Export Instability and the External Balance in Developing Countries

Uncertainty about the export earnings accruing to a country (sometimes referred to as export instability) is an important source of macroeconomic uncertainty in many developing countries. Theory predicts that countries should react to increases in this form of uncertainty by increasing their level of savings. The resulting asset accumulations would then act as the country’s insurance against the greater riskiness in its income stream. The paper tests this implication for a large sample of developing countries. In general, the results suggest that developing countries have indeed responded to increases in export instability by building up precautionary savings balances.

Abstract

Uncertainty about the export earnings accruing to a country (sometimes referred to as export instability) is an important source of macroeconomic uncertainty in many developing countries. Theory predicts that countries should react to increases in this form of uncertainty by increasing their level of savings. The resulting asset accumulations would then act as the country’s insurance against the greater riskiness in its income stream. The paper tests this implication for a large sample of developing countries. In general, the results suggest that developing countries have indeed responded to increases in export instability by building up precautionary savings balances.

I. Introduction

Export instability, that is uncertainty about the export earnings accruing to a country (which empirically arises mainly as a result of price or terms of trade uncertainty, rather than uncertainty about export volumes), is an important source of macroeconomic uncertainty in developing countries. These countries have taken a number of different approaches to reducing their exposures to instability in export revenues, including diversification of the export base, and the use of commodity-price linked hedging instruments. It is fair to say, however, that these strategies have by no means eliminated the problem of export instability for developing countries. Diversification of the export base is really only a long-term solution toward the goal of self- insurance, and may not even be desirable if such diversification runs counter to the country’s comparative advantage. As to available hedging instruments, these markets remain limited to only a selected range of the commodities in which developing countries have a significant exposure. To a significant extent, therefore, the risk associated with export instability in commodity-producing developing countries must be regarded as nondiversifiable.

The relevance of this issue has increased recently, as policy makers in a number of developing countries have turned their attention to the problems associated with the sharp decline in commodity prices since the mid-1980s. In addition to the negative trend in prices that has been debated in the literature at least since the contributions of Prebisch (1950) and Singer (1950), an issue that has recently come to the fore is the steady increase in the volatility of commodity prices over the past two decades. 1/ Greater volatility in commodity prices translates into increased variability in the export earnings of a number of commodity-exporting countries. Absent domestic policies designed to eliminate or reduce the underlying volatility in world prices, an optimal response by domestic agents would be to build up precautionary balances so as to be able to protect consumption (thereby increasing welfare) when particularly large real income shocks occur. 2/ Controlling for the other determinants of savings behavior, an implication of the precautionary savings hypothesis is that greater uncertainty in export earnings should be correlated with increased savings. Moreover, in an open economy, these savings should be reflected at a macroeconomic level in the external current account balance, which after all simply measures a country’s national savings net of investment.

This paper considers the effect of export instability on the external balance in a dynamic optimizing model with incomplete markets for risky assets. As argued previously, the assumption of incomplete markets is more realistic than the alternative, since international capital markets have done little yet to diversify the risks facing developing countries. The assumption of a dynamic economy is made in order to capture the effects of export instability on the trade balance, which is intertemporal in nature. The main channel that is emphasized in this paper is the effect of export instability on savings behavior, through the precautionary savings motive. This channel has recently received renewed attention in the literature, where it has been argued that labor income uncertainty is an important factor in explaining household savings behavior in the United States (see, for example, Caballero (1990)). We extend this idea to the aggregate level and consider a small commodity-producing developing country which faces a nondiversifiable risk in its export earnings. In this case, export revenues play the role of household labor income in the existing literature, and the effect of export instability on savings behavior should show up in the trade balance or the current account, which measures the economy’s savings net of investment.

In this paper, we draw on two strands in the literature: the first is the literature dealing with current account determination in an intertemporal context (Intertemporal Current Account models for short); 1/ the second, as alluded to previously, is the recent (closed-economy macro) literature on precautionary savings. 2/ The modern ICA literature, which for the most part assumes full certainty, shows that the effect on the current account of a terms of trade shock depends on the persistence of that shock. If a favorable shock is expected to be short-lived, its effects on savings behavior, and hence on the current account, will be much larger than if the shock is expected to last a long time. In fact, what really matters for the current account is the present discounted value of expected changes in real export earnings. If export earnings today are high relative to their average expected value in the future, the trade balance will show a surplus (smaller deficit) as agents accumulate foreign assets to keep consumption at desired levels when exports return to trend levels.

As mentioned previously, the ICA literature has generally ignored uncertainty. It turns out that the incorporation of uncertainty into otherwise standard intertemporal models of the current account creates an additional channel through which export instability (induced either by relative price or volume effects) affects macroeconomic behavior. Specifically, if export earnings are uncertain, their volatility (in addition to their expected value, discussed above) will also influence the trade balance. This is the analogue to the effect of uncertainty in household labor income on savings behavior emphasized in the (closed-economy) precautionary savings literature.

