- Donal McGettigan
- Published Date:
- February 2000
The virulence of the financial crisis in Asia and the continuing crisis in Russia highlight the importance of assessing the sustainability of a country’s current account balance, and, more generally, its vulnerability to external crisis.1 It is not surprising, therefore, that many previous assessments of external sustainability have been undertaken for a variety of industrial and emerging market economies. To date, however, very few such studies have focused on transition economies.
Large current account imbalances have been recorded in the Baltics, Russia, and other countries of the former Soviet Union since independence. For example, deficits greater than 15 percent of GDP were recorded for Armenia, Azerbaijan, and Turkmenistan in 1997. Such imbalances are exceptionally high by industrial country standards. They also far exceed those experienced by emerging market economies that have witnessed balance of payments crises over the past few years. For example, Mexico ran deficits of 8 percent and 10 percent in 1994 and 1995, respectively, around the time of its external crisis.2 Furthermore, even narrower imbalances were recorded in ASEAN economies in 1996 and 1997, just before the recent financial market turmoil. Besides Thailand, which also experienced a current account deficit of 8 percent of GDP in 1996, imbalances recorded by the other major economies caught up in the crisis, that is, South Korea, Indonesia, and Malaysia, were far smaller.
Are the current account positions of the Baltics, Russia, and other countries of the former Soviet Union, therefore, sustainable or do they reflect the special circumstances of transition, and will they be matched by offsetting surpluses in the future? The intertemporal approach to the current account, which views this balance as the outcome of forward-looking savings and investment decisions of economic agents, provides a useful framework for assessing the appropriateness of a country’s current account position.3 Using such a framework, it can be shown that deficits may enhance welfare under certain conditions. For instance, if a country’s output is below its permanent long-run level, current account deficits can lead to a smoothing of its consumption pattern over time. Deficits may also reflect the use of foreign funds to facilitate worthwhile investment projects that cannot be financed from domestic savings alone. Both arguments have been used in the past to justify current account deficits in these countries.
Although deficits can be beneficial, there are circumstances where resultant debt positions become unsustainable. This paper focuses on a variety of indicators, based on current account and other external considerations, that have previously been used to gauge the sustainability of a country’s external position, and attempts to assess their potential usefulness as applied to the Baltics, Russia, and the other countries of the former Soviet Union.4 Such a study is particularly important in light of the recent Russian crisis. While the study proposes some preliminary deductions concerning the external sustainability of these countries, this is not its primary focus. For a proper analysis of external sustainability, it would be necessary to supplement the use of indicators with in-depth individual country analyses, as argued in IMF (1998).
Current account sustainability is a surprisingly difficult concept to tie down. Ex ante solvency is sometimes employed as the relevant criterion in assessing the long-run feasibility of current account imbalances. An economy is deemed to be solvent if the net present value of its future trade surpluses is at least equal to the current value of its net external debt. This is a very weak condition, however, in that it only requires that a country’s external debts be repaid over the very long run. Therefore, even if a country has been running persistently large current account deficits, it is considered solvent as long as offsetting current account surpluses are envisaged sometime in the future.
A more widespread idea is that of sustainability. A country’s current account position may be deemed sustainable if—assuming domestic policies and the external macroeconomic environment are unaltered—the country does not violate its intertemporal solvency constraint. As Ostry (1997) and Milesi-Ferretti and Razin (1996) argue, however, the notion of sustainability is difficult to apply operationally. Current account imbalances reflect the savings and investment decisions of both the public and private sectors, as well as the lending decisions of foreign investors. Savings and investment decisions of the private sector are forward-looking variables that depend on the expectations of the future evolution of a variety of economic variables. The assumption that policies remain unchanged may be incompatible with such expectations.
Accordingly, alternative approaches to the notion of sustainability are sometimes used. If the continuation of current policies is likely to lead to the need for a drastic policy shift or to a crisis, then the current imbalance is deemed to be unsustainable. This concept is employed by Milesi-Ferretti and Razin (1996). Ostry (1997) makes the useful distinction between the sustainability and the risks associated with a given current account position. Unforeseen shocks, such as a terms-of-trade deterioration or an increase in world interest rates, can turn what is considered a sustainable current account balance ex ante into an unsustainable balance ex post. Such shocks also include changes in investors’ willingness to lend due to the perception that a country may be unable (or unwilling) to pay its external debt. Taking into account the potential risk of unsustainability broadens the concept considerably, thereby paving the way for a wide variety of external indicators. This is the approach adopted in this paper, which analyzes a large number of alternative sustainability indicators.
In a later section, the paper outlines and analyzes a set of commonly used indicators of current account sustainability. Special features of transition countries, which may affect the interpretation of the indicators, are highlighted throughout. Before proceeding to such a discussion, however, the paper briefly outlines current account developments in the countries over the last few years.
Section II of the paper outlines the evolution of current account positions in the countries since independence. Section III assesses the potential usefulness of some of the main indicators used to analyze current account and external sustainability as applied to these countries, while taking due account of the special features of transition economies. Section IV summarizes and concludes. Given its importance, the Russian crisis5 is covered separately in an appendix, and the usefulness of the various indicators used in the paper are assessed.