III Indicators of Current Account Sustainability
Author: Mr. Donal McGettigan
Language:
English
Keywords:
OP; deficit; debt; debt stock ratio; GDP ratio; imbalance; current account balance; debt stock; exchange rate appreciation; foreign currency; cumulated current account position; Current account; Current account balance; Current account deficits; Baltics
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Abstract

Previous studies have investigated the potential usefulness of current account or, more broadly, external sustainability indicators. Recent papers that examine the effectiveness of a variety of indicators in predicting current account/external crises in both industrial and emerging economies include Milesi-Ferretti and Razin (1996); Kaminsky and Reinhart (1996); Goldstein (1997); Kaminsky, Lizondo, and Reinhart (1998); and IMF (1998). Roubini and Wachtel (1997) is the only paper to date that concentrates on current account sustainability in a wide variety of transition economies.

Previous studies have investigated the potential usefulness of current account or, more broadly, external sustainability indicators. Recent papers that examine the effectiveness of a variety of indicators in predicting current account/external crises in both industrial and emerging economies include Milesi-Ferretti and Razin (1996); Kaminsky and Reinhart (1996); Goldstein (1997); Kaminsky, Lizondo, and Reinhart (1998); and IMF (1998). Roubini and Wachtel (1997) is the only paper to date that concentrates on current account sustainability in a wide variety of transition economies.

External crises have been defined in a number of different ways. Some studies, such as Frankel and Rose (1996), confine their definition of crisis to an actual devaluation or sharp depreciation of the currency, that is, successful attacks on the currency.17 Others, such as Eichengreen, Rose, and Wyplosz (1995); Sachs, Tornell, and Velasco (1996): and Kaminsky. Lizondo, and Reinhart (1998). widen the definition to incorporate situations where such attacks are unsuccessful, but where the authorities have used either a large increase in domestic interest rates and/or a substantial amount of foreign reserves to defend the currency. In doing so, these authors employ a variant of the exchange market pressure index approach pioneered by Girton and Roper (1977).

The first part of this section outlines briefly the types of indicators suggested by theory as potentially useful. Subsequently, the most effective indicators, based on previous empirical work—especially the summary findings of Kaminsky, Lizondo, and Reinhart (1998)18—are highlighted and accompanied by some cautionary notes concerning the usefulness of indicators. An examination of the potential value of a subset of such indicators in a transition economy context concludes the section.

The Theoretical Literature

A variety of indicators can be justified on the basis of the theoretical literature on speculative attacks and balance of payments crises. Kaminsky. Lizondo, and Reinhart (1998), whose main findings are distilled here, present a clear and concise description relating this literature to indicators and providing references to useful survey articles.19 The seminal first-generation article in this area (Krugman, 1979) relates balance of payments crises to economic fundamentals, indicating the usefulness of indicators, such as excessive fiscal deficits and credit growth, and various reserve adequacy measures. Subsequent extensions of this work suggest the usefulness of fundamentals, such as the real exchange rate, and the trade and current account balances. Later second-generation models, such as Ozkan and Sutherland (1995). argue that the authorities weigh the benefits of a fixed exchange rate regime against the output costs of maintaining it. Accordingly, output developments could also feature as a useful indicator in this context. This suggests that variables providing information on the cost of maintaining an exchange rate peg, such as indicators of banking system soundness, may also be useful. Other recent models, such as Obstfeld (1996), convey the possibility of self-fulfilling crises, which, although not independent of fundamentals, makes their relationship with subsequent crises much less watertight. Finally, the possibility of contagion following from the devaluation of trading partners is raised by Gerlach and Smets (1994) and Calvo and Reinhart (1996), thus suggesting the need for indicators of a country’s vulnerability to contagion effects.20

Findings of Previous Empirical Studies

Kaminsky, Lizondo, and Reinhart (1998) highlight the very large number of indicators used in the literature in assessing external sustainability. In the studies they review, 103 different indicators have been used, covering capital account, debt profile, current account and international, financial, real sector, and fiscal indicators, together with institutional/ structural and political variables.21 Based on the results of a variety of quantitative studies, they find that international reserves, the real exchange rate, credit growth, credit to the public sector, and domestic inflation receive support as useful indicators of currency crises. They also note some backing for the trade balance, export performance, money growth, the ratio of M2 to international reserves, real GDP growth, and the fiscal deficit. Interestingly, they find that the current account balance does not emerge as a useful indicator.22 As the authors acknowledge, however, their findings are tentative, having been based on the limited number of studies that employed formal statistical techniques.

The authors argue that previous methodologies suffer from several defects and that their signalsbased approach addresses some of these. Using this approach, they build upon the work of Kaminsky and Reinhart (1996) that examines 76 currency crises, covering 15 developing and 5 industrial countries during the 1970–95 period. Many indicators, including most of those discussed above, are analyzed, and the authors find that the real exchange rate emerges as the single most useful warning indicator. Exports, stock prices, M2/international reserves, and output are also found to be effective indicators.

IMF (1998) notes the potential value of indicators of vulnerability to crisis but also adds some cautionary notes concerning their usefulness. First, it observes that “while many of the proposed early warning systems have been able to predict particular crises, few have displayed the ability to do so consistently” (p. 88). Following the logic of Goodhart’s Law, it argues further that, while it is highly unlikely that consistently useful indicators will be identified, even if such indicators did emerge they would lose their usefulness once they began to be incorporated into the behavior of market participants and governments. IMF (1998) also points out that, in the case of contagion, the above indicators may not provide the best warning signals for nonoriginating countries. In such cases, a crisis in a closely linked country may be the best signal, although many indicators provide insights into a country’s vulnerability to spillovers. Finally, it notes that indicators are unlikely to summarize adequately the circumstances leading to a crisis, because these could include elements of vulnerability, as well as political developments, market sentiments, and economic shocks. Accordingly, warning indicators need to be complemented by indepth country-specific analyses (see pp. 94–95).

Indicators of Sustainability

As outlined above, previous studies have assessed the effectiveness of indicators by analyzing their behavior prior to periods of external crisis. Excepting the current situation in Russia—whose effects have recently begun to spread to other countries of the region, especially Ukraine—there are no such historical episodes to analyze in the Baltics. Russia, and other countries of the former Soviet Union and, accordingly, the conventional mode of analysis is not possible. This section concentrates, therefore, on the potential usefulness of the chosen indicators by taking into consideration the main features of transition economies. More specifically, both the background to the Russian crisis and the possible usefulness of the various indicators in the Russian case are analyzed in Appendix I. While this paper deals primarily with sustainability indicators within a specific group of transition countries. Appendix II refers to various crisis episodes in certain Central European transition countries, and the usefulness of the various indicators is again considered in this context. Indeed, it is likely that the various strengths and weaknesses associated with employing sustainability indicators, as applied to the Baltics, Russia, and other countries of the former Soviet Union, would be just as relevant in the case of Central European transition countries.