In an open economy, the current account measures the economy’s savings net of investment. If the economy’s export earnings are more uncertain, the economy will tend to increase its savings (and hence its current account surplus) as a means of insuring itself against the increased risk in its income stream. These additional savings (like the asset accumulations of an individual household) are made because they help to reduce the volatility of consumption and utility when export earnings are stochastic. International borrowing and lending in this context thus has a double payoff to the country, enabling it to smooth consumption relative to both expected changes in revenues over time, and to the volatility of the underlying revenue process. 1/

Our theoretical results thus emphasize two main channels through which export instability affects the external balance. The first is the standard consumption smoothing channel which has been emphasized in recent contributions to the current account literature, where certainty equivalence is assumed. The second is the volatility of export earnings which directly affects the economy’s demand for precautionary savings, and thereby alters the external current balance. The higher is this volatility, the higher will be the current account surplus (the smaller the deficit) that the country will wish to maintain in order to insure itself against future shocks. This is the channel which has been ignored in previous work on the current account (which assumed certainty equivalence), and which is tested for in this paper.

The paper is organized as follows. The next section presents a stylized model of a small commodity-exporting country that allows one to solve analytically for the current account in terms of the two channels described above. In Section III, we test this model against data for a large sample of developing countries. Because of the relative paucity of data in the time-series dimension, we estimate the model for a panel consisting of about sixty developing countries, covering Africa, Asia, the Middle East, and Latin America, over a twenty-five year period. The empirical results, taken up more fully below, reveal that export instability has, in general, exerted a systematic effect on savings behavior and the external balance of developing countries. An increase in export instability, other things equal, raises the precautionary demand for savings and the external balance of developing countries. Moreover, the effect is not insignificant, with precautionary savings accounting for perhaps 3 1/2 percent of average imports for the nonfuel primary commodity exporters, and up to 14 percent of average imports for the fuel exporters. The results therefore suggest that agents in these countries may have been more successful at using financial markets to insure themselves against shocks to their export earnings than had previously been believed. Finally, the main conclusions of the paper are summarized in Section IV.

II. The Model

The model developed in this section is highly stylized, and the structure is kept as simple as possible while still permitting an analysis of the question of how export instability affects savings behavior and the external balance in developing countries. We consider a small developing country which consumes a single composite commodity, which we assume is not produced domestically. In addition, the country produces a good, the domestic consumption of which is assumed to be negligible. All domestic production is therefore shipped abroad, so we refer to this good as exports. We ignore in the model the additional considerations that arise as a result of nontraded goods. These considerations have been emphasized elsewhere, and would in any case complicate the analysis sufficiently (by making the relative price of nontradables endogenous) so as to make an investigation of the issue we are concerned with here--the effect of export instability on the external balance--intractable. 1/

Agents are assumed to maximize the expected value of the discounted sum of current and future utilities:

(1)Σt=0βtE{u(mt)},

where β is the subjective discount factor, u(.) is the instantaneous utility function, and mt denotes consumption of the single good which, as noted previously, is imported from abroad. In addition to the transversality condition which rules out Ponzi-type schemes, consumers’ decisions must satisfy their dynamic budget constraints, which hold that in any period t:

(2)bt+1=(1+r)bt+ptxtmt,

where bt denotes the economy’s bond holdings at time t, pt denotes the (stochastic) terms of trade at time t, xt denotes the volume of exports and mt the volume of imports at time t. 1/

As is known from the formal theory of consumption under uncertainty, not all utility functions are consistent with the existence of a precautionary demand for savings, even when agents are risk averse. Since the purpose of this paper is to test for the existence of such a demand, we need to adopt a class of utility function that allows for precautionary savings. Following the work of Leland (1968), Sandmo (1970), Drèze and Modigliani (1976), and Miller (1976), who showed that precautionary savings are consistent with utility functions with a positive third derivative, we assume here that the instantaneous utility function has the constant-absolute-risk-aversion (CARA) form, viz.:

(3)u(mt)=(1/α)eαmt,

where α > 0 denotes the Arrow-Pratt measure of (absolute) risk aversion.

Under the simplifying assumption that the exogenous foreign interest rate is equal to the rate of time preference, the first order necessary condition is given by:

(4)eαmt=Eteαmt+1.

