tille. 1 This box focuses on pass-through to trade prices at the border. Pass-through to retail prices of traded goods is further limited by distribution costs (Campa and Goldberg, 2005). 2 These estimates, however, may underestimate the degree of pass-through as they fail to take into account the compositional effect associated with firms’ entry and exit following exchange rate movements (Rodríguez-López, 2006). 3 Campa and Goldberg (2005) find some decline of pass-through between 1975 and 2003 that primarily reflects a change of the import mix toward goods with low pass-through. Marazzi and others (2005) argue that the pass-through to U.S. import prices has declined further in recent years. Hellerstein, Daly, and Marsh (2006) find no evidence of a declining pass-through, while Thomas and Marquez (2006) argue that the measurement of foreign prices is central to the results and find that pass-through to import prices has remained constant at about 0.5 for the United States. 4 Both elasticities are with respect to relative prices and are taken in absolute value. 5 Defining the coefficient of pass-through to import prices at home as β_m and the coefficient of pass-through to export prices as 1 − β_x, the adjusted Marshall Lerner condition can be expressed as η_mβ_m + η_xβ_x > β_m + β_x − 1, where the left-hand side is the impact of a 1 percent depreciation on real net exports and the right-hand side is the impact of a 1 percent depreciation on the terms of trade. The traditional Marshall Lerner condition follows from assuming a complete pass-through to import prices at home (β_m = 1) and to import prices abroad (β_x = 1) (Gust and Sheets, 2006). 6 This is the traditional case of producer-currency pricing (e.g., Obstfeld and Rogoff, 1996 and 2000). 7 This is the case of local-currency pricing (e.g., Devereux and Engel, 2002). 8 As stressed by Dillon and Goldberg (2006), however, using this coefficient as a measure of the pass-through to U.S. export prices is valid only as a first approximation, as this estimate applies to all the imports of those countries, not just those from the United States. Faruqee’s (2006) direct estimates of pass-through to U.S. export prices in U.S. dollars are consistent with a pass-through to foreign-currency prices of U.S. exports of about 0.85 after 18 months.

Against this background, the basic standard empirical model was re-estimated controlling for the heterogeneity in individual sector price elasticities and for vertical integration:

• To control for the presence of heterogeneity in elasticities across sectors, the standard model was estimated for 17 categories of U.S. imports and 16 categories of U.S. exports, and aggregate trade price elasticities were calculated as the simple averages of individual elasticities.²⁰ This methodology yields much higher estimates of U.S. trade price elasticities—import price elasticities more than double while export price elasticities increase from zero to about 0.3 (in absolute value)—and the Houthakker-Magee asymmetry in income elasticities disappears (see Table 3.2).

• To correct for vertical integration, the basic model for U.S. imports was re-estimated adding U.S. exports of key intermediate products as an additional explanatory variable. This specification yields estimates of U.S. import price elasticities that are about twice as high as in the standard empirical model and have a much lower income elasticity (see Table 3.2).

Finally, the standard trade model was adapted to allow for the possibility that the responsiveness of trade to relative price changes depends on the size of the relative price changes—owing to the existence of fixed costs of entry into trade emphasized in the “new trade theory.” In particular, the standard trade model for the United States was re-estimated using a nonlinear error correction specification that allows trade volumes to return to their long-run level at a faster pace when the change in relative trade prices is above a certain threshold.²¹ The results show strong evidence of a nonlinear dynamic adjustment for U.S. import volumes. Specifically, they indicate that when relative import prices change by more than 2 percent per quarter (in absolute value), U.S. import volumes return to their long-run level much more rapidly, that is, after 5 quarters compared with 11 quarters when the changes are slower than the threshold.²²

Applying the same methodology to other OECD countries generally confirms that import and export volumes tend to react more strongly to changes in relative prices above a certain threshold. These thresholds varied considerably across countries, however, raising the question of whether the effectiveness of real exchange rate changes depends on structural differences across these economies.

Exchange Rate Effectiveness and Flexibility of Markets

Does the effectiveness of changes in real exchange rates increase with the flexibility of labor and product markets? In the traditional macroeconomic approach to trade modeling, countries expand their exports by exporting more “existing” goods, while the “new trade theory” has long emphasized the importance of trade in new varieties and new markets (Krugman, 1989). A growing body of empirical evidence supports the notion that fast-growing countries tend to increase their market share essentially by expanding the range of goods that they export.²³

This finding carries important implications for the role of exchange rate movements in external adjustment. As entry and exit into export markets require firms to sustain fixed costs, only large and persistent changes in relative prices may induce firms to incur such costs—consistent with the evidence of nonlin-earities in trade responsiveness discussed above. Moreover, more flexible production structures (that is, with lower fixed costs of entry and exit) could help firms take advantage of new opportunities when relative prices change permanently, and thus enhance a country’s aggregate trade responsiveness to exchange rate movements.

Two pieces of evidence point to a correlation between the effectiveness of real exchange rates and economic flexibility. First, there is a negative correlation between the thresholds in relative price changes found in the nonlinear model of trade volumes described above and an index of flexibility of product and labor markets (Figure 3.9).²⁴ This suggests that relative prices may need to change less to generate a faster adjustment of trade volumes in countries in which labor and product market rigidities are smaller. Second, separating the reversal episodes analyzed earlier based on the degree of flexibility of the economies in which they occurred suggests that changes in real effective exchange rates during adjustment have been smaller in relatively more flexible economies. Moreover, the negative trade-off between total real exchange rate depreciation and the average change in GDP after the reversal is found only for the more flexible economies, suggesting that only for them have the exchange rate movements been effective in cushioning (other things being equal) the output costs associated with adjustment (see Figure 3.9).

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Thresholds in Relative Trade Prices, Real Effective Exchange Rate, and Flexibility of Markets

Countries with higher values of the flexibility index tend to have lower thresholds in the growth rate of relative prices of imports and exports. More flexible economies have experienced smaller movements in real effective exchange rate (REER) during reversal episodes. Only for these economies does there appear to be a trade-off between REER depreciation and GDP growth during deficit reversals.

Sources: IMF, International Financial Statistics; OECD, Economic Outlook (2006); World Bank, World Development Indicators (2006); WorldBank, Cost of Doing Business database; and IMF staff calculations.¹Maximum change in REER within the period surrounding the reversal (−T … T), median across episodes. An increase represents a real appreciation while a decrease represents a real depreciation of a country’s currency relative to its trading partners.²Advanced economies only. Average real GDP growth after the reversal (1 … T) less average real GDP growth before the reversal (−T … −1) on the x-axis. Maximum change in REER within the period surrounding the reversal (−T … T) on the y-axis. Median across episodes.

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These findings suggest that changes in real exchange rates needed for a given amount of external adjustment will likely be larger for economies where rigidities in product and labor markets make it more difficult for firms to enter and exit trade.²⁵ Moreover, increased protectionism, by reducing effective flexibility in economies, would tend to raise the growth costs associated with deficit reversals for any given adjustment in relative prices.