III Rest of the World
- International Monetary Fund
- Published Date:
- July 1990
The rest of the world is divided into two separate regions in MULTIMOD: capital exporting countries, comprising primarily high-income oil exporters, and the other developing countries. While some variables and behavioral relationships are assumed to be the same in these two regions, it was necessary to separate them because a key feature of the model (constraints on external financing) is unlikely to be relevant for the high-income oil exporters. Most of the discussion below concerns the developing country bloc, where financing constraints do apply.26
The developing country (DC) model has a number of features that distinguish it from the structure of the model for industrial countries. First, as a group the countries are assumed to be finance constrained, in the sense that they do not face a perfectly elastic supply of funds from the industrial countries. Instead, the amount available is determined endogenously, on the basis of a measure of ability to service additional debt. Second, because of the heterogeneity of the countries considered, this model has greater commodity disaggregation; the region produces primary commodities as well as a composite manufactured good and oil. Third, lack of adequate data and the problems of aggregating dissimilar countries have induced us to include less detail on financial markets and on the effects of policy instruments. Finally, the existence of financing constraints implies that some category of expenditure in developing countries is not equal to its desired, equilibrium level. In the model, imports are determined residually by the balance of payments identity; correspondingly, the amount of domestic investment is the counterpart of the decision by foreigners to lend to the region: there is no separate investment function.
A key feature of the model is the determination of the net flow of financing from industrial to developing countries. The availability of financing is assumed to depend on the ratio of interest on debt to exports evaluated at expected real interest rates and exports in the future. Because it is forward looking, this ratio is a measure of solvency. The amount of financing available depends on the difference (if positive) between some critical upper limit for the ratio and its current level. If the gap is negative, developing countries are assumed to be constrained to run down net debt, that is, to run a current account surplus (adjusted for the inflation component in debt service). Therefore, from any initial level the interest ratio will tend to converge, in time, to the critical level, which is imposed exogenously on the model.
Algebraically, the financing equation can be written as follows. Call α the ratio of interest to exports; r a weighted average of short-and long-term U.S. interest rates (assumed to apply both to debt and to foreign reserves); PX and X are export prices and volumes of developing countries; D is the stock of developing countries’ debt; FR are foreign reserves (both official and private); and E is the dollar exchange rate:
The change in debt is assumed to reflect both expected growth in developing countries’ exports plus an adjustment term that takes the ratio of interest to exports toward its exogenous target level, χ. Let g be the expected average annual growth rate of the dollar value of exports over some future period. Let ρ, a fraction between 0 and unity, be a function of the χ/α ratio such that ρ goes to unity as the ratio goes to infinity and to zero as χ/α goes to zero. Then the financing equation, in error-correction form with the same long-run properties as equation (42), can be written
The proportion ρ is intended to capture the fact that within the developing country region there is a distribution of debt ratios, corresponding to a range of indebtedness. For those countries whose ratio far exceeds x, new financing is unlikely to be forthcoming initially, even if exports rise. For other countries whose interest ratios are within the threshold level, financing is likely to grow with exports. However, a sustained growth in exports will tend to graduate countries in the first group into the second group, by bringing their interest ratios down to acceptable levels. The behavior of the average developing country ratio will roughly capture the proportion of countries that are below the threshold level at which they can obtain additional financing. In the model that is simulated below, ρ is set to a constant, 0.6. In future work, its value may, however, be endogenized.
Thus financing and repayment for developing countries are a function of the average rate of growth of the future expected value of their nominal exports, the rate of convergence μ, and the ratio of interest to exports a (which depends on the inherited debt stock and the interest rate). This relationship captures the behavior both of lenders, who are assumed to assess the solvency of borrowers, and of the borrowing countries, who can influence the allocation of resources and their ability to service debt. The flow of financing changes partly as a result of forces beyond the control of developing countries themselves—interest rates and demand for their exports—and partly as a result of the policies of developing countries that influence investment in the export sector. The threshold level χ and the speed of adjustment μ were calibrated to give a realistic path for future financing flows; however, it is clear that these parameters may also be influenced by regulations in industrial countries that affect the lending behavior of financial institutions.
In simulations it was found that developing country debt was overly sensitive to changes in interest rates. Different speeds of adjustment were therefore assumed for changes in exports and changes in the interest rate. In particular, it was assumed that a 10 percent change in exports had the same contemporaneous effect as a 1 percent change in interest rates (about 100 basis points).
Structure of Aggregate Developing Country Model
As mentioned above, output of this region consists of a composite manufactured good, oil, primary commodities, and a nontraded good. The supply structure of these four goods is assumed to be quite different. As in the industrial country models, the price of the manufactured good is not perfectly flexible and does not move immediately to equate demand for the good and potential output. Instead, an increase in demand will increase both output and, over time, the price of the region’s manufactured good. Because manufactured goods are differentiated, producers have some market power to price their good differently from goods produced in other countries. The rate of change in the price of the DC manufactured good depends negatively on the gap between capacity output in this sector and actual output. However, since historical data did not exist for capacity output for developing countries as a whole, the coefficient could not be estimated. Instead, the effect of capacity utilization on price was given a value based on similar equations for industrial countries.
