3. Anatomy of External Shocks in Low-Income Countries
Author:
Mr. Valerio Crispolti
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Ms. Era Dabla-Norris
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Mr. Jun I Kim
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Ms. Kazuko Shirono
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https://orcid.org/0000-0003-2325-1075
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Mr. George C. Tsibouris
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Language:
English
Keywords:
OP; external shock; reserve; IMF staff calculation; cost; welfare cost; terms-of-trade shock; external shock event; growth loss; International reserves; Imports; Consumption; Terms of trade; Foreign direct investment; Global
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Abstract

Although the potential growth and welfare costs of external shocks in LICs are well documented, the role of reserves in mitigating the impact of such shocks warrants further attention. An event study approach is used to evaluate the macroeconomic consequences of various external shocks faced by LICs in relation to their levels of reserve coverage during the period 1980–2007 and during the subsequent global financial crisis. For each country, shock episodes are identified, and associated macroeconomic costs are derived, while differentiating the countries by their structural characteristics, such as the exchange rate regime, export and import concentration, debt levels, and the presence of a financial arrangement with the IMF. Building on these results, the analysis examines whether the macroeconomic costs associated with external shocks were larger in LICs that had lower international reserve holdings prior to a shock event.

Although the potential growth and welfare costs of external shocks in LICs are well documented, the role of reserves in mitigating the impact of such shocks warrants further attention. An event study approach is used to evaluate the macroeconomic consequences of various external shocks faced by LICs in relation to their levels of reserve coverage during the period 1980–2007 and during the subsequent global financial crisis. For each country, shock episodes are identified, and associated macroeconomic costs are derived, while differentiating the countries by their structural characteristics, such as the exchange rate regime, export and import concentration, debt levels, and the presence of a financial arrangement with the IMF. Building on these results, the analysis examines whether the macroeconomic costs associated with external shocks were larger in LICs that had lower international reserve holdings prior to a shock event.

Event Study Analysis

An external shock event is defined as a “significant worsening” in a country’s climatic conditions, terms of trade, external demand (proxied by real GDP growth in trading partners), foreign direct investment (FDI), or aid inflows. More precisely, a shock occurs if the annual percentage change of the shock variable (e.g., terms of trade) falls below the bottom 10th percentile of its country-specific distribution (Figure 3.1).1 Although the literature provides alternative definitions of shock events, this one presents several advantages, including (1) controlling for heterogeneity among LICs by using country-specific distributions, (2) capturing rare events by focusing on the bottom tenth percentile of distribution for the shock variable, and (3) centering the analysis on the reaction to the shock by assuming the same frequency of shocks for each country. Alternative definitions of shock events were also considered and are described in Appendix 2.

Figure 3.1.
Figure 3.1.

Definition of Shock Episodes

Source: IMF staff calculations.

For each shock event, the analysis identifies its economic impact and measures its cost in terms of forgone growth of real GDP and per capita consumption.2,3 In particular, the economic impact of a shock was evaluated through a five-year event window capturing the behavior of the relevant macroeconomic variables from one year before the shock episode until three years after the episode. By contrast, the economic cost associated with a shock was determined as the cumulative sum of the estimated growth losses, based on pre-shock trends, over the years following a shock episode.4 The estimated growth loss in terms of GDP or per capita consumption is computed as the negative difference between a country’s “shock” growth index—based on actual growth—and the “no-shock” growth index—based on pre-shock trends (Figure 3.2).5 The number of years in which a country experienced a loss may be interpreted as a measure of duration of the economic cost associated with a shock. Both the impact and the cost of shocks in LICs were examined differentiating between economies with different structural characteristics, including the exchange rate regime, export and import concentration, debt levels, and the presence of an IMF program.6

Figure 3.2.
Figure 3.2.

Identifying the Cost Associated with a Shock

Source: IMF staff calculations.Note: The cumulative sum of the annual losses represents the cost in percentage points associated with a shock. In this example, the duration is seven years.

