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The author would like to thank Robert Rennhack, Alexander Hoffmeister, Juan Carlos Di Tata, and participants in the seminar at the Central Bank of Costa Rica for useful and interesting comments. I would also like to thank Jorge Shepherd and Ana Maria Eyzaguirre for valuable editorial assistance.
It is estimated that Intel was responsible for about 38 percent of Costa Rica’s total exports of goods in 1999, and that real GDP growth excluding Intel was about 3½ percent. The quantification of Intel’s contribution to GDP growth and current account net receipts is subject to considerable uncertainty.
One should bear in mind the possibility that a “Dutch disease” type of problem may arise in Costa Rica as the increased export earnings brought about by Intel could lead to a real exchange rate appreciation and consequent loss of competitiveness for other export activities. There is evidence in the economic literature that current account deficits are more likely to become unsustainable in countries which have a less diversified export base (for example, see Ghosh and Ostry (1994)).
For a detailed discussion of the competitiveness indicators used here, see Lipschitz and McDonald (1992).
Comprehensive data on private external debt is not available.
A counterpart of the lower access to public external financing was the increase in the government domestic debt from about 13 percent of GDP in 1991 to about 24 percent of GDP in 1999.
Calvo (1996) argues that the instability of this ratio, not only its level, is an important causality factor in currency and external crisis.
The ratio of NIR relative to quasi money plus short-term domestic debt in 1999 returned to 16.4 (approximately the same level of 1997), after falling to 12.3 in 1998.
Judging from the 3½ percent real GDP growth (excluding Intel) observed in 1999 and assuming a potential real GDP growth of about 4 percent or 4½ percent a year.
Besides the modernization of the export base, an equilibrium appreciation of the exchange rate may have been induced by higher capital inflows and broadly improved terms of trade (Figure 9a). This issue will be treated in more detail in the following sections of this paper.
This framework was developed by the IMF’s Coordinating Group on Exchange Rate Issues (CGER) and is regularly used to estimate equilibrium exchange rates for industrialized countries. See International Monetary Fund (1997).
Gaba (1993) and Villanueva (1993) estimate trade elasticities for Costa Rica which are broadly in line with the CGER and MULTIMOD elasticities used here. Using those elasticities specifically estimated for Costa Rica yields very similar results which show the robustness of the estimates to reasonable variations in the trade elasticities assumed. The results obtained under different elasticities are thus omitted for simplicity.
Most of the adjustment from the observed to the underlying current account deficit stemmed from closing the positive output gap in the United States, which would reduce Costa Rica’s exports. Since Costa Rica’s REER fluctuated moderately in the last three years, the impact of lagged effects of the real exchange rate on the underlying current account is less significant than that of the relative business cycles.
Debelle and Faruqee (1996) explain the negative sign on per capita income as possibly capturing the constrained access of poor countries to international capital markets, which would force them to maintain stronger current account positions. I view another possibility in that low income per capita might be associated with lower education levels and thus (ceteris paribus) lower returns on investment, lower investment levels, and a better current account balance.
Given the public sector debt to GDP ratio of about 42 percent, an average real interest rate of about 9⅓ percent, and a potential real GDP growth rate of 4½ percent, the primary surplus necessary to stabilize the debt to GDP ratio is approximately 2 percent. The overall deficit associated with this primary surplus is equivalent to about 2½ percent of GDP.
A study on current account sustainability published by the Central Bank of Costa Rica indicates that current account deficits in the range between 2.7 percent and 3.7 percent of GDP are sustainable under realistic assumptions. For details see Zuñiga at al. (1997).
In fact, CGER studies at the IMF have carefully highlighted that this type of analysis is primarily geared at identifying “badly misaligned exchange rates.”
Model selection was based on R-squared, adjusted R-squared, Schwarz criterion, and autocorrelation and normality tests on residuals.
A similar variable was used by Elbadawi to proxy the degree of economic oneness in Chile, India, and Ghana, with satisfactory results.
This variable is a proxy for “sustainable” net capital flows. Choosing the variable which best represents sustainable or long-run capital flows has been a controversial issue in the literature. Here we follow Manteu and Mello (1992) in using net foreign direct investment for this purpose.
The Ljung-Box Q-statistics for residuals and squared residuals up to 10 lags are not significant at the 5 percent significance level; the Breusch-Godfrey LM statistic (with 2 lags) of 2.96 is not significant; the Jarque-Bera statistic of 2.2 is not significant; and the CUSUM and CUSUM of squares tast statistics stay within the 5 percent significance lines throughout the sample period.
While the impact of changes in government consumption and terms of trade on the equilibrium exchange rate cannot be determined by theoretical models a priori, empirical studies usually indicate that higher government consumption leads to an appreciation of the exchange rate (probably reflecting a higher ratio of nontradables to tradables in the government consumption bundle vis-à-vis the private sector’s) and that an improvement in the terms of trade also leads to an appreciation of the exchange rate, implying that the income effect of the change in relative prices dominates the substitution effect. See Elbadawi (1994).
The Ljung-Box Q-statistics for residuals and squared residuals up to 10 lags are not significant at the 5 percent significance level; the Breusch-Godfrey LM statistic (with 2 lags) of 1.44 is not significant; the Jarque-Bera statistic of 0.6 is not significant; the CUSUM test statistic stay within the 5 percent significance lines throughout the sample period; and the CUSUM of squares test statistic stay within the 5 percent significance lines in all but four observations following the major currency devaluation which took place in 1981.
As in other models of FEER, the nominal exchange rate is excluded a priori from the cointegrating equation due to the very nature of the theory, which argues that the exchange rate is driven only by fundamentals in the long run.
A variable introducing the impact of expansionary credit policies did not reach minimum levels of significance and was also excluded from the final regression. However, when I estimated a simple dynamic model in first differences out of the cointegration/error-correction framework, expansionary (contractionary) credit policies appeared as a significant cause for REER appreciation (depreciation).
Using moving averages is suggested by Elbadawi as a way to capture trend movements and smooth away temporary shocks; the choice of the averaging period is based on the fact that, given the error-correction coefficient, about 95 percent of an exogenous shock to the system will have been eliminated after 5 years. The constructed index was normalized so that the EER equals the REER in 1995; this year was chosen because both the observed and the underlying current account deficit were around sustainable levels (as defined in the previous section) and because the REER fluctuated moderately in 1994–96.
The depreciating EER in 1991–93, on the other hand, reflected mainly the increase in trade openess and an improvement in the fiscal position.
It is assumed that the adjustment from the actual to the debt-stabilizing deficit is achieved through a reduction in current expenditures.