IV External Sustainability
- Jaewoo Lee, Jonathan Ostry, Alessandro Prati, Luca Ricci, and Gian Milesi-Ferretti
- Published Date:
- April 2008
The external sustainability (ES) approach, not previously used in Consultative Group on Exchange Rate Issues (CGER) assessments, complements the two other methodologies by focusing on the relationship between the sustainability of a country’s external stock position and its flow current account position, trade balance, and real exchange rate. It consists of three steps. The first involves determining the ratios of trade or current account balance to GDP that would stabilize the net foreign asset position at given “benchmark” values. The second step compares these NFA-stabilizing trade or current account balances with the level of a country’s trade or current account balance expected to prevail over the medium term. And, finally, the third step consists of assessing the adjustment in the real effective exchange rate that is needed to close the gap between the medium-term trade and current account balances and the NFA-stabilizing trade and current account balances.
Unlike the macroeconomic balance (MB) and equilibrium real exchange rate (ERER) approaches, which rely on econometric estimation, the ES approach requires only a few assumptions about the economy’s potential growth rate, inflation rate, and rates of return on external assets and liabilities. This simple and transparent structure makes it a natural reference point against which to compare more sophisticated econometric approaches. The implications of the ES approach are straightforward. Debtor economies that grow faster can afford to run larger current account deficits and smaller trade balances without increasing their ratio of external liabilities to GDP. Also, high rates of return on external assets and liabilities imply that debtor countries need larger trade balances (and creditor countries can afford larger deficits) to stabilize the external position. Finally, economies that earn lower rates of return on their assets than they pay out on their liabilities (for example, because of risk premiums on their external debt) must—other things being equal—run larger trade surpluses to stabilize their net foreign assets.
We first discuss the theoretical basis for the external sustainability approach and define how results relate to the underlying variables. Then we discuss the choice of the benchmark value for net foreign assets. The next subsection provides a simple example that determines the current account balance consistent with stabilization of net foreign assets at their most recent level. Finally, we briefly discuss the implications of the NFA-stabilizing trade and current account balances for the medium-term real exchange rate.
Like approaches to public debt sustainability that develop the concept of the debt-stabilizing primary fiscal balance, the ES approach relies on an intertemporal budget constraint—in this case for the economy as a whole rather than just the fiscal sector—which requires that the present value of future trade surpluses is sufficient to pay for the country’s outstanding external liabilities. One simple (albeit not unique) way to satisfy a country’s intertemporal budget constraint is to ensure that the size of net foreign assets is stabilized relative to the size of the economy, thus preventing assets or liabilities from growing without bound. We invoke this assumption in the following discussion.
To determine the level of the current account balance that stabilizes NFA at a given level, we use the accumulation equation for net foreign assets (denoted by Bt), which states that changes in net foreign assets are due either to net financial flows (net purchases of foreign assets minus net foreign purchases of domestic assets) or to changes in the valuation of outstanding foreign assets and liabilities:
where CAt is the current account balance, KGt is capital gains arising from valuation changes, and Et includes factors such as capital account transfers and errors and omissions that can drive a wedge between the current account balance and net financial flows. Assuming that E = 0, so that the current account and net financial flows coincide, and denoting ratios to GDP by lowercase letters, Equation (1) can be rewritten as follows:
where gt is the growth rate of real GDP and πt is the inflation rate. If it is further assumed that capital gains are zero and the benchmark level of NFA is denoted by bs, the current account that stabilizes NFA at bs is
Using the same approach, and assuming for simplicity that the real rates of return on external assets and liabilities are the same (r), the level of the trade balance inclusive of services and transfers (bgst) consistent with stabilizing NFA at the level bs is
Condition (4) is analogous to the determination of the debt-stabilizing primary balance in public debt sus-tainability analysis. Conditions (3) and (4) imply the following links between the current account, economic growth, inflation, and the net external position:
Net foreign asset position. The current account balance consistent with stabilizing the ratio of net foreign assets to GDP at a level bs is proportional to bs. For example, for a country with a nominal growth rate of 5 percent, the current account balance necessary to stabilize net foreign assets at −50 percent of GDP is about −2.5 percent. If the interest rate exceeds the growth rate, the trade balance consistent with a stable net foreign asset position is instead inversely proportional to bs. For example, if the nominal rate of interest is 7 percent, stabilizing net foreign assets at −50 percent of GDP requires a trade surplus of 1 percent of GDP. Finally, Equation (4) shows that if the rate of return and the rate of growth are close in value, the trade balance necessary to stabilize net foreign assets is not very sensitive to the benchmark level bs.