Shock Frequency and Size

Between 1980 and 2007, LICs were confronted with a large shock event every 10 years on average (Table 3.1).7 The likelihood of a shock to FDI inflows was about 16 percent, whereas the likelihoods of a significant worsening in the climatic conditions or the terms of trade were 13 and 11 percent, respectively. By contrast, shocks to external demand were less frequent. The size of shocks varied by their nature. Typically, shocks to external demand and terms of trade had a magnitude of about two standard deviations from the sample mean. This implied, for example, a shock to the terms of trade would result in a fall in relative prices of about 29 percent. On the other hand, aid and FDI shocks had somewhat smaller effects, about one standard deviation, equivalent to a decline of 5 and 3 percentage points of GDP, respectively.

Table 3.1.

Frequency and Size of Shocks

(Average values)

article image
Sources: IMF, World Economic Outlook, April 2010; and IMF staff calculations. Note: FDI: foreign direct investment.

In percentage points of GDP.

The geographical distribution of shocks showed noteworthy differences (Table 3.2). Shocks to external demand occurred more frequently in the Middle East, East Asia, and sub-Saharan Africa. Significant changes in the terms of trade and climatic conditions were more likely to occur in the Middle East and East Asia, whereas FDI shocks were prominent in South Asia and sub-Saharan Africa. Finally, drops in aid flows were important in Eastern Europe and Latin America. In terms of size, external demand shocks amounted to almost two standard deviations in Eastern Europe and the Middle East; shocks to the terms of trade had relatively larger effects in the Middle East, Latin America, and sub-Saharan Africa. The size of FDI and aid shocks significantly exceeded the sample average in East and South Asia, as well as in Latin America.

Table 3.2.

Frequency and Size of Shocks by Region

(Average values)

article image
Source: IMF, World Economic Outlook, April 2010; and IMF staff calculations.

In percentage points of GDP.

Macroeconomic Impact of External Shocks (1980–2007)

Shock episodes were accompanied by a visible deterioration of the macroeconomic situation in the sample. In the case of a terms-of-trade shock, the median GDP growth rate fell by 0.5 percentage points in the year following the shock episode and remained below the pre-shock trend during the entire event window (Figure 3.3). Similarly, median real per capita consumption growth remained subdued during the event window, more so in the presence of a significant worsening in external demand (Table A2.4). Against this background, the current account deficit generally widened and remained depressed for about two years before returning to pre-shock levels. Reserve coverage in months of imports showed different trends. It fell following shocks to external demand and the terms of trade, possibly reflecting the use of international reserves to finance imports when sources of foreign exchange were limited. By contrast, reserve coverage increased steadily after a shock to FDI and aid flows, suggesting that in LICs foreign financing flows have large import content.

Figure 3.3.
Figure 3.3.

Macroeconomic Impact of Terms-of-Trade Shocks

(Annual percentage changes unless otherwise indicated; median values)

Source: IMF, World Economic Outlook, April 2010; and IMF staff calculations.

Structural vulnerabilities exacerbated the impact of shocks (Figure 3.4, Table A2.4). External demand shocks had a larger macroeconomic impact in highly indebted and commodity-exporting economies, reflecting their greater dependence on exports as sources of financing.8 After a terms-of-trade shock, countries with a fixed exchange rate regime showed a protracted slowdown in economic activity and a decline in per capita absorption. The macroeconomic consequences of climatic shocks were more visible in islands and commodity-exporting countries, likely reflecting their fairly concentrated production base. Finally, a significant worsening in FDI and aid flows had a fairly prolonged impact in countries without an IMF-supported program around the time of the shock episode.

Figure 3.4.
Figure 3.4.

Macroeconomic Impact of Shocks by Structural Characteristics

(Average annual percentage changes; median values)

Sources: IMF, World Economic Outlook, April 2010; and IMF staff calculations.

The macroeconomic costs associated with external shocks were large and persistent (Figure A2.4). In the presence of an external demand shock, cumulative losses expressed as forgone GDP growth were as high as 2 percentage points of GDP over four years (Figure 3.5). The macroeconomic costs related to a significant worsening in FDI inflows and climatic conditions were typically modest, approximately 0.2 percentage points of GDP growth in a year. By contrast, shocks to terms of trade were not accompanied by any output loss. Costs in terms of forgone growth of real per capita consumption were larger.9 After a terms-of-trade shock, consumption growth remained below trend for 13 years, resulting in a cumulative loss of 18 percentage points. Although this result seems to overstate the cost of terms-of-trade shocks in LICs, previous research suggests that such shocks have a prolonged impact on households’ purchasing power and hence on consumption (IMF, 2008). In the case of a shock to external demand, costs amounted to 7 percentage points over six years, whereas cumulative losses were rather modest and short-lived under FDI and climatic shocks.