Real Exchange Rate

The real exchange rate (RER) has emerged as perhaps the most reliable indicator of susceptibility to external crisis, although, as explained below, it is difficult to interpret. When a country’s RER is overvalued beyond a certain threshold level, the likelihood of an external crisis is higher than otherwise. While the RER indicator always requires careful interpretation, this is especially true for the Baltics, Russia, and other countries of the former Soviet Union, where the identification of equilibrium exchange rates is especially difficult, given their economic transition. It appears, on the basis of available evidence, that RERs are not overvalued in the majority of these countries. The danger of overvaluation appears to be increasing, however, and, accordingly, a greater focus on the countries’ competitiveness will be needed in the future.

It is not surprising that the RER emerges as the most useful indicator of external crises in previous studies. As Goldfajn and Valés (1998) contend, the RER indicator should be interpreted as “a key summary variable of several other underlying fundamentals rather than the unique determinant of currency crises” (see p. 876). For example, rapid expansion of monetary aggregates or the inability to absorb large capital inflows (the counterpart of large current account deficits) in a pegged exchange rate regime are instances of developments that may lead to external crisis and that may, in turn, be reflected in an overvalued RER. In other words, the RER may. in certain circumstances, be a proximate rather than an ultimate cause of external crisis. An overvalued RER can adversely affect a country’s competitive position, however, leading to a worsening of the current account balance and, through this channel, directly precipitate a crisis. In summary, the RER can be both a harbinger and a cause of external crises.23

The greatest difficulty in using the RER as an indicator is attempting to gauge the extent of overvaluation, if any. As Krajnyák and Zettelmeyer (1998) discuss, the conventional methods of assessing overvaluation cannot be used in the case of transition economies. One commonly used approach involves comparing the current exchange rate with its level in a reference year in which the RER is deemed to be in equilibrium. The difficulties with this approach are that it implicitly assumes an unchanging equilibrium RER and it requires a reference equilibrium period. Neither of these conditions is fulfilled in transition economies. Equilibrium exchange rates generally change as transition proceeds, and no period since the start of transition can reasonably be used as an equilibrium reference period. The alternative approach is to make use of sophisticated econometric techniques to assess the equilibrium RER. Given the lack of time series data since the beginning of the transition process, this methodology is also precluded.

Krajnyák and Zettelmeyer, therefore, suggest an alternative approach to analyzing the competitive position of the Baltics, Russia, and other countries of the former Soviet Union. They overcome the problems associated with the use of the price-based real exchange rate by using the dollar wage as a proxy for the real exchange rate.24 By relating this wage measure to a variety of fundamentals, the equilibrium wage is calculated for various transition economies over the period 1990–9525 and is compared with the evolution of the actual real wage over the same period. The authors’ main finding, based on the dollar wage proxy, is that the real exchange rates in a majority of these economies are substantially undervalued, and that none of these countries appears to have an overvalued ERR. These findings are echoed by Halpern and Wyplosz (1997). This discovery masks other interesting underlying findings, however. Although the actual dollar wages rose monotonically for those countries covered during 1992–95, the equilibrium dollar wage declined or remained flat over the same period for all the countries except Estonia, where equilibrium wages increased somewhat. Accordingly, the gap between actual and equilibrium dollar wages, although very large in 1992, had narrowed considerably since then. Nevertheless, the gap remained large for most of the countries, where, as a group, actual wages were estimated to be around 10 percent of their equilibrium levels in 1992, rising to 40 percent in 1995.26

Krajnyák and Zettelmeyer proceed to examine the likelihood that actual wages are underreported in transition economies, along with the corollary that the above figures may present an overly sanguine account of their competitiveness. In doing so, they argue that there are two possible sources of bias. The first is that in-kind payments and other nonwage benefits may represent a large share of worker remuneration in transition economies. They specify, however, that this factor is likely to be more important at the beginning of the transition process. The second bias arises from the inadequate reporting of private sector wages. The authors argue that the incorporation of the public-private wage gap in their approach does not alter the basic finding of pervasive undervaluation. They do not consider the first source of bias in this calculation, however, which is a source of concern. IMF (1998) estimates that in the Baltics, Russia, and other countries of the former Soviet Union social benefits still account for a large share of overall compensation (20 percent or more), reflecting important housing-related benefits.27

Table 3.1 depicts CPI-based real exchange rates over the period 1993–97, while Figure 3.1 maps the percentage increase in the real exchange rate alongside its cumulative current account position over the same time frame. The large real exchange rate appreciations that have taken place since 1993 are clear from the table, although this seems to have moderated, at least temporarily, during 1996–97. Figure 3.1 and the associated regression—which reflects only the simple correlation between two variables—suggest that, while a negative relationship emerges between the extent of real exchange rate appreciation and the cumulated current account position, the relationship is not statistically significant. Moreover, such relationships are very fragile and highly dependent upon the base year chosen.

Table 3.1.

Real Exchange Rate

(CPI-based index 1993 = 100)

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Sources: Data provided by national authorities; and IMF staff estimates.

Period average data are not available for the base vear.

Figure 3.1.
Figure 3.1.

Exchange Rate Appreciation and Current Account Balance, 1993–971

Source: Data provided by national authorities; and IMF staff estimates.1 The vertical axis measures the percentage of real exchange rate appreciation; the horizontal axis measures the average current account balance as a percentage of GDP.

Roubini and Wachtel (1997) conclude that many of the real appreciations that have taken place in transition economies have, indeed, caused a loss of competitiveness, which, in turn, has led to a worsening of current account balances. Figure 3.1 does not provide their argument with much support.28 According to these authors, the real appreciation is the consequence of the choice of a pegged exchange rate regime combined with inflation inertia and ensuing capital inflows. They also argue that such real exchange rate overvaluation can occur under a regime of managed floating, unless the central bank follows a crawling peg policy of targeting the real exchange rate.

In substantiating this view, they rely on what they term as circumstantial evidence and explain that they adopted such an approach because it is not possible to derive a good measure of the equilibrium real exchange rate. Based on the analysis of ten transition economies’ experiences (in which Ukraine and the Baltics were included), they conclude that those countries with the strongest commitment to fixed rates experienced the largest real appreciations and the most severe worsening of their current account. In Figure 3.1, however, two out of the three countries from the Baltics, Russia, and former Soviet Union group that have experienced the greatest real appreciations since 1993 have followed a flexible exchange rate regime—Tajikistan and Ukraine—while the other country, Georgia, only pegged its currency to the dollar in 1995.29 In sum, Roubini and Wachtel argue that any initial undervaluation of the exchange rate at the start of transition appears to have been more than eroded by the subsequent real appreciations, although their grounds for such an argument do not appear to be especially watertight.

Furthermore, once stabilization is achieved, real appreciation can be expected to take place, both to offset any previous overshooting of real depreciation at the start of transition, and as a result of more foreign direct investment and other capital inflows. Real appreciation would also be expected as a result of the better economic outlook once stabilization has taken place. Such real appreciation may also be associated with wider current account deficits, but this may be a benign development reflecting increased imports of capital or intermediate goods, rather than any fundamental competitiveness problem. It is important, therefore, to distinguish between good and bad real exchange rate appreciations and current account deficits. Some countries will exhibit large real appreciations and current account deficits because they are undertaking reforms and are creditworthy, while others may simply exhibit such characteristics because they have simply mismanaged their economies.30

It is fair to say, therefore, that the Roubini and Wachtel view remains in the minority and is not given much empirical support. As they acknowledge, EBRD (1996); Halpern and Wyplosz (1997); IMF (1997); and Krajnyák and Zettelmeyer (1998) all support the fundamentals view referred to above, rather than the misalignment view.31

In summary, a great deal of controversy surrounds the competitive position of transition countries, and the interpretation of real exchange rate indicators is far from straightforward in such a context. Nevertheless, much of the empirical literature has identified the real exchange rate as one of the most useful indicators of external sustainability. As real exchange rates in the Baltics, Russia, and other countries of the former Soviet Union move closer to their equilibrium values, it will become increasingly important to focus on exchange rate indicators, while at the same time bearing in mind the many interpretations to which this type of indicator is subject.