Economic growth. The absolute size of the current account balance and trade balance consistent with stabilizing net foreign assets at any given level bs is proportional to the rate of growth. To continue with the previous example, the current account balance consistent with stabilizing net foreign assets at −50 percent of GDP becomes −4 percent of GDP if nominal growth is 8 percent, compared with the value of −2.5 percent when growth was assumed to be 5 percent.
Rates of return. For a given growth rate, an increase in the rate of return on external assets and liabilities requires a larger trade balance for a debtor country and a smaller trade balance for a creditor country to stabilize the ratio of net foreign assets to GDP at any given level. For both debtors and creditors, the absolute size of the trade balance that stabilizes NFA at a given level grows with the absolute size of the differential between the rates of return and the growth rate.
Rate of return differentials. As shown in Appendix 4.1, a positive rate of return differential between external assets and liabilities implies that a smaller trade balance is necessary to stabilize the ratio of NFA to GDP. Conversely, a negative differential requires a larger trade balance to stabilize NFA. The effect is proportional to the size of the return differential and to the size of gross external positions, and is therefore increasing in the level of international financial integration. A 2 percent return differential between external assets and liabilities when these are about 100 percent of GDP—a value lower than the current one in many advanced economies—implies that the NFA-stabilizing trade balance is 2 percentage points of GDP lower than what Equation (4) would suggest. For example, the U.S. net foreign asset position has been broadly stable as a ratio of GDP since 2001, despite very large trade and current account deficits, because of a substantial positive return differential between U.S. external assets and liabilities.32
Choosing a Benchmark Level for Net Foreign Assets
Clearly, the benchmark level of net foreign assets is a key element in the assessment of the current account balance (or of the exchange rate). However, the choice of bs is to some extent arbitrary, and may reflect a variety of considerations. For example, low external exposure is likely to be associated with reduced risks of external crises or disruption, but may also leave faster convergence possibilities unexploited by forgoing higher access to foreign capital. For creditor countries, similar considerations apply—a large stock of foreign assets is a useful buffer against external risks and declining domestic returns on capital, but may also imply inefficiently low domestic consumption and investment. Benchmark levels could also be estimated on the basis of cross-country and time-series evidence, relating the external asset positions to underlying fundamentals such as the level of development, demographics, and fiscal policy (as in Lane and Milesi-Ferretti, 2001), analogously to the empirical analysis of current account balances underpinning the MB approach.
In the example below, the workings of this approach are illustrated using the NFA position in 2006—the latest year for which complete data are available—as the benchmark level. While stabilization of the NFA position at its 2006 level has little normative content, it does provide a useful perspective on whether projected current account developments at current exchange rates are expected to lead to larger debtor or creditor positions over time. Assessing whether such trends in external positions are desirable provides an additional perspective on the appropriateness of current real exchange rates from a medium-term perspective. One important factor to be taken into account in addressing these trends is the impact of large shifts in commodity prices, particularly for exporters of nonrenewable resources. In such cases, an increase in commodity prices should be reflected in a temporary accumulation of net foreign assets through current account surpluses, particularly for countries where such resources are likely to be rapidly depleted.
An Example: Using 2006 NFA as the Benchmark Level
In this example, the current account balance that would stabilize the ratio of NFA to GDP at its estimated level in 2006 is derived. The current account that stabilizes NFA at the 2006 level (in percent of GDP) is computed by using Equation (3). For the calculation, an inflation rate of 2.5 percent is assumed, consistent with the WEO projections for the United States over the medium term.33 The real GDP growth for each country, gt, is assumed to be the potential output growth rate embodied in WEO projections.
Results for the country groupings used in Section II are presented in Table 4, where the NFA-stabilizing current account balance is compared with the projected medium-term current account at prevailing real exchange rates. Among non-European advanced economies, projected current account deficits at current real exchange rates would lead to a substantial increase in external liabilities, reflecting the large projected current account imbalances for the United States.
(In percent of GDP)
|Central and Eastern|
Among most emerging market economies, projected current account balances exceed the levels that would stabilize NFA at its 2006 level, indicating a trend toward reduced external liabilities and/or increased net foreign assets, which is particularly pronounced in emerging Asia, already a net creditor region. In contrast, projected current accounts are associated with a worsening external position in Central and Eastern European countries, where in several cases sizable current account deficits are expected to persist over the medium term.