Figure 3.5.
Figure 3.5.

Costs by Shock Type

(Losses with respect to pre-shock trend in percentage points; median values)

Source: IMF, World Economic Outlook, April 2010; and IMF staff calculations.

The magnitude and persistence of costs varied significantly depending on the structural characteristics of the economy (Figures 3.6 and A2.4). Generally, costs in terms of real GDP growth were larger and more persistent in islands, as well as in commodity-exporting and -importing economies. Countries with a flexible exchange rate regime prior to a shock event showed hardly any loss, highlighting the role of the exchange rate as a shock absorber. Also, an early program engagement with the IMF in the proximity of a shock event was generally associated with very limited losses. Finally, costs related to a worsening in climatic conditions were fairly large in island economies with cumulative losses reaching approximately 14 percentage points of GDP after a decade.

Figure 3.6.
Figure 3.6.

Costs by Shock Type and Structural Characteristics

(Cumulative losses; percentage points; median values)

Source: IMF, World Economic Outlook, April 2010; and IMF staff calculations.

The analysis in terms of real per capita consumption growth gave similar results. Namely, countries with a fixed exchange rate regime normally suffered larger consumption losses than economies with a flexible regime, confirming previous findings on the role of the exchange rate. Also, consumption sharply dropped with respect to the pre-shock trend in commodity-exporting and -importing countries following shocks to external demand and terms of trade. In islands and highly indebted economies, costs associated with a significant worsening in terms of trade exceeded 20 percentage points of consumption over 10 years. Notably, the presence of an IMF-supported program did not produce tangible benefits in shielding consumption, perhaps reflecting the role played by fiscal consolidation in such arrangements. The results of the analysis broadly hold if costs were measured in terms of forgone per capita absorption growth.10

The Role of International Reserves

International reserve holdings helped contain the economic costs associated with external shocks. In particular, the role of international reserves was assessed by grouping LICs according to whether their reserve coverage was strictly above or below three months of imports in the year preceding the shock event and comparing losses between the two groups.11 Under most shocks, annual losses declined as reserve holdings approached three months of imports, suggesting that in LICs the standard rule of thumb of three months of imports is at most a lower bound (Figure 3.7).

Figure 3.7.
Figure 3.7.

Annual Losses and Level of Reserves

Sources: IMF, World Economic Outlook, April 2010; and IMF staff calculations.Note: Reserve coverage is measured in months of imports.

Countries with higher levels of international reserves in the year preceeding a shock event were better able to cushion economic activity (Figures A2.5 and A2.6). In terms of real GDP growth, countries with reserve coverage above three months of imports did not suffer any losses except in the case of shocks to FDI inflows (Figure 3.8). Economies with reserve coverage of less than three months of imports, however, generally encountered significant costs, particularly from an external demand shock, with cumulative losses reaching approximately 13 percentage points over eight years. Higher reserves were also associated with a smoother adjustment of real per capita consumption growth. Except for FDI shocks, cumulative losses in terms of forgone consumption growth were generally about 2 percentage points in countries with more than three months of imports. By contrast, countries with lower reserve coverage presented an annual average loss of about 1 percentage point for nearly six years. In the case of a terms-of-trade shock, cumulative losses were more than 20 times larger for countries with reserves of less than three months of imports than for those with more than three months of imports, suggesting that the benefits of entering a shock episode with higher reserve holdings may be substantial.

Figure 3.8.
Figure 3.8.

Costs of External Shocks by Variable and Type of Shock

(Losses computed with respect to pre-shock trend in percentage points; median values)

Sources: IMF, World Economic Outlook, April 2010; and IMF staff calculations.

The benefits of facing a shock episode with higher reserve coverage are even more pronounced if the costs of shocks are expressed in terms of real per capita absorption growth (Figure 3.9). Economies with reserve holdings below three months of imports were associated with an annual average loss of about 2.6 percentage points for about 10 years. Losses were particularly large and prolonged in the face of external-demand and terms-of-trade shocks, as the average annual loss reached 3.3 percentage points over 16 years. By contrast, countries with reserve coverage above three months of imports were not associated with any loss under any type of shock. The marked difference between absorption and consumption costs seems to suggest that investment may play an important role as a shock absorber in countries that have a limited amount of international reserves.