This condition states that the marginal utility cost of giving up one unit of good m at time t should be equated to the expected utility gain from consuming one more unit of m at t+1. Alternatively, dividing the lefthand side of (4) by the righthand side, the condition states that the intertemporal marginal rate of substitution should equal the ratio of the prices of present and future consumption, which is unity here. 2/

To begin with, since the issue at hand involves how savings respond to changes in the variance of export earnings over time, it is necessary to make some assumption about how agents perceive the future behavior of this variance. One way to proceed would be to consider a comparative statics exercise in which the current account responds to exogenous changes in the variance of (the lifetime innovation to) export earnings. 1/ The problem with such an approach is that it tries to identify agents’ systematic response to changes in uncertainty even though, within the model, these agents are assumed to have assigned a zero probability to such changes. Therefore, in this paper we choose to abandon this type of comparativestatics exercise and assume instead that agents make their consumption decisions taking explicit account of the stochastic properties of the variance process. 2/

Here, we assume that the variance follows an AR(1) process with parameter ρ. 3/ To solve for the consumption function, we use a “guess and verify” method. Our guess for the consumption process is:

(5)mtmt1=ξt+Λt1st/[r+(1ρ)]

where ξt is the life-time innovation in export earnings,

(6)ξt=r(1+r)Σj=01(1+r)j{Etpt+jxt+jEt1pt+jxt+j},

Λt-1 is the stochastic slope of the consumption path between periods t-1 and t, which depends on the variance of ξt-1, denoted σξt12; and st is the innovation to Λt. 4/ Intuitively, under certainty equivalence, the first difference of consumption would just be equal to ξt. In our case, however, there are two additional terms, which reflect precautionary savings behavior. A high value of the variance last period raises Λt-1, which increases the growth rate of consumption (lowers mt-1), in line with the precautionary savings hypothesis. A positive innovation to the variance today--which implies a positive drawing for the shock st--lowers consumption today mt, thereby reducing the growth rate of consumption. If ρ = 1, so that the innovation to today’s variance is permanent, agents revise upward their estimate of the future variance by the full amount of the shock and, therefore, the effect on consumption growth is equal to the annuity value of the innovation st/r. If ρ < 1, the shock gets reversed in the future, and the effect of the innovation on consumption is accordingly smaller.

Substituting (5) into (4) yields: 1/

(7)Λt=(1/α)[log(Eteαξt+1)+log(Ete(α/[r+(1ρ)])st+1)]

If the innovations to export earnings have a normal distribution (with mean zero), then so will ξ. If, moreover, the innovations to the variance process follow a normal distribution, then we can evaluate the expectations in (6) to yield:

(8)Λt=αρσξt22+ασs22[r+(1ρ)]2,

where σs2 is the (known and constant) variance of s. Clearly, with Λt as defined in (8), the guess for the consumption process in (5) satisfies the first order condition in (4).

Once Λt has been obtained, we can guess a final form of the consumption function:

(9)mt*=r(1+r)Σj=01(1+r)j(Etpt+jxt+j)+rbtΛt/[r+(1ρ)].

Thus, according to (9), consumption in any period is equal to permanent export earnings minus a term in the variance of export earnings. To check our guess, we need to show that (9) satisfies (5). Note from (9):

(10)mt*mt1*=mt*(1+r)mt1*+rmt1*=r(1+r)Σj=01(1+r)j{Et(pt+jxit+j)Et1(pt+jxt+j)}+r[bt(1+r)bt1+mt1*pt1xt1]Λt+(1+r)Λt1[r+(1ρ)]

But from the budget constraint (2):

(11)bt(1+r)bt1+mt1*pt1xt1=0

Substituting the process for Λt gives:

(12)mt*mt1*=ξt+Λt1st/[r+(1ρ)]

which is (5), as was to be verified.

By definition, the current account is equal to the change in foreign assets. Using the budget constraint (2) together with the solution for the consumption function given in (9) gives a simple expression for the current account as the present value of expected changes in export earnings plus a term in the variance of the innovations to export earnings:

(13)cat*=Σj=11(1+r)j{EtΔpt+jxt+j}+αρσξt22[r+(1ρ)]+constant

where Δ is the (backward) difference operator, Δxt = xt - xt-1, and where, from (8), the constant depends on the (known) variance of the shocks to the Λ process. Equation (13) clearly illustrates the implications of precautionary savings for the current account, revealing that both risk aversion (α) and the persistence of the shocks to the variance process (ρ) magnify the effect of the precautionary savings motive on the current account. Specifically, innovations to the variance process that die out quickly (low value of ρ) will have little effect on precautionary savings, and hence on the current account. In contrast, shocks to export earnings (embodied in the first term in (13)) that display low persistence will have a large effect on the current account as they will lead to a correspondingly large expected change in export earnings (since these will quickly return to their trend levels in the case of a transitory shock).