As discussed above, stabilization of the NFA position at its 2006 level has little normative content. Nevertheless, the exercise provides a perspective on how current account balances expected to prevail at current exchange rates would affect the net external asset position of countries over the medium term. On this basis, the results suggest that emerging market countries as a bloc seem likely to further increase their net asset positions, mirroring a further deterioration in the position of non-European advanced economies, which mainly reflects the position of the United States.
Current Account, Net Foreign Assets, and Exchange Rate Adjustment
The last step of the approach consists of deriving the medium-term real effective exchange rate that would be consistent with stabilization of net foreign assets at the benchmark level. As in the MB approach, this calculation relies on estimating the change in the real effective exchange rate needed to induce the necessary shift in the trade balance and current account.34 Appendix 4.1 discusses in greater detail some conceptual issues arising from this calculation, particularly in light of the fact that the ratio of net foreign assets to GDP depends in general on the real effective exchange rate.
In this appendix, we derive a more complete link between the trade balance, net foreign assets, and rates of return on external assets and liabilities. To determine the trade balance that stabilizes net foreign assets, we need to consider the income balance—which depends on the NFA itself and on yields on external assets and liabilities. Disregarding capital gains and losses on external holdings, the NFA-stabilizing level of the trade balance can simply be obtained by subtracting the income balance from the NFA-stabilizing level of current account, as in Equation (4) in the text.
Alternatively, we can derive directly the level of trade balance that stabilizes NFA at the anchor level, incorporating information on capital gains (see Lane and Milesi-Ferretti, 2007a and 2007b). Decomposing NFA into assets and liabilities (a and l), Equation (2) can be rewritten as
Decomposing external assets and liabilities further into their “equity” and “debt” components, we can rewrite Equation (5) as
where the superscripts EQ and D stand for the “equity” and “debt” components, respectively, and 1 + nt = (1 + gt)(1 + πt), that is, nt is the growth rate of nominal GDP.
To apply this formula, we need to determine the levels of assets and liabilities that are consistent with an anchor level of NFA bs. We assume that the ratios among different assets and liabilities remain constant at the levels prevailing in the “benchmark,” and thereby derive one balance sheet composition that is consistent with bs:
What is the “value added” of Equations (6) and (8) with respect to (3)? First, Equations (6) and (8) better reflect the increasing role of portfolio equity investment. The current account only records dividends earned and paid on cross-border portfolio equity holdings; however, most of the returns on equity occur through changes in the capital value of stocks, which are not captured in the current account. This can be easily understood by considering one example. The average dividend on portfolio equity holdings overseas over 1996–2005 (as recorded in the U.S. current account) was about 2 percent, but the average return (including capital gains, not incorporated in the current account) was over 10 percent.35 Because portfolio equity and foreign direct investment (FDI) holdings represent a significant share of GDP, ignoring net capital gains and focusing exclusively on the current account gives an incomplete picture of the likely evolution of net foreign assets.
A second reason why Equations (6) and (8) are more appropriate than (3) relates to the role of inflation differentials. Consider a country that has liabilities in foreign currency (for example, euros), an inflation rate higher than trading partners, and a broadly stable real exchange rate. In this case, the investment income balance of the current account will understate the true cost of debt servicing, because the country will incur a systematic capital loss on its external liabilities as its exchange rate depreciates vis-à-vis the euro.
Exchange Rate Adjustment
As briefly discussed in Section IV, the level of net foreign assets is in general not invariant to changes in the real effective exchange rate, reflecting different currencies of denomination for external assets and liabilities. For example, in a country with external liabilities (mostly) in domestic currency and external assets (mostly) in foreign currency, a real exchange rate depreciation would tend to improve the net external position by increasing the domestic-currency value of foreign assets. Conversely, in a country where foreign assets and liabilities are both denominated in foreign currency, a real depreciation would worsen the net external position if the country is a debtor or improve it if the country is a creditor, as it would raise the domestic-currency value of net foreign assets. To the extent that the rate of appreciation or depreciation is not fully incorporated in return differentials, its implications for net foreign assets must be taken into account when calculating a path for the real exchange rate that ensures convergence to the desired or benchmark level of net foreign assets.
Consider, for example, the case of a debtor country whose net foreign position b is negatively related to the real effective exchange rate. In this case, as shown by Blanchard, Giavazzi, and Sa (2005), external adjustment would require a gradual depreciation, if the initial depreciation were large enough to ensure that bgsts = bgsts it would also increase b above bs and subsequently drive it further and further away from bs. With a gradual depreciation, the net external position would initially improve, but the trade balance would not improve by enough to ensure a stable external position. Hence b would deteriorate, the real exchange rate would depreciate further, and the trade balance would improve until a new steady state was reached where b = bS and bgst = bgstS.