Fiscal Policy Indicators

If Ricardian equivalence holds completely, any increase in the fiscal deficit (i.e., a decrease in net government savings) will be fully offset by an increase in private sector savings (in order to pay for the implied extra future taxes made necessary by the increased deficit).32 Consequently, no relationship between fiscal and current account balances would be observed. There are many reasons why Ricardian equivalence does not generally hold in practice, however, including liquidity constraints, rule-ofthumb consumption behavior, and the presence of distortionary taxes.33

Accordingly, imperfect substitutability between private and public savings should generally hold, while budget deficits and current account imbalances should be related. As Milesi-Ferretti and Razin (1996) suggest, stronger links between current account and fiscal balances should be observed in underdeveloped financial systems (i.e., where liquidity constraints are likely to be more binding). Furthermore, if public debt levels are low, the possibility of budget deficits leading to imminent tax increases will be seen as remote, thereby further severing the link between public and private sector savings behavior.

Given that liquidity constraints are likely to be prevalent in the Baltics, Russia, and other countries of the former Soviet Union due to their generally underdeveloped financial systems, one would not expect Ricardian equivalence to be of much practical consequence for these countries. Indeed, the importance of the fiscal aspect of the external debt position of the countries has been emphasized by previous studies.34 For example, Kapur and van der Mensbrugghe (1997) emphasize that concerns on debt sustainability arise primarily but not exclusively from the fiscal perspective and propose two additional fiscal indicators to monitor the fiscal debt sustainability angle.35 Odling-Smee and Zavoico (1997 and 1998) also stress the importance of the fiscal aspect of external borrowing in these economies, although they expect this to be gradually supplanted by private sector borrowing as stabilization proceeds, at least for those countries viewed as acceptable risks. Besides being directly linked with current account deficits, large fiscal imbalances may also be associated with excessive monetary growth or real appreciation of the exchange rate, thus further increasing a country’s susceptibility to crisis.

The primacy of fiscal considerations in the external borrowing of this group of countries appears to be supported by their sources of external financing during 1993–97. Official disbursements, grants, and debt rescheduling have been far more important sources of financing over this period than private capital flows and foreign direct investment, as presented in Table 2.3. Once it is acknowledged that the fiscal positions of these countries are inextricably linked to their external debt positions, fiscal and external sustainability become intertwined. Accordingly, a variety of fiscal indicators are examined below. The importance of analyzing fiscal indicators in the context of these economies is also underscored by the Russian crisis, in which fiscal weaknesses played a large role.

General government balances are presented in Table 3.2. Excessive fiscal deficits played a central role in the generation of speculative attacks according to Krugman’s seminal paper (1979). Furthermore, deficits have been found to be a useful leading indicator of external crisis in previous studies, such as Edwards (1989); Eichengreen, Rose, and Wyplosz (1995); Moreno (1995); and Ötker and Pazarbasioglu (1995).

Table 3.2.

General Government Balances

(In percent of GDP)

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Sources: Data provided by national authorities; and IMF staff estimates.

One positive feature of the table is the finding that, over the sample period, most of the fiscal balances have improved significantly (albeit from very large initial fiscal deficits in some cases),36 with the median deficit decreasing to just above 3 percent in 1997 from 8.6 percent in 1993. Moreover, Estonia and Latvia recorded small surpluses in 1997, while Turkmenistan was in balance. However, several of the other countries continued to run disturbingly large deficits in 1997. These were Armenia, Kazakhstan, the Kyrgyz Republic, Moldova. Russia, and Ukraine, whose fiscal deficits all exceeded 5 percent of GDP in 1997. Indeed, one of the main factors, besides the contagion effects from the Asian crisis and lower oil prices, that contributed to the recent crises in Russia and Ukraine was their weak fiscal positions.

Given the lack of suitable data, general government fiscal balances have been used as a measure of overall fiscal stance. Ideally, the analysis should also include the fiscal balances of the lower tiers of government and off-budget entities, which are important in many of these countries. Furthermore, the quasifiscal deficits arising from the activities of central banks and other entities should be added to the conventional government deficit to get a fuller picture. This would, for example, make the accounts of Belarus and Turkmenistan look far worse.37 Quasifiscal balances stem from operations that are comparable to subsidies and taxes imposed by the general government.38 Furthermore, contingent liabilities of the general government should, ideally, be included in the analysis. For example, in certain of the countries concerned, government guarantees offered to back up commercial loans are common. Such guarantees, if called upon, can significantly worsen the fiscal outlook. Closely related to this is the concept of the contingent deferred fiscal deficit. This occurs when the central bank or another government entity is willing to bail out a troubled state enterprise when the need arises. By focusing exclusively on general government balances, only a partial picture of overall fiscal balances is obtained.

The fiscal deficit, although a useful indicator in its own right, has to be broken down into its component parts to get a fuller picture of the likelihood of an external crisis. An important aspect of fiscal sustainability is the ability of the authorities to collect sufficient revenues. An unsustainable underlying position may be masked by, for example, sequestration, the buildup of arrears, or the postponement of capital expenditures, which result in the conventionally measured government deficit being low despite inadequate revenues. General government revenues of the Baltics, Russia, and other countries of the former Soviet Union are presented in Table 3.3, alongside government expenditures, both of which are expressed as a percentage of GDP.

Table 3.3.

General Government Revenue and Expenditure

(In percent of GDP)

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Sources: Data provided national authorities: and IMF staff estimates.

Including net lending.

Revenue includes grants, and expenditure excludes net lending.

Ratios of general government revenues are generally low in industrial countries: the mean rate in 1997 for the Baltics, Russia, and other countries of the former Soviet Union was 28.2 percent of GDP, compared to 42.3 percent in advanced industrial economies. However, although general government revenues declined sharply relative to GDP—to 26.1 percent in 1996 from 31.5 percent in 1993—they increased to 28.2 percent in 1997. The ability to generate sufficient government revenues is a particularly difficult problem for Georgia and Tajikistan, where these revenues were estimated to be 10 percent and 14 percent of GDP, respectively, in 1997. Buiter (1997) contends it is unlikely that even the most basic functions of the state can be undertaken with inadequate government receipts and that “the very survival of the state is put at risk by very low tax revenues” (see p. 35). The generally low revenue-to-GDP ratios reflect in part the difficulties of adapting Soviet-inherited tax systems to new market-oriented environments.39 Those countries facing revenue difficulties will need to strengthen their tax revenue bases and efficiency of collection methods as a matter of priority. These low revenue-to-GDP ratios are not entirely unexpected, however, given the countries’ stages of economic development. Barbone and Polackova (1996), for example, find that the main determinant of a country’s revenue-to-GDP ratio is its purchasing-power-parity-based level of GDP. Their analysis suggests that transition economies, such as Belarus and Ukraine—whose revenues are 46 percent and 38 percent of GDP, respectively—may be collecting too much revenue for their stages of development, indicating that expenditures may be too high in such countries. Their analysis also suggests that revenue-to-GDP ratios of between 20 percent and 30 percent of GDP are achievable for those countries less advanced in transition.