Equation (13) also carries a number of policy implications. It shows for example that the desirability of building up precautionary balances (either explicitly through a government-sponsored stabilization fund or simply through the voluntary savings behavior of the various agents in the economy) depends on the persistence of the shocks to the variance process and also on how risk averse agents are. In addition, the feasibility of maintaining these balances is diminished if the country finds itself pushed below its subsistence level by a large permanent negative shock, or is denied access to international capital markets. The model may therefore be expected to perform best in countries where achieving subsistence consumption levels is not difficult, and where access to the international capital markets for consumption-smoothing purposes is possible. Also, the model may not find much evidence of precautionary savings behavior if the underlying fundamentals are relatively stable, which would likely be the case for countries with a highly diversified export base. 1/

To implement the model empirically, we need an estimate of the variance of ξ. 2/ The most obvious strategy would be to estimate the lifetime innovation to export earnings by fitting a univariate process for export earnings. As shown by Campbell (1987), however, such a procedure is likely to overestimate the extent of uncertainty, as long as agents have more information about the future course of export earnings than is contained in its past values. When agents do possess such information, the current account ought to be a useful predictor of (Granger-cause) subsequent movements in export earnings. 1/ Therefore, the procedure followed here is to estimate the following bivariate, first order VAR in [Δ(ptxt), cat],

(14)[Δ(ptxt)cat]=[Ψ11Ψ12Ψ21Ψ22][Δ(pt1xt1)cat1]+t.

In equation (14), the data on the current account are detrended prior to estimation of the VAR.

The problem with (14) from the point of view of retrieving the innovation ξ is that ξ depends on innovations in the Level of export earnings, while the VAR in (14) is in terms of the first difference of export earnings. Using the definition of ξ, and projecting (14) forwards, however, one can show that:

(15)ξt=r(1+r)Σj=01(1+r)j[10]Σj=0jΨit=[10][IΨ/(1+r)]1t

Given ξ, its instantaneous variance, period by period, may be calculated by simply squaring the expression in (15), yielding a time series σξt2. 2/ In our empirical work, in addition to using just the current realization ξt, we also experiment with taking an average of the current realization of ξ and one, two, and five leads and lags of ξt when calculating σξt2. We refer to these various estimates of σξt2 as the one (no leads or lags), three (one lead and one lag), five (two leads and two lags), and eleven (five leads and five lags) period measures, respectively.

We are now in a position to test the model of the current account postulated in equation (13), and to examine whether export instability plays an important role in the determination of the current account in developing countries. It is useful to separate out that part of the current account which does not depend on export instability, and which from (13) is simply equal to the expected present value of future declines in real export earnings, denoted pdv: 3/

(16)pdvt=Σj=11(1+r)j{EtΔ(pt+jxt+j)}

Then from (13) the actual (optimal) current account should equal pdv plus a term in the variance of ξ. Thus, our final regression is of the form:

(17)cat=a0+a1pdvt+a2σξt2+ut,

where, under the null, a1 = 1 and a2=αρ2[r+(1ρ)]. Since, by construction, pdv will be correlated with the error term ut in (17), this regression cannot be estimated via Ordinary Least Squares. To overcome this problem, an instrumental variables procedure is used to estimate (17), where the instruments consist of the first difference of export earnings, and two lags of the current account.

III. Empirical Results

Before turning to the empirical results, it bears emphasizing that the quantitative importance of precautionary savings will depend on both the magnitude of the coefficient a2 defined previously, as well as on how large the variance to the lifetime innovation in export earnings is. Although the empirical results reported below will directly shed light on this issue, it is perhaps worth trying to get some rough idea of the orders of magnitude involved here. To this end, one can see that if one takes a typical value of the risk aversion parameter, say about 2.0, and assume that the autoregressive coefficient on the variance is about 0.25, 1/ this would yield a value of a2 of about 1/3 for any plausible value of the real interest rate. Higher values of the risk aversion or autoregressive parameters could easily result in a value of a2 of about 0.5. 2/

As to the variance, Table 1 provides information on the volatility of the lifetime innovation in export earnings. As can be seen, there is quite a bit of variation across different regions, and by type of predominant export, in the underlying volatilities. 3/ For example, the coefficient of variation varies from about 19 percent for the Western Hemisphere countries to 72 percent for the Middle Eastern countries, reflecting as we shall see the variability in oil prices over the two oil shocks which our sample spans. As far as type of predominant export is concerned, actual volatilities for the diversified exporters and for the WEO’s classification of exporters of services and recipients of private transfers, are 16 and 8 percent respectively. Much higher volatilities are recorded by exporters of primary products (31 percent) and fuel exporters (65 percent). As to exporters of manufactures, their volatility, at just over 17 percent, lies in the middle range.

Table 1.

Volatility of the Lifetime Innovation in Export Earnings 1/

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The volatility measures are rendered unitless by dividing the (one period measured of the) variance of the lifetime innovation by the square of average imports, taking the square root, and multiplying by 100 percent. Average imports, rather than the innovation, are used to deflate the variance, because the innovation has a mean of zero.