Figure 3.9.
Figure 3.9.

Absorption Costs of External Shocks by Reserve Coverage

(Losses computed with respect to preshock trend, in percentage points; median values)

Source: IMF, World Economic Outlook, April 2010; and IMF staff calculations.

Structural characteristics of the economy had a bearing on the role of international reserves (Figures A2.5 and A2.6). Reserve coverage above three months of imports was not a safe haven when it came to GDP losses from a terms-of-trade shock—particularly for island economies and countries with an exchange rate peg (Figure 3.10). Similarly, cumulative losses were significant in oil-exporting and commodity-importing countries after a significant worsening of external demand. Reserves above three months of imports, however, appeared to be an adequate cushion against all shocks in heavily indebted economies. In terms of per capita consumption growth losses, international reserves seem to have allowed for consumption smoothing. Under a fixed exchange rate regime, costs were somewhat smaller in countries with reserve coverage of more than three months of imports prior to the shock episode. Among countries with reserve coverage below three months of imports, losses were larger in commodity-importing countries, islands, and heavily indebted economies. Countries without an IMF program generally experienced a more prolonged adjustment than countries with an IMF program in the proximity of a shock episode.

Figure 3.10.
Figure 3.10.

Costs of External Shocks by Structural Characteristics of the Economy

(Cumulative losses, in percentage points; median values)

Sources: IMF, World Economic Outlook, April 2010; and IMF staff calculations.

The Global Financial Crisis (2007–10)

The global financial crisis has had a significant impact on LICs (Figure 3.11). In 2008, these economies faced an unprecedented surge in oil and food prices, which increased countries’ policy challenges to maintain macroeconomic stability (IMF, 2008). In 2009 and early 2010, the spillovers from the financial crisis in the advanced countries put LICs under additional strain as external demand and sources of foreign financing declined markedly (IMF, 2009). As a result, between 2007 and 2009, the median GDP growth and real per capita consumption in LICs dropped by 3 and more than 4 percentage points, respectively. External imbalances also widened markedly. In 2008, the median current account deficit deteriorated by about 3 percentage points of GDP, mainly reflecting a sharp worsening in terms of trade. Though international prices softened thereafter, external accounts remained under pressure due to adverse spillovers from the global financial crisis. Against this background, median reserve coverage experienced large swings. In 2008, it fell by almost one month of imports following a lower accumulation of international reserves and higher import prices (Table A2.6).12 In 2009, median coverage increased by one and a half months of imports as countries adjusted to the shock and the special drawing right (SDR) allocation from the IMF became available to all members.13

Figure 3.11.
Figure 3.11.

Macroeconomic Impact of the Crisis

(Median values)

Sources: IMF, World Economic Outlook, September 2011; and IMF staff calculations.

International reserves helped LICs withstand the impact of the global crisis (Figure 3.12). Countries that entered the crisis with reserve coverage above three months of imports were better able to buffer economic activity and smooth consumption than economies with a lower level of international reserves in 2007. In countries with reserve holdings above three months of imports, the median accumulation of international reserves came almost to a halt in 2008, falling to 3 percent (compared with an increase of 30 percent in 2007) and remaining consistently below that of economies with fewer reserves thereafter (Table A2.6). Economies with a slender level of reserves showed a sharper correction in median real per capita investment, possibly indicating that, absent a comfortable level of reserves, LICs curtailed investment in an attempt to protect consumption.

Figure 3.12.
Figure 3.12.

Macroeconomic Impact of the Crisis by Level of Reserves

(In percent; median values)

Sources: IMF, World Economic Outlook, September 2011; and IMF staff calculations.

As in the event study analysis for the prior period, the potential benefits of holding international reserves differed according to the structural characteristics of the economy (Figure 3.13). Median GDP growth declined in island economies with reserve coverage below three months of imports prior to the shock event, while remaining largely positive in islands with higher reserves (Table A2.6). Similarly, countries with high debt, fairly concentrated exports, and no financial arrangement with the IMF experienced a rather slow pace of economic growth. In terms of real per capita consumption growth, heavily indebted countries with reserves below three months of imports confirmed their vulnerability to external shocks. Higher reserve coverage, however, could not prevent a significant adjustment of consumption patterns in commodity-importing and island economies.