On the other side of the balance sheet, Table 3.3 shows that government expenditure as a percentage of GDP has generally fallen more rapidly than government revenue. The average level of expenditures in this group of countries fell to 30.9 percent of GDP in 1996 from 43.6 percent in 1993, although, like the case for revenue, this increased somewhat in 1997 to 31.8 percent of GDP. Such expenditure patterns are reflected in the lower deficits presented in Table 3.2.40 Expenditure on subsidies and capital investment has fallen sharply, while social expenditures have seen their share of increases.41 Fischer, Sahay, and Végh (1998), however, argue that the sharp reductions in government expenditure in transition economies may be adversely affecting the reform process and that growth could be augmented by more expenditures in areas such as improving government administration or building market-based institutions. Furthermore, as pointed out by Cheasty and Davis (1996) and Tanzi (1997), reductions in expenditure have often been indiscriminate and determined by financing constraints rather than by wellthought-out public spending plans. In addition, many such cuts took place through sequestration and/or the buildup of arrears, which are deleterious to long-term planning and incentive structures.

Despite the general reduction of deficits since 1993. fiscal balances in these countries are likely to remain under considerable pressure for the foreseeable future. The inefficient pension and entitlement programs, together with generally aging populations, will place fiscal authorities under considerable strain in the coming years, unless they undertake fundamental reforms.42 Health, education, and other essential public services have suffered during the transition process, thus implying additional expenditures in coming years. Furthermore, there will be a continuing demand for subsidies from inefficient state enterprises, and potentially large contingent liabilities face many of the governments. Hence, the observed improvements in fiscal balances should not lead to complacency. If foreign investors suspect that the governments will be unwilling or unable to pay at some stage in the future, this could lead to the cessation of private capital flows.

The notion that external debt is primarily a fiscal problem in these economies is supported when comparing average current account balances across the countries to average government and private sector savings investment balances (see final column of Table 3.4). The average government savingsinvestment balances are, in general, more closely aligned with the current account than are the private balances (the main exceptions being Belarus, Estonia, and Russia). An even clearer indication of the importance of government debt in the total is the unweighted average of the countries’ current account balances over 1993–97. which was -7.9 percent, of which average government balances accounted for -6.1 percent. This provides evidence that the bulk of the debt stock incurred during that period was owed by governments, rather than the private sector. This finding would be strengthened further if off-budget government debt were included.

Table 3.4.

Current Account Balance, General Government Balance, and Private Sector Savings-Investment Balances

(In percent of GDP)

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Sources: Data provided by national authorities; and IMF staff estimates.

For general government, simple correlation between current account and general government balances.

For private sector, simple correlation between current account and private sector savings-investment balances.

Commitment basis and excluding grants.

An interesting pattern emerges, however, when the movements of current account, fiscal, and private sector savings-investment balances over time are compared in Figure 3.3. In most of the countries, private sector balances are more closely linked to movements in the current account than are fiscal balances. This is borne out in Table 3.4, where the simple correlations between the current account, and the public and private savings-investment balances are presented. In all of the countries, the simple correlations are far stronger between private sector and current account balances, except for Kazakhstan and Ukraine, where the correlations are far stronger in the case of government balances, and for Georgia and Tajikistan, where the correlations are similar.

Figure 3.2.
Figure 3.2.

Increase in Dollar Wages and Current Account Balance, 1993–971,2

Source: Data provided by national authorities; and IMF staff estimates.1 The vertical axis measures the percentage increase in dollar wages; the horizontal axis measures the average current account balance as a percentage of GDP.2 Data for Georgia are not available.
Figure 3.3.
Figure 3.3.
Figure 3.3.

Current Account, General Government, and Private Sector Balances

(In percent of GDP)

Source: Data provided by national authorities; and IMF staff estimates.1 Data for 1993 not available.

In 1993, at the start of our sample period, most of the countries were experiencing very large fiscal deficits and had not yet embarked upon the stabilization process.43 Thus, large government debt stocks were building up during this time. By 1994, however, most of the countries had embarked on serious stabilization attempts,44 which is reflected in the sharp reductions in fiscal deficits in most of them. The current account balances have not fully reflected these fiscal developments, however, and instead are becoming increasingly determined by private sector balances. This can be seen clearly in Table 3.4, where the overall averages of current account, government, and private sector balances are calculated on an annual basis. In 1993, the average government deficit of 9.1 percent was partly offset by positive private sector balances of 1.2 percent, to give a current account deficit of 7.9 percent. However, by 1995, although fiscal imbalances continued to account for the bulk of the current account deficit, private sector balances turned slightly negative. By the end of the period in 1997, fiscal deficits had generally been brought under control, with the result that private sector imbalances accounted for 65 percent of the overall average current account deficit.

One possible reason for this is that much of the so called private savings-investment balances in Figure 3.3 should actually be categorized as public or, alternatively, they could be government guaranteed. As Buiter (1997) emphasizes, the fiscal balances of the lower tiers of government and off-budget entities are very important in the Baltics, Russia, and other countries of the former Soviet Union. Furthermore, the quasi-fiscal deficits of central banks, which should be added to the conventional government deficit, are not incorporated into our analysis. Therefore, by focusing only on general government balances, the result may be a distorted picture of overall fiscal balances. Unfortunately, lack of data precludes such features from being incorporated into the analysis. Another possibility, however, is that private sector borrowing has become more important than public sector borrowing as transition has progressed, as argued by Odling-Smee and Zavoico (1998). Such a development would be expected as transition proceeded and as confidence of investors in the reform process improved.

Finally, one of the indicators, along the lines suggested by Kapur and van der Mensbrugghe (1997), budgetary debt service as a percentage of government revenue, is presented in Table 3.5. As they argue, such an indicator “is a measure (admittedly limited since it combines above and below the line items) of the government’s ability to service its total debt out of current income without taking into account domestic financing or foreign disbursements to the budget” (see p. 12). The data in the table suggest that, although budgetary debt service does not generally account for a very large percentage of government expenditure, it has increased significantly since the start of the sample period in certain countries, such as the Kyrgyz Republic, Lithuania, and Moldova.

Table 3.5.

Budgetary Debt Service

(In percent of government revenues)

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Sources: Data provided by national authorities; and IMF staff estimates.

Savings and Investment

By definition, a country’s current account balance is the difference between national savings and domestic investment. Where investment exceeds savings, the difference must be financed by foreign borrowing, which is reflected in current account deficits. Information on the composition of the current account can be useful in gauging its sustainability. Two main features of the composition of the current account are of interest: whether the foreign borrowing is being used for consumption or investment purposes; and whether the current account imbalance reflects public or private sector savingsinvestment imbalances.