How big are precautionary savings relative to, say, average imports in our sample? Using the entries in Table 1 and a conservative value for the coefficient a2 of 1/3, gives some indication. Since, as explained below, the regressor in the empirical work is the variance divided by average imports 1/, the entries in Table 1 divided by 100 percent and squared, give the value of the regressor as a fraction of average imports. In percentage terms, one can see that the numbers range from 0.6 percent to 41.9 percent by type of export, and from 3.5 to 52.4 percent by region. Multiplying these numbers by 1/3 thus gives some indication of the relative importance of precautionary savings. To take a couple of examples, for the African region, precautionary savings would account for about 5 percent of average imports over the sample, while for the commodity exporting group, precautionary savings would account for about 3 1/2 percent of average imports’, and for the fuel exporters, it would make up as much as 14 percent of average imports.

The empirical analysis was undertaken using annual data for sixty developing countries over the period 1965-1991. The source for all data was the World Bank’s World Tables. Developing countries from all regions were included in the study, which covered twenty-six countries from Africa: Algeria, Benin, Burkina Faso, Cameroon, Central African Republic, Congo, Cote d’Ivoire, Ethiopia, Gabon, Gambia, Ghana, Guinea Bissau, Kenya, Liberia, Morocco, Madagascar, Mali, Mauritius, Malawi, Niger, Nigeria, Senegal, Tunisia, Uganda, Zaire, Zimbabwe; eleven countries from Asia: Bangladesh, China, Indonesia, India, Korea, Malaysia, Pakistan, Philippines, Papua New Guinea, Singapore, Thailand; seven countries from the Middle East: Egypt, Israel, Jordan, Kuwait, Lebanon, Libya, Saudi Aribia; and sixteen countries from Western Hemisphere: Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Ecuador, El Salvador, Guatemala, Honduras, Jamaica, Mexico, Panama, Paraguay, Peru, Uruguay, Venezuela.

Equation (17) was estimated using an instrumental variables procedure over the entire sample, as well as over various sub-groupings to be discussed below. Country-specific constants (“fixed effects”) were allowed for in the regressions. In addition, because the coefficient on the variance in (17) depends on the degree of absolute risk aversion (α), and because the latter is unlikely to be independent of the level of consumption or imports, we deflate each country’s variance measure by average imports. This implies that the coefficient on the deflated variance measure should now depend on relative risk aversion, which is more likely to be constant across countries with very different income levels, as in our sample. Finally, because the net interest income component of the current account is a predetermined variable (since it depends on last period’s asset stock), precautionary savings will be reflected mainly in the trade balance, which is therefore used as the dependent variable in the regressions reported below.

Table 2 reports the estimation results for the full sample, using the one, three, five, and eleven period measures of the variance. Overall, the model works well, in terms of the overall fit of the regressions, the sign of the point estimates and, in the case of the coefficient on pdv, the magnitude of the parameter estimate. As mentioned previously, pdv represents the certainty-equivalent portion of the model and, theoretically, the parameter estimate should be unity. It can be seen from Table 1 that in most cases the null hypothesis that this parameter is in fact unity cannot be rejected. 1/ In all cases, the variance measure exerts a positive influence on the trade balance, so that as uncertainty about real export earnings increases, agents increase their precautionary savings to insure themselves against increased riskiness of their income streams. In all cases, that is independent of the number of time periods used in calculating the variance, the coefficient on the variance is statistically different from zero.

Table 2.

Effect of Export Instability on the Trade Balance: Full Sample 1/

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An asterisk denotes significance of the coefficient at the 5 percent level.

Several factors will influence the model’s overall performance. First, turning to the certainty-equivalent portion of the model, it is unlikely that that all countries in the sample will be equally able to smooth away the cyclical component of shocks to export earnings by using the international capital market. Some countries may be completely shut off from the international capital market (either because private agents are subject to capital controls and governments do not behave optimally, or because foreign banks perceive the countries to be insolvent and thus unable to repay loans), while others may find it easy to borrow abroad. Thus, it would be inappropriate from an econometric standpoint to constrain the coefficient on pdv--which measures the country’s ability to use the international capital market to smooth away the cyclical component of export earnings--to be equal across all countries in the sample.

Second, an important factor in being able to detect a systematic effect of instability about the terms of trade or export receipts of a country is that the instability actually gets transmitted to the agents in the economy who are going to do the saving. If institutional arrangements result in an artificial smoothing of prices in some countries even though underlying world prices are unstable, and if the government, say, does not undertake the savings that would otherwise have been undertaken by the private sector, then we will be unable to detect much effect of export instability on the external balance. Since the extent to which such institutional arrangements are important is likely to differ across countries, this too argues in favor of looking at the results in a more disaggregated fashion.

Third, the underlying uncertainty of export earnings may differ according to the extent to which the export base of the country is heavily concentrated in a particular commodity. Indeed, export diversification strategies are often recommended as a means toward the goal of self-insurance, since export earnings are likely to be less volatile for countries with more diversified exports. If export diversification results in highly stable export earnings, then precautionary savings behavior may be very difficult to identify empirically. 1/

The first type of disaggregation that we turn to is the World Economic Outlook’s (WEO) classification of developing countries by predominant export. The WEO classifies developing countries into four broad categories by predominant (usually meaning more than 50 percent of the total) export: fuel exporters; exporters of manufactured products; exporters of primary products; and exporters of services and recipients of private transfers. Countries whose export earnings are not dominated by any one of the above categories are classified as having a diversified export base. Thus, all told, there are five categories, denoted below by fuel, manufactures, primary commodities, transfers, and diversified.