Figure 3.13.
Figure 3.13.

Macroeconomic Performance by Level of Reserves and Structural Characteristics

(Average annual percent change between 2008 and 2010, unless otherwise indicated)

Sources: IMF, World Economic Outlook, September 2011; and IMF staff calculations.
1

Shock episodes that were contiguous or less than three years apart were recorded as one shock event occurring in the earliest available year. Moreover, shock events were derived independently from each other (i.e., the matrix of variances and covariances of shocks is assumed to be diagonal). Finally, the threshold of the 10th percentile was derived from the country-specific distribution of the shock variable excluding the 1st and 99th percentiles so as to limit the impact of outliers on the analysis.

2

The economic impact and cost of shocks are assessed without controlling for the presence of combined-shock episodes (i.e., instances in which two or more shocks of a different nature happen simultaneously). Although this may overemphasize annual losses associated with shock events, combined shocks were not frequent in the sample: one out of six shock years featured two simultaneous shocks, and one out of thirty featured three simultaneous shocks.

3

The impact and cost of shocks were also computed in terms of real per capita absorption growth. Because the findings of this analysis are broadly consistent with those based on GDP and per capita consumption growth, they are not discussed at length in this chapter. Nonetheless, detailed results on the impact and cost of shocks in terms of per capita absorption are available from the authors upon request.

4

The pre-shock trend is defined as the average growth rate of the relevant variable in the three years preceding the shock event.

5

By construction, both indices take on the value 100 in the year preceding the shock. Subsequently, the “no-shock” index increases at a constant rate given by the variable’s pre-shock trend growth; whereas, the “shock” index follows actual growth after the shock occurred. As a result, the difference between the two indices represents the loss in percentage points of growth.

6

The exchange rate classification follows Ghosh, Gulde, and Wolf (2002) and the relevant regime is the one prevailing the year before the shock event. The presence of a program with the IMF is assessed during the period ranging from a year prior to the shock to three years after; countries were then differentiated depending on whether they had a program with the IMF (i.e. either in the year of the shock or the one before) or no arrangement at all.

7

Although this result is a straightforward consequence of the definition of shock used in the analysis, the actual frequency of shocks in the sample may differ from 10 percent (i.e., a shock every 10 years) because of the adjustments mentioned in footnote 1.

8

See Table A1.1 for a definition of commodity importer/exporter and a list of the countries included in each group. Heavily indebted economies are defined as countries where the public or external debt-to-GDP ratio was on average greater than 50 percent during the sample period.

9

Similar conclusions would be reached if costs were expressed in terms of real per capita absorption growth.

10

Space does not permit detailed results to be provided here. They are available from the authors upon request.

11

It is important to stress that the threshold of three months of imports should be considered as illustrative. Alternative rules—including different thresholds for reserve coverage in month of imports or as a share of GDP—were also examined, but did not yield substantially different results.

12

This result is in line with the findings of the event study analysis for shocks to external demand and terms of trade (Table A2.4).

13

See Table A2.5 for more information on the size of the SDR allocation in LICs.

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Cover Assessing Reserve Adequacy in Low-Income Countries
Assessing Reserve Adequacy in Low-Income Countries
Author:
Mr. Valerio Crispolti
,
Ms. Era Dabla-Norris
,
Mr. Jun I Kim
,
Ms. Kazuko Shirono https://orcid.org/0000-0003-2325-1075
, and
Mr. George C. Tsibouris
ISBN:
9781616354121
ISSN:
0251-6365
Publication Date:
08 Mar 2013
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781616354121.084
Pages:
78
  • <sup><xref rid="Rch03fig01" ref-type="fig">Figure 3.1</xref>.</sup>
    View in gallery
    Figure 3.1.

    Definition of Shock Episodes

  • <sup><xref rid="Rch03fig02" ref-type="fig">Figure 3.2</xref>.</sup>
    View in gallery
    Figure 3.2.