The second topic has already been examined above. As for the first topic, borrowing for investment purposes is generally considered more sustainable than borrowing for consumption purposes.45,46 Productive investment increases a country’s growth potential and. accordingly, boosts its capacity to service future debt repayments (see, for example, Goldstein, 1997: and Milesi-Ferretti and Razin. 1996). This is based upon the assumptions that investment projects are profitable and chosen efficiently, and cannot be financed from domestic savings alone. In transition economies, capital requirements are high, given the need to replace largely obsolete capital stocks, and savings are generally very low. Furthermore, the various structural reforms being undertaken in such countries should lead to increases in the marginal productivity of domestic investments.47 Accordingly, it may be optimal for the Baltics, Russia, and other countries of the former Soviet Union to run current account deficits in order to tap foreign savings and direct them toward productive investments. It has been shown, however, that these countries have generally run large deficits since independence, although it is not clear whether these foreign savings have been used for investment purposes.

Data on the uses to which these countries have applied foreign borrowing are very limited. Investment data are unavailable for certain countries (i.e., Belarus and Tajikistan), and the information provided for many of the remaining countries should be treated with considerable caution. According to Kapur and van der Mensbrugghe (1997), it appears that the vast majority of mainly official borrowing has been used to finance public consumption rather than investment. Odling-Smee and Zavoico (1997) also make this argument and cite the very low levels of investment as a proportion of government expenditures as supporting evidence.48 Table 3.6 presents figures on current account, savings, and investment balances, together with the data on government capital expenditures.

Table 3.6.

Current Account Balance, Savings-Investment Balances, and Capital Expenditure Balance

(In percent of GDP)

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Sources: Data provided by national authorities; and IMF staff estimates

Government capital expenditure figures confirm the point made by Odling-Smee and Zavoico (1997) that these expenditures are, in general, very low in the Baltics. Russia, and other countries of the former Soviet Union. In the majority of these countries, government capital expenditure was less than 4 percent of GDP in 1997. In many cases—Azerbaijan, Georgia, Kazakhstan, Tajikistan, and Turkmenistan—such expenditures accounted for less than 1.5 percent of GDP. However, overall (gross) investment rates are generally not that low. In certain cases, such as Georgia, Kazakhstan, the Kyrgyz Republic, and Uzbekistan, the current account deficit positions have been associated with low investment rates, as predicted above. This is not the case, however, for the majority of the countries, with investment rates in excess of 30 percent of GDP being recorded in Armenia, Estonia, and Turkmenistan in 1997; and rates in excess of 20 percent in Azerbaijan, Latvia, Lithuania, Moldova, and Russia.49 Given the existing scope for increased allocative efficiency and more intensive use of existing factors of production in these countries, together with the generally respectable recorded rates of investment, most of their investment rates should be compatible with high growth rates in the medium term. Accordingly, the data have not generally supported the widespread argument that the large buildup of debt stocks in these countries since independence has mainly gone to consumption, and that their capacity to repay over the longer term would not have been enhanced by worthwhile investment. It is unlikely, however, that high growth figures can be supported continually by the low increments in capital stock in certain countries without significant bottlenecks.

Even if the above investment data are overstated, the view that foreign borrowing for consumption, rather than investment, purposes is more likely to increase external vulnerability may not be valid in the case of the Baltics, Russia, and other countries of the former Soviet Union in the early years of transition. As shown, government expenditures fell steeply during 1993–97 in response to high initial fiscal deficits. Insisting that capital flows be used for investment purposes in the face of such (temporary) deficits may not have been feasible. Accordingly, financing a part of government consumption may have been more sustainable than the likely alternative of greater monetary financing and higher inflation.50 Furthermore, as Kapur and van der Mensbrugghe (1997) speculate, such borrowing may also have been useful in the political economy sense, in that it may have fostered public support for reforms that otherwise would not have been forthcoming. In this sense, the capacity to repay may have been boosted through such reforms, even though only a small proportion of the borrowed funds was used for investment purposes in some countries. Now that reforms are progressing, fiscal imbalances are being brought under greater control. Accordingly, the conventional assessments of sustainability, based upon the investment/consumption breakdown of current account deficits, should be a more useful indicator of the sustainability of deficits in the future than it has been in the past.51

Finally, Grafe and Wyplosz (1998), using a model tailored specifically for transition economies, find that current-account-financed increases in consumption can be helpful. In their model, additional consumption boosts demand in the nontraded sector, leading to an increased private sector real wage, which, in turn, results in a reallocation of labor away from remaining inefficient state-owned enterprises. Their model does not contain a long-term budget constraint, however, and others argue that direct investment is preferable in the sense that it leads to an acceleration of the capital accumulation process.

A related argument in favor of the sustainability of these countries’ current account positions is that future imbalances are much more likely to derive from the private sector, rather than the government. This reflects their generally successful efforts to date to rein in public sector imbalances and the fact that their private sectors will have more access to foreign capital as reform proceeds. According to the Lawson doctrine,52 current account deficits are only cause for concern when they emanate from the public sector. Private sector imbalances simply reflect the utility-maximizing decisions of private individuals, which are self-correcting over time. The recent Asian crisis, together with the earlier Mexican crisis of 1994, both of which took place against a backdrop of sound fiscal positions, provides telling evidence against such a viewpoint, however.

Many theoretical arguments may also be leveled against this view.53 Private sector decisions may be distorted by government regulations or interference, as may have been the case with the banking sector and the large conglomerates in Asia. This certainly remains the case in the Baltics, Russia, and other countries of the former Soviet Union, where government interference remains extensive, even in those most advanced in the reform process. Furthermore, investment decisions in the private sector may be subject to herd behavior, as happens when speculative bubbles develop. Most importantly for these economies, however, is the fact that it is very difficult to differentiate clearly between what is private and what is public sector debt. In times of crisis, much of what is labeled private debt becomes the responsibilty of the public sector; for example, this arises where large banks and enterprises end up being restructured at taxpayers’ expense. Overall, therefore, the fact that fiscal balances are being brought under control in many of these countries, together with the corollary that future current account balances in such countries will mainly reflect private sector decisions, provides no grounds for complacency against the possibility of future balance of payments crises. Indeed, EBRD (1997) argues that fiscal problems will be the most likely cause of external instability in transition economies in the future. The veracity of this prediction is evidenced by the fiscal concerns that led to the recent runs on the Russian ruble and the Ukranian hryvnia.

Openness and Trade Composition

The more open an economy in terms of exports relative to GDP, the easier it is to generate foreign exchange earnings and service external debt payments. Milesi-Ferretti and Razin (1996) confirm the usefulness of this measure in predicting a variety of crisis episodes. A guide to the openness of the Baltics. Russia, and other countries of the former Soviet Union is given in Table 3.7, where the export-to-GDP ratios during 1993–97 are presented.54

Table 3.7.

Exports

(In percent of GDP)

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Sources: Data provided by national authorities; and IMF staff estimates.