Tables 3-6 report the empirical results for the five country groupings, and the one, three, five, and eleven period variance measures, respectively. In each of the tables, the constrained regression assumes that the effect of pdv is the same in all countries within a region, while the unconstrained regression allows this parameter to vary across countries. Since the various slope coefficients (one for each of the sixty countries) on the pdv are not of immediate interest, these are not reported in the tables, but are available from the authors on request.

Table 3.

Effect of Export Instability by Type of Exporter: One-Period Variance Measure 1/

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An asterisk denotes significance of the coefficient at the 5 percent level.

The constrained regression assumes that the slope coefficients on the PDV variable are equal across countries.

The unconstrained regression allows the slope coefficients on the PDV variable to vary across countries.

Table 4.

Effect of Export Instability by Type of Exporter: Three-Period Variance Measure 1/

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An asterisk denotes significance of the coefficient at the 5 percent level.

The constrained regression assumes that the slope coefficients on the PDV variable are equal across countries.

The unconstrained regression allows the slope coefficients on the PDV variable to vary across countries.

Table 5.

Effect of Export Instability by Type of Exporter: Five-Period Variance Measure 1/

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An asterisk denotes significance of the coefficient at the 5 percent level.

The constrained regression assumes that the slope coefficients on the PDV variable are equal across countries.

The unconstrained regression allows the slope coefficients on the PDV variable to vary across countries.

Table 6.

Effect of Export Instability by Type of Exporter: Eleven-Period Variance Measure 1/

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An asterisk denotes significance of the coefficient at the 5 percent level.

The constrained regression assumes that the slope coefficients on the PDV variable are equal across countries.

The unconstrained regression allows the slope coefficients on the PDV variable to vary across countries.

As mentioned previously, our priors tell us that the results of the unconstrained regression are likely to provide more reliable information, since they do not assume that factors which affect the ability of countries to smooth away the cyclical component of export earnings are equal in all countries. Nevertheless, if the constraint that the slope coefficients on pdv is equal across countries is true for a particular country grouping, then the efficiency of parameter estimates will increase, which could result in a higher coefficient of determination. 2/

There is a consistent pattern in the results. Turning first to the effect of the variance of export earnings, we see that this parameter is statistically significant for the fuel exporters, exporters of manufactures, and exporters of primary commodities, in virtually all cases 1/, that is independent of which variance measure is used. This contrasts sharply with the results for the recipients of private transfers and countries with a diversified export base. In the former case, the relatively poor results may reflect liquidity constraints and a general lack of access to international capital markets while in the latter case, the results may simply reflect the fact that for these countries, the underlying uncertainty is relatively small and therefore the data are unable to find much evidence of precautionary savings. 2/ Second, the model’s overall performance seems to be best for the fuel exporters, as measured by the high coefficient of determination for this sub-group (usually above 90 percent). For the manufacturing exporters (unconstrained regressions), even this simple model explains between 25 and 30 percent of the variation in the trade balance, while for the commodity exporters, R-squared’s vary between 5 and 20 percent for the unconstrained regressions (they are higher for the constrained regressions for some variance measures). For the remaining sub-groupings, the model overall performs well but the variance is not found to play a statistically significant role, with the slope coefficients on the pdv variable having much more explanatory power. 3/

The second type of disaggregation that we undertake is a regional one, which is reported in Tables 7-10. The picture that emerges here is that the model seems to work best for the Middle East region, where the variance is highly significant in virtually all cases, and the predictive capacity of the model is also high, implying that the coefficient(s) on the PDV slope terms (not reported) are also highly significant. These results are consistent with those reported in Tables 3-6, since this region is dominated by the fuel exporters. The results suggest that these economies in particular seem to save for precautionary purposes in response to increases in the underlying volatility of their export earning streams.

Table 7.

Effect of Export Instability by Region: One-Period Variance Measure 1/

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An asterisk denotes significance of the coefficient at the 5 percent level.

The constrained regression assumes that the slope coefficients on the PDV variable are equal across countries.

The unconstrained regression allows the slope coefficients on the PDV variable to vary across countries.

Table 8.

Effect of Export Instability by Region: Three-Period Variance Measure 1/

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An asterisk denotes significance of the coefficient at the 5 percent level.

The constrained regression assumes that the slope coefficients on the PDV variable are equal across countries.

The unconstrained regression allows the slope coefficients on the PDV variable to vary across countries.

Table 9.