    Identifying the Cost Associated with a Shock

  • <sup><xref rid="Rch03fig03" ref-type="fig">Figure 3.3</xref>.</sup>
    View in gallery
    Figure 3.3.

    Macroeconomic Impact of Terms-of-Trade Shocks

    (Annual percentage changes unless otherwise indicated; median values)

  • <sup><xref rid="Rch03fig04" ref-type="fig">Figure 3.4</xref>.</sup>
    View in gallery
    Figure 3.4.

    Macroeconomic Impact of Shocks by Structural Characteristics

    (Average annual percentage changes; median values)

  • <sup><xref rid="Rch03fig05" ref-type="fig">Figure 3.5</xref>.</sup>
    View in gallery
    Figure 3.5.

    Costs by Shock Type

    (Losses with respect to pre-shock trend in percentage points; median values)

  • <sup><xref rid="Rch03fig06" ref-type="fig">Figure 3.6</xref>.</sup>
    View in gallery
    Figure 3.6.

    Costs by Shock Type and Structural Characteristics

    (Cumulative losses; percentage points; median values)

  • <sup><xref rid="Rch03fig07" ref-type="fig">Figure 3.7</xref>.</sup>
    View in gallery
    Figure 3.7.

    Annual Losses and Level of Reserves

  • <sup><xref rid="Rch03fig08" ref-type="fig">Figure 3.8</xref>.</sup>
    View in gallery
    Figure 3.8.

    Costs of External Shocks by Variable and Type of Shock

    (Losses computed with respect to pre-shock trend in percentage points; median values)

  • <sup><xref rid="Rch03fig09" ref-type="fig">Figure 3.9</xref>.</sup>
    View in gallery
    Figure 3.9.

    Absorption Costs of External Shocks by Reserve Coverage

    (Losses computed with respect to preshock trend, in percentage points; median values)

  • <sup><xref rid="Rch03fig10" ref-type="fig">Figure 3.10</xref>.</sup>
    View in gallery
    Figure 3.10.

    Costs of External Shocks by Structural Characteristics of the Economy

    (Cumulative losses, in percentage points; median values)

  • <sup><xref rid="Rch03fig11" ref-type="fig">Figure 3.11</xref>.</sup>
    View in gallery
    Figure 3.11.

    Macroeconomic Impact of the Crisis

    (Median values)

  • <sup><xref rid="Rch03fig12" ref-type="fig">Figure 3.12</xref>.</sup>
    View in gallery
    Figure 3.12.

    Macroeconomic Impact of the Crisis by Level of Reserves

    (In percent; median values)

  • <sup><xref rid="Rch03fig13" ref-type="fig">Figure 3.13</xref>.</sup>
    View in gallery
    Figure 3.13.

    Macroeconomic Performance by Level of Reserves and Structural Characteristics

    (Average annual percent change between 2008 and 2010, unless otherwise indicated)

Figure 3.1.

Definition of Shock Episodes
Figure 3.2.

Identifying the Cost Associated with a Shock
Figure 3.3.

Macroeconomic Impact of Terms-of-Trade Shocks

(Annual percentage changes unless otherwise indicated; median values)
Figure 3.4.

Macroeconomic Impact of Shocks by Structural Characteristics

(Average annual percentage changes; median values)
Figure 3.5.

Costs by Shock Type

(Losses with respect to pre-shock trend in percentage points; median values)
Figure 3.6.

Costs by Shock Type and Structural Characteristics

(Cumulative losses; percentage points; median values)
Figure 3.7.

Annual Losses and Level of Reserves
Figure 3.8.

Costs of External Shocks by Variable and Type of Shock

(Losses computed with respect to pre-shock trend in percentage points; median values)
Figure 3.9.

Absorption Costs of External Shocks by Reserve Coverage

(Losses computed with respect to preshock trend, in percentage points; median values)
Figure 3.10.

Costs of External Shocks by Structural Characteristics of the Economy

(Cumulative losses, in percentage points; median values)
Figure 3.11.

Macroeconomic Impact of the Crisis

(Median values)
Figure 3.12.

Macroeconomic Impact of the Crisis by Level of Reserves

(In percent; median values)
Figure 3.13.

Macroeconomic Performance by Level of Reserves and Structural Characteristics

(Average annual percent change between 2008 and 2010, unless otherwise indicated)

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