The share of exports in GDP has fallen sharply in many of these countries, particularly in Armenia. Georgia, and Ukraine, although the export share has increased in the Kyrgyz Republic, Moldova, and Tajikistan. The overall trend is downward, however, with the mean ratio falling to 37 percent in 1997 from 44 percent in 1994. Some of the decline in the early years reflects the breakup of the former Soviet Union and the associated disruption of its trading system, the general lack of funds for imported inputs, and the adverse terms-of-trade shocks that affected most of the countries after independence. Nevertheless, export growth has been quite strong, far exceeding the mainly negative average real GDP growth rates over the period. Indeed, in 1995 and 1996 average export growth rates of 34 percent and 11 percent were registered, respectively. Therefore, the declining trend reflects something other than poor export performance.

The hypothesis of this paper is that the declining share of exports to GDP mainly reflects the strong real exchange rate appreciations that have taken place across this group of countries over the period. Because many exports are determined by world prices in dollar terms, and because real appreciation leads to an increase in GDP in dollar terms, the result is a mechanistic decline in the export-to-GDP ratio if the combined rate of real appreciation and real GDP growth exceeds the growth of dollar denominated exports. Excluding Turkmenistan, whose export share fell sharply, the general trend decline was generally reversed in the last year of the sample period, with the median export-to-GDP ratio increasing to 37 percent from 30 percent.55 This increase, however, merely reflects the stabilization of average real exchange rates (see Table 3.1), rather than an increase in export growth: mean export growth actually registered a decline to 6 percent from 11 percent over 1996–97.

Real exchange rates in the Baltics, Russia, and other countries of the former Soviet Union remain undervalued, and, accordingly, the ratio of exports to GDP tends to be overstated. Any real exchange rate appreciation that takes place as reform proceeds will put downward pressure on the exports-to-GDP ratio, on the assumption that the law of one price holds for tradable goods.56 This will be offset to the extent that the countries develop their export markets over time.

Openness is a mixed blessing, however, in terms of a country’s vulnerability to external crises. A highly open economy is more vulnerable to terms-of-trade shocks, particularly if it has a very narrow export base and if its exports are predominantly in raw materials whose prices are very volatile. Furthermore, the type of contagion effects recently seen in Asia, whereby a depreciation of one country’s exchange rate leads to a depreciation of the equilibrium rate of its close trading partners, suggests that countries are vulnerable to contagion effects from partners with which they have close trading links. They are also more vulnerable to external demand shocks if their exports are heavily concentrated among a few countries.

Some rough idea of the vulnerability of this group of countries (excluding Russia) to spillover effects can be obtained from Table 3.8, which provides details of the percentage of each country’s exports and imports accounted for by trade with Russia in 1997. The figures show that the countries of Belarus, Moldova, and Turkmenistan are most affected by spillover effects, according to this measure, with over 60 percent of their exports destined to the Russian market. As for Estonia and Tajikistan, only 10 percent or less of their exports are accounted for by Russia.57

Table 3.8.

Trade with Russia

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Sources: Data provided by national authorities; and IMF staff estimates.

Economic Growth

The higher a country’s GDP growth rate, the greater the current account imbalance it can sustain without increasing its debt-to-GDP ratio. Therefore, all other things being equal, higher growth rates lead to more sustainable external positions.58,59 The growth rates of the Baltics, Russia, and other countries of the former Soviet Union over 1993–97 are presented in Table 3.9. The main points to note are the vast declines in output sustained in the earlier years of transition and the subsequent turnaround that has occurred in the majority of countries in recent years.60 Output initially contracted because of, among other things, difficulties in the transition from centrally planned to market economies. Some of these difficulties were the decline in traditional industries that initially exceeded the growth of new sectors, adverse terms-of-trade shocks associated with trade liberalization, and the general breakdown of existing trade and supply links following the abolition of the Council for Mutual Economic Assistance (CMEA) trading arrangements and the breakup of the former Soviet Union. The rate of output decline in the earlier years may have been overstated, however, because of the growth of the informal and service sectors; improvements in product quality, which did not tend to be captured clearly in official growth figures, especially at the start of transition; and the overstatement of production levels under the Soviet regime.61

Table 3.9.

GDP Growth Rates

(In percent per annum)

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Sources: Data provided by national authorities; and IMF staff estimates.

Data up to and including 1997 suggest that the mean annual growth rates have shown a remarkable turnaround—to 2.6 percent in 1997 from -12.2 percent in 1994—as reforms have proceeded and the initial transitional difficulties have been alleviated. Turkmenistan, which has not yet engaged upon any serious reform efforts, is the main exception to this general turnaround, having undergone an estimated 26 percent decline in real GDP in 1997.62 Growth in the Baltics, where reform efforts began earlier than elsewhere, experienced a quicker turnaround in growth than most of the other countries. In 1997. for example, the Baltics recorded an average GDP growth rate of almost 8 percent. The Russian crisis has seen growth reversals not only in Russia, but in Kazakhstan, Moldova, and Ukraine, whereas the Baltics have continued to register healthy, although somewhat lower, growth since the crisis.

In terms of external sustainability, the capacity to generate robust growth over the medium-to-long term is of utmost importance. Detailed evaluations of the prospects for growth in transition economies are discussed in detail in IMF (1996) and EBRD (1997).63 The salient points that emerge from these analyses are highlighted below.

Both analyses use past growth experiences of industrial and developing countries as an initial gauge of the potential medium- and long-term growth rates in transition economies. Such growth records illustrate that sustained per capita growth rates of above 3 percent per annum have been relatively rare in the past and were generally associated with growth catch-up phases, which were in turn associated with high rates of investment and significant technological advances. Other than such catch-up periods, sustained annual per capita growth rates of above 2.5 percent were not common.

Both studies contend, however, that the previous rapid growth achievements of the newly industrialized Asian economies may be of more relevance to transition economies if reforms proceed satisfactorily. Separate analyses undertaken in both studies and based upon cross-section growth equations suggest that medium- and long-term growth prospects of the Baltics, Russia, and other countries of the former Soviet Union could indeed be considerably higher than the overall historical average of developing and industrial economies. The reasons are, inter alia, the low initial per capita output of most of these countries, which allows substantial room for catchup, and the generally favorable achievements in education as well as the infant mortality and life expectancy indicators, which contribute to a well functioning labor force, especially compared with other developing countries. When such variables are included in cross-country growth equations, the resulting potential per capita growth rates for this group of countries are more than 4 percent over a 25-year period in the EBRD application, except for Armenia and Moldova, whose calculated potential growth rates are 3.2 percent and 2.8 percent, respectively. In the IMF growth regressions, they are generally in the 3.5–4.75 percent range, which also includes Eastern European transition economies. Economic growth in the Baltics, Russia, and other countries of the former Soviet Union could exceed even these strong growth figures over the medium term, given the current high levels of economic slack that generally exist, in the form of hidden or open unemployment, and the underused capital stock and land resources. Nevertheless, the above long-term growth scenarios should be viewed as indicative only, in that they are subject to a variety of drawbacks, such as data difficulties, the use of overly parsimonious equations, simultaneity problems, and the fact that cross-country results may not be suitable for assessing an individual country’s potential growth prospects.

Perhaps the biggest problem of such an approach is the omission of any variable that attempts to capture the institutional environment of transition economies and the degree to which market-led reforms have progressed. After all, catch-up growth is not automatic; it requires a supportive economic environment. In IMF (1996), the EBRD’s index of reform progress is charted alongside real output growth in the Baltics, Russia, and other countries of the former Soviet Union, and a significant and positive relationship emerges. A number of other studies have also found a positive relationship between reform efforts and subsequent growth rates in transition economies.64

To address this omitted variable problem, EBRD (1997) incorporates a country-risk variable in a supplementary regression, with the result that the potential growth rate of Russia—the only one of these countries included in the latter exercise—is lowered to 5.1 percent from 5.9 percent.65 As the EBRD suggests, many of the other countries are likely to have setups even less conducive to growth than Russia; and, therefore, the earlier potential growth rates may be too optimistic. On the other hand, such differences serve to illustrate the potential gains from implementing structural reforms to provide a conducive economic environment.

Composition of External Liabilities

Recent episodes in Asia and Latin America have shown the potential importance of the composition of a country’s external liabilities in determining its vulnerability to crisis. The category of capital flow (e.g., debt, equity, direct investment); its duration; its currency denomination; its interest rate structure (i.e., fixed or floating); and the type of creditor involved are all important factors in determining an economy’s ability to withstand negative shocks. Furthermore, if a country’s debt-management capacity is weak, this could lead to a bunching of debt payments, thus adding to vulnerability.

Foreign direct investment (FDI) is generally regarded as the most stable form of inflow. FDI does not create debt, is tied to physical investment in the host country, and contributes to an economy’s growth potential. Reisen (1997) points out that FDI is largely determined by noncyclical considerations—being influenced by longer-term profitability rather than short-term considerations—and that it exerts less pressure on the real exchange rate than other forms of investment. In the event of a crisis, it is more difficult for such investors to off-load their investments. Furthermore, the general benefits of FDI, such as technology transfer, the development of management expertise, and the fostering of domestic supply responses, are well known. However, Dooley, Fernandez-Arias, and Kletzer (1994) find that net FDI flows are quite volatile, and the marked decline of FDI in Russia in the aftermath of its crisis bears testimony to this.

Equity investment is generally thought to be more stable than portfolio investment, in that the effects of a negative shock are shared with foreign investors through a decline in stock prices. Longer-term portfolio investment is more stable than the short-term variety, fixed-rate borrowing promotes greater stability than variable-rate borrowing, and foreign currency-denominated instruments can leave a country more vulnerable than domestically denominated debt.66 Furthermore, short-term bank loans, of the type that dominated the Asian crisis, are often viewed as contingent liabilities of government and appear to leave the debtor countries very vulnerable to outside shocks.

The basic problem during a crisis is that creditors find it very difficult to distinguish between solvency and liquidity problems. Accordingly, if a negative shock occurs, creditors may be unwilling to roll over loans and may even sell their existing holdings. Thus, retaining sufficient foreign exchange reserves to sustain investors’ confidence is very important.

Sources of external financing in the Baltics, Russia, and other countries of the former Soviet Union during 1993–97 were presented earlier in Table 2.3. Clearly, such external financing is very different from that of the countries caught up in the Asian crisis. Together, official disbursements and net use of Fund credit comprised 26 percent of external financing for the former over this period. Debt rescheduling agreements formed a further substantive element of overall financing, representing 30 percent of external financing. FDI started from a low base of 1 percent of overall external financing in 1993, but rose steadily to 24 percent in 1997.67 Overall private capital flows also started from a low level, and, while increasing to 36 percent of overall external financing in 1997. it represents a lower proportion than in other emerging economies.

Capital from official sources is less prone to sudden reversal in times of difficulty than are private capital flows, thereby partly insulating the majority of these countries from this source of vulnerability.68 Nevertheless, tranches of Fund and Bank programs have often been delayed in the past in response to poor policy practices. Although FDI has only recently begun to play a prominent role in capital flows, it has been increasing rapidly, thus providing further stability.69 Against this, as reforms proceed, private investors have been devoting more resources to this region up until very recently, thus leaving recipient countries more vulnerable to reversals of such flows. Furthermore, much of the borrowing of those countries in the group that are most exposed to private investors is short-term, foreign-currency denominated debt, leaving them particularly vulnerable to capital flow reversal. As noted earlier, many of these countries lack the institutional capacity to smooth their repayment schedule, which further contributes to their vulnerability. This vulnerability is highlighted by the sharp increases in treasury bill yields experienced by Russia and Ukraine in recent months.

As seen in Table 2.2, the overall external debt burden of these economies is not generally very high, although it has increased significantly since independence. To provide a more detailed picture of the countries’ debt-servicing requirements, their overall debt service and debt stock, as a percentage of gross international reserves during 1993–97, are presented in Table 3.10.70 The wide variation in the ratios of debt service to external reserves is noteworthy, as is the corresponding variation in the debt stock figures. Debt service in several of these countries accounts for a dangerously high ratio of gross reserves: debt service dwarfs reserves in Tajikistan and is higher than reserves in Russia and Ukraine,71 thus indicating potential vulnerability to crisis from this source. The debt stock figures are also very high relative to reserves in these three countries, as well as being high in Georgia, the Kyrgyz Republic, and Moldova.

Table 3.10.

Overall Debt Service and Debt Stock Relative to Gross Reserves

(In percent of gross reserves)

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Sources: Data provided by national authorities; and IMF staff estimates.

Foreign Exchange Reserve Adequacy Indicators

Besides relating foreign exchange reserves to external debt and associated debt-servicing requirements, a further way to gauge reserve adequacy is by relating reserve coverage to imports. For instance. Frankel and Rose (1996) and Edin and Vredin (1993) both use this variable and find that it is a useful indicator. However, in a world of highly mobile capital flows, this may not be the most suitable measure of reserve adequacy. Even if a country’s reserves provide adequate import coverage, they may be very low in relation to short-term debt-servicing needs, as already discussed. Furthermore, in periods of uncertainty, such reserves may not be adequate when liquid domestic liabilities are being converted into foreign exchange.

Accordingly, Calvo and Mendoza (1996) have suggested the use of another reserves adequacy indicator, the ratio of M2 to gross foreign reserves, which takes into consideration the possibility of domestic capital flight. In times of capital inflow reversal, holders of liquid domestic liabilities may attempt to convert them to foreign exchange and send the funds abroad. Accordingly, an indicator, such as that suggested by Calvo and Mendoza, may be a useful signal of a country’s vulnerability to financial crisis.72

M2. which includes currency and banks’ demand/ savings deposits, is one measure of the potential liabilities that domestic agents may wish to convert into foreign exchange in times of uncertainty. As Sachs, Torniell, and Velasco (1996) argue, although M2 includes liabilities of private commercial banks, in the face of widespread withdrawals from such banks the monetary authority may be forced to extend the necessary covering credit to avoid a bank run. These extended funds would, in turn, be used to purchase foreign exchange from the central bank, thus illustrating the importance of reserve coverage in terms of a broad measure such as M2, rather than the narrower monetary base. Rojas-Suárez and Weisbrod (1995) contend that if a country’s banking system is perceived as sound, residents may convert domestic currency deposits into foreign-currency denominated deposits in response to an external crisis, rather than purchase foreign exchange. In such circumstances, it is more sensible to compare the monetary base with foreign exchange reserves, rather than with a broader money measure. However, if the banking system is perceived as weak, as in many of these countries, then the use of a broader M2/reserves indicator is more appropriate.