Effect of Export Instability by Region: Five-Period Variance Measure 1/

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An asterisk denotes significance of the coefficient at the 5 percent level.

The constrained regression assumes that the slope coefficients on the PDV variable are equal across countries.

The unconstrained regression allows the slope coefficients on the PDV variable to vary across countries.

Table 10.

Effect of Export Instability by Region: Eleven-Period Variance Measure 1/

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An asterisk denotes significance of the coefficient at the 5 percent level.

The constrained regression assumes that the slope coefficients on the PDV variable are equal across countries.

The unconstrained regression allows the slope coefficients on the PDV variable to vary across countries.

Tables 7-10 also reveal that the data fail to find any significant effect of export instability on savings behavior in the African region. As alluded to previously, this may be due to a number of factors, including the fact that in many of these countries price stabilization programs may effectively insulate the domestic private sector from the effects of International price shocks and governments frequently do not make up for the private sector by increasing their own savings in the face of changes in the risks associated with their export earnings. In addition, these countries may be affected by the fact that subsistence consumption levels are not always assured, so that it is not feasible to maintain precautionary balances despite the increased volatility in export earnings, and more generally by liquidity constraints and lack of access to international capital markets.

The model also seems to work well for the Asian countries, with a majority of the regressions finding a statistically significant effect of export instability on precautionary savings. The model’s overall predictive ability varies depending on the variance measure used and whether the constraints imposed on the PDV slope coefficients are binding or not; nevertheless’, in some cases, R-squareds of nearly 50 percent are achieved. Finally, if one recalls that we have no priors as to which of the particular variance measures should perform best 1/, the results for the Western Hemisphere region are reasonable, at least for the five-year variance measure in the case where slope coefficients on the PDV variable are not constrained. In that case, the variance is significant at the 10 percent level and the R-squared is above 70 percent.

IV. Conclusion

Uncertainty about the terms of trade and/or export revenues is an important source of macroeconomic uncertainty in a number of developing countries. Theory dictates that smoother consumption streams and hence higher welfare can be achieved if agents increase their savings when they perceive that the variability of their export receipts will increase. This is the precautionary savings motive that has been argued to underlie a significant portion of aggregate savings in a number of industrial countries, including the United States. In this paper, we sought to test empirically whether this precautionary savings motive was present in the case of developing countries which have uncertain export earnings. Our finding was that in general the precautionary motive has exerted a significant influence on savings behavior and the external balance of developing countries; quantitatively, its importance has varied across the sample, accounting for about 14 percent of average imports in the case of fuel exporters and about 3 1/2 percent of average imports for exporters of nonfuel primary commodities.

Of course, whether or not export instability increases precautionary savings will depend on a number of factors. For example, some countries have instituted explicit stabilization funds whose purpose is to build up precautionary balances so as to insure consumption (public or private) in the face of commodity price shocks. In some cases, though, the fund’s purpose can equally well be achieved by accumulating (foreign) assets whose returns are uncorrelated with the export revenues accruing to the country. In either case, the resulting balances are part of domestic savings and, therefore, in a financially open economy, changes in the level of such balances will be reflected in the country’s external current account balance, which after all is identically equal to national savings net of investment.

However, in a number of developing countries, government policies may inhibit the transmission of relative price shocks to the domestic economy and this would mitigate the private sector’s incentives to accumulate precautionary balances. If the government does not accumulate these balances in place of the private sector, i.e., if it does not behave optimally, then one would not be able to find much evidence of precautionary savings in the data. Alternatively, if the underlying source of uncertainty is reduced because the country has a highly diversified export base, then again one will not find much evidence that precautionary savings are important for such countries. Finally, the inability to maintain consumption above a subsistence level, generalized liquidity constraints, and lack of access to international capital markets, may also adversely affect the model’s performance in the case of some of the poorer countries in the sample, since agents there will not find it feasible to maintain precautionary balances when they perceive that the uncertainty of their export earnings has increased.

The evidence presented in this paper suggested that, for the developing countries as a whole, the data indeed support the view that these countries have attempted to build up precautionary balances when export instability increases. Moreover, a more disaggregated view of the results suggests that the precautionary-savings effect is stronger for countries with an export base that is more heavily concentrated in a few commodities than it is for countries with a highly diversified structure of exports. Finally, there was also some evidence to suggest that the precautionary savings motive varied from region to region, and that this might be a reflection of the differing extents to which price stabilization measures are used across the differing regions, and the differing abilities of the various agents in these countries to use capital markets to smooth consumption. An implication would be that, for a given level of underlying uncertainty, countries that use public policy in attempts to insulate themselves from relative price shocks may enjoy significant benefits by instead relying on international capital markets as a means of insuring themselves against commodity price shocks.

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1/

Princeton University and International Monetary Fund, respectively. We thank Eduardo Borensztein, Carmen Reinhart, and Peter Wickham for helpful comments on an earlier draft.