The nontraded good is also assumed not to have a perfectly flexible price, and hence the model exhibits increases in output when demand increases. It is assumed that increases in consumption fall on nontraded goods in some fixed proportion. The price of nontraded goods is, however, not modeled explicitly, and furthermore it is assumed that there is no capacity constraint on the production of nontraded goods: output can be increased without shifting resources out of the other sectors.
In contrast, both oil and primary commodities are treated as homogeneous goods, each with a single world price. For oil, the price in real terms is taken to be exogenous, and the developing countries and high-income oil exporters are jointly treated as residual suppliers, such that world demand and supply are equal. For primary commodities, the relative price is endogenous and moves immediately to clear the market. The supply of commodities is assumed to be given by the accumulated capital stock in this sector; the paradigm is a crop harvest or production from mines where individual producers are too small to influence the price, and where marginal costs of contemporaneous supply are infinite. Therefore, an increase in demand for primary commodities will at first bring about an increase in their price but not in the quantity produced. Only over time, as resources are shifted into this sector in response to improved profitability, will supply increase. Given the quantity of exports and net financing less interest payments, the quantity of imports is determined residually. Implicit then is the assumption that the amount of financing constrains domestic expenditure; notional import demand (if it were made explicit) would be larger than actual imports.
Domestic demand is disaggregated only into consumption and investment; in the data, private and government demands are not distinguished. Consumption (C) depends on a measure of disposable income YD that includes the real flow of financing available, as well as lagged consumption:
As in the industrial countries, where disposable income has an effect on consumption, both net national product and the flow of additional financing tend to increase current consumption. The long-run effect of YD on C is greater than unity, which reflects the fact that there are constraints on consumption in the short to medium run.
The amount of new financing that is not consumed is available for investment. This amount must be large enough to sustain the increased debt interest payments on the higher value of debt, since the model uses the value expected in the future for nominal exports in calculating the amount of endogenous financing. Starting from an equilibrium with the ratio of interest to exports at its threshold level, the marginal product of capital, times the proportion invested, must be greater than the rate of interest on an additional unit of debt. Otherwise, an additional dollar of debt will raise the numerator of the ratio of interest to exports by more than the denominator. Because an assessment of the marginal product of capital is implicit in the equation for the supply of foreign financing, there is no additional investment equation; instead, investment is determined residually as the sum of domestic saving and foreign saving (that is, the current account deficit), with the latter determined by the solvency criterion.
Investment is allocated by sector on the basis of rate of return considerations. A number of factors—taxes and subsidies, relative prices and wages, and shifts in production technology—are necessary for a complete story. Neither the data nor the model is adequate for such a treatment; however, the model does focus on one important element, namely, the sharp fall in the profitability of producing primary commodities and the overhang of productive capacity that is the result of capital stock accumulated when investment in this sector was attractive (for instance, in mining). Given low rates of depreciation, output may continue to be high even if no new resources are being shifted into the primary commodity sector. In the model, the share of new investment that goes into the production of primary commodities relative to manufactures is made to depend on their relative prices; when this ratio is very low, investment in the primary commodities sector is just equal to depreciation—that is, there is no net investment. As profitability in primary commodities rises, the share of total net investment devoted to primary commodities will increase.
The remaining additional investment will be directed to the production of manufactures; for the purposes of the model, neither nontraded goods nor oil is assumed to involve capital. The desired supply of manufactures and the production of commodities will then depend on the existing stock of capital in that sector and on a time trend. In the absence of actual data on capital stocks by sector, production functions were not estimated, but instead their parameters were chosen on the basis of plausible factor shares. Once in place, capital is assumed not to be mobile between sectors. Only new net investment will alter the shares of capital in the two sectors.
Capital Exporting Countries
This group of countries, comprising mainly the high-income oil exporters, is treated separately, first because the countries are in general considerably wealthier than the developing countries discussed above and hence do not face constraints on their balance of payments financing, and second, because their oil exports constitute so large a fraction of GNP that the structure of the model for this region can be made simpler.
In this model, trade volumes and prices are modeled in the same detail as for other developing countries, but neither domestic demand nor output of manufactures is modeled. Furthermore, imports are assumed not to be constrained by available financing; instead, import volume equations for primary commodities and manufactures both depend on the relative price of this region’s output (identified with the price of oil) and the import price of the relevant good. Imports of commodities (ICOM) are explained by a simple first-difference equation, in logs, where RPC is the relative price of commodities to output of the capital exporting developing countries:
Imports of manufactures are given by an equation that is similar in form to those for industrial countries, with the absorption elasticity constrained to unity:
The balance of payments identity determines the region’s accumulation of net foreign assets.