Current Account Shocks Research Articles

Probabilistic assessment of external sustainability in Portugal

Portugal is one of the most externally indebted economies in the eurozone. The deeply negative net international investment position (NIIP) suggests that large current account surpluses will be needed in the future to restore external sustainability. Despite significant interest in the scope for external adjustment within a monetary union, little is known about the