1/

For a detailed analysis of the stylized facts, see Reinhart and Wickham (1994).

2/

Of course, the issue of the negative trend in commodity prices and the increased volatility are not independent. It may be that countries whose real incomes fall below a subsistence level owing to the secular behavior of their commodity exports may be unable to build up the necessary balances to insure themselves against greater volatility.

2/

The early contributions include Fisher (1956), Friedman (1957), Leland (1968), Sandmo (1970), Drèze and Modigliani (1972), and Miller (1976). The recent literature includes Skinner (1988), Zeldes (1989), Caballero (1990), and Caroll (1992). See also van Wincoop (1992) for a two-period model of precautionary savings in an open economy.

1/

Increased volatility should result in greater external savings, and so should not be affected by the country’s access to international loans. However, if a country has no access to international capital markets, and so is unable to smooth away the cyclical component of shocks to export earnings, the consumption-smoothing model presented below is unlikely to work well (for an empirical analysis of the performance of the consumption-smoothing model for a sample of developing countries, see Ghosh and Ostry (1993)). In addition, if real incomes are insufficient to maintain even a subsistence level of consumption, the feasibility of maintaining precautionary balances is called into question.

1/

In addition, data limitations would preclude us from undertaking the empirical analysis of this paper if a more disaggregated commodity structure were employed.

1/

The numeraire is taken to be the import good. In equation (2), therefore, the terms of trade are defined as the price of exports relative to imports. Also, bond holdings are in terms of the foreign good.

2/

Recall that the consumption interest rate here is equal to the world interest rate since we ignore nontraded goods. This implies that the consumption rate of interest is nonstochastic here, and equal to the rate of time preference.

1/

Export earnings are likely to be nonstationary in practice so their variance would not be defined. However, as shown below, consumption depends on the variance of the lifetime innovation to export earnings (where the innovation is by construction stationary), and so this variance is indeed well defined.

2/

Caballero (1990) pioneers this approach in the context of a single household facing a labor income process with stochastic higher moments.

3/

Allowing for more general ARMA processes is straightforward and does not alter the qualitative results.

4/

It is straightforward to verify that the innovation to the Λ process, st, is proportional to the innovation to the variance process. Also, it is clear that if the variance process is an AR(1) with parameter ρ, then the Λ process will also be an AR(1) with parameter ρ.

1/

We assume that ξ and s are independent stochastic processes.

1/

To empirically identify precautionary savings effects through estimation of an equation such as (13), there must be sufficient variation in the volatility measure over the sample. Table 1 (discussed below) reveals considerable cross-country variation in the variance of the lifetime-innovation in export earnings. There is also substantial variation through time; for some formal tests, see Reinhart and Wickham (1994).

2/

As is clear from (6), ξ is stationary so its variance is well defined.

1/

This is the analogy to Campbell’s (1987) point that household saving ought to Granger-cause subsequent movements in household labor income. Thus, the longer shocks to the variance process persist, the greater will be the demand for precautionary savings, other things equal.

2/

From (15), this variance is increasing in the persistence of the shocks to export earnings.

3/

This part of the current account is present in both certainty-equivalent and non-certainty equivalent models alike.

1/

Although this coefficient is not estimated here, its value using data for the United States was found to be in the range 0.2-0.5.

2/

Indeed, as will be seen below, most of the parameter estimates are between 0.1 and 0.6, and therefore appear to reflect plausible values for the underlying parameters (which are not themselves identified).

3/

Although not reported in the Table, the variation in the volatility measure through time is also large. Using the one-period measure, it is not uncommon, for example, to find ten- and even fourteen-fold increases in the coefficient of variation over the sample for particular countries. It is also the case that there is relatively less variation in the volatility measure for countries with relatively low average volatilities, for example among the diversified exporters or the recipients of private transfers.

1/

This implies that the coefficient, a2, depends on relative, rather than on absolute, risk aversion. Hence the value for the risk aversion parameter of 2.0 given previously is indeed plausible.

1/

All standard errors reported are heteroscedastic-consistent (White) standard errors.

1/

As an empirical matter, if the variance of the lifetime innovation in export earnings is small, it also tends to be relatively stable through time, making identification of the precautionary savings motive all the more difficult.

2/

As can be seen, this occurs in a couple of cases in Tables 3-6.

1/

The only exception is the five-year variance measure.

2/

Indeed, Table 1 showed that the coefficient of variation of the lifetime innovation of export earnings was smaller for exporters with a diversified export base than for any other country grouping except for the recipients of private transfers. It is also the case that the coefficient of variation is relatively stable through time for countries in this grouping.

3/

In some cases, the point estimate on the variance is negative, although it is never statistically significant.

1/

This would depend, inter alia, on the persistence of shocks to the variance process.

Export Instability and the External Balance in Developing Countries
Author: Mr. Atish R. Ghosh and Mr. Jonathan David Ostry