Many differences of opinion surround the interpretation of the M2/reserves measure. Roubini and Wachtel (1997) argue that the ratio is affected by the stage of development of the banking system and the extent of intermediation that results, thus making it a difficult indicator to interpret. Similarly, Calvo and Mendoza (1996) contend that it is not the size of the ratio between M2 and reserves that matters, rather it is sudden and large shocks to the gap that are important. They cite Austria as an example of a country where the ratio is large, yet the economy is stable, making it less vulnerable to shocks. On the other hand, they observe that the instability of the ratio in certain emerging countries makes them more vulnerable to crisis. In contrast, Sachs, Tornell, and Velasco (1996) argue that it is the stock of M2 relative to foreign exchange reserves that is important, and that a large M2-to-reserves ratio is an indicator of vulnerability even when domestic credit policy is tight.73

Regarding empirical results of previous studies, Bilson (1979) finds that base money relative to reserves helps predict the possibility of subsequent devaluation, while Edwards (1989) and Klein and Marion (1994) contend that both a base money and an Ml measure are useful indicators. Kaminsky and Reinhart (1996); Sachs, Tornell, and Velasco (1996); and IMF (1998) find that M2 relative to reserves is a useful indicator of vulnerability.

Table 3.11 presents the ratio of reserves to imports during 1993–97, while Table 3.12 gives the ratio of M2 to international reserves, both of which are converted to U.S. dollars. The financial sector is not very developed in the Baltics, Russia, and other countries of the former Soviet Union, which means that M2 relative to GDP is, in general, low by international standards. Therefore, it is more useful to concentrate on the overall trend in M2 relative to reserves to get a better picture of vulnerability.

Table 3.11.

Gross Foreign Exchange Reserves

(In months of imports)

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Sources: Data provided by national authorities; and IMF staff estimates.
Table 3.12.

Ratio of M2 to Gross Foreign Exchange Reserves

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Sources: Data provided by national authorities: and IMF staff estimates.

M2 excluding foreign currency deposits.

The main point of note of reserves-to-imports data is that, despite their increase over the sample period, these ratios are quite low, except for Turkmenistan. In the cases of Belarus and Tajikistan, the ratios are well below unity, thus indicating a pressing need to build up additional reserves. Overall, reserves appear inadequate relative to imports, and most of the countries appear quite vulnerable from this perspective.

Turning to the M2-to-reserves ratios, these do not appear excessive in any of the countries, except perhaps for Belarus and Russia. For example, Goldstein (1997) reported that Mexican M2 was five times higher than gross reserves in December 1994, just before the crisis. Taking other examples, this ratio was more than six in Korea, and more than four in Thailand, Indonesia, and Malaysia in July 1997. These countries all have more highly developed financial systems than the Baltics, Russia, and other countries of the Soviet Union. The highest ratios in 1997 in the latter group were recorded for Belarus and Russia, with ratios of about 3.5—far higher than Ukraine, the next highest at 2.4. Moreover. Armenia. Kazakhstan, and Turkmenistan all recorded ratios of less than unity in 1997. Accordingly, it appears that the banking sector is in need of reform in many of these countries, although the sector may be too small in most—with the exceptions of Belarus and Russia—to be of central concern from an external vulnerability viewpoint.

Financial Sector Indicators

In the past, financial and external crises have often occurred at around the same time: several prominent examples that recently gained widespread attention are Thailand, Indonesia, Korea, and Russia.74 This has prompted several studies to examine the links between these two types of crises. Velasco (1987) and Rojas-Suárez and Weisbrod (1995) examine these links from a theoretical viewpoint, while Kaminsky and Reinhart (1996) provide an empirical analysis of the issue. The latter find, after examining a variety of crises episodes, that the linkages between both types of crisis have strengthened since the 1970s, as liberalization has proceeded. Furthermore, their empirical results suggest that banking crises help predict external crises, but the reverse is not supported. This suggests that financial market indicators of potential banking crises may be useful in predicting external crises in an indirect manner. Roubini and Wachtel (1997) emphasize the connection between the soundness of the transition economies’ banking systems and their ability to sustain current account deficits. They argue, inter alia, that the uncertainty associated with a poorly performing banking system may inhibit capital inflows, thereby possibly prompting an external crisis. Kaminsky and Reinhart (1996) contend that, if a monetary authority finances the bailout of troubled financial institutions following a banking crisis, either through printing money or debt issuance, its ability to maintain the existing exchange rate commitment is impeded.

In the Baltics, Russia, and other countries of the former Soviet Union, most of the financial sectors are quite thin, even considering their low levels of GDP. as demonstrated by EBRD (1998). This leaves these economies less vulnerable to spillover effects arising from banking crises than other, more intermediated, countries. Reflecting this, countries such as Latvia and Lithuania continued growing during their banking crises, unlike the experience in other developing countries. Furthermore, financial sector indicators used elsewhere, such as the preponderance of bad loans, are either simply not available or are of very poor quality in the case of the Baltics, Russia, and other countries of the former Soviet Union. Finally, given the special circumstances of transition, banking problems in these countries may reflect the difficulties of transition and may not be amenable to the use of those indicators that have proved useful elsewhere.75 For all these reasons, and the fact that banking sector crises are not the central focus of this paper, only a small subset of financial sector indicators are considered over and above the M2-toreserves ratio examined in the previous subsection.76

Although several of the studies discussed in the previous subsection have demonstrated the usefulness of the M2-to-reserves ratio as a crisis indicator, banking crises generally do not stem from the deposits side of banks’ balance sheets, but from the assets side in the form of a marked deterioration of asset quality. The first asset-side indicator considered here is private sector credit growth. Krugman’s (1979) seminal first-generation model of speculative attacks emphasized the importance of excessive credit growth in prompting such attacks. If overall credit growth exceeds money demand growth, the result will either be a depletion of reserves under a fixed exchange rate regime, or a weakening of the exchange rate and higher inflation in a flexible regime. Sachs, Tornell, and Velasco (1996) further argue that excessive credit growth can lead to a deterioration in the quality of the banking sector’s loan portfolio, thus leaving the sector vulnerable to crisis. Studies such as Gavin and Hausmann (1995); Frankel and Rose (1996); Sachs, Tornell. and Velasco (1996); and Demirgüç-Kunt and Detragiache (1997) have found that domestic credit can be a useful crisis indicator. Table 3.13 presents figures on credit growth to the private sector relative to GDP Sachs. Tornell, and Velasco analyze changes in the credit-to GDP ratio to gauge whether excessive credit growth has taken place. As they argue, very high levels of private sector credit to output need not be a cause for alarm, because such ratios may merely signify financial deepening, which is of itself no cause for concern. However, sharp increases in these ratios are of concern in that they may be conveying important signals about deteriorating new loan quality.

Table 3.13.

Ratio of Total Bank Credit to the Economy to GDP

(In percent)

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Sources: Data provided by national authorities: and IMF staff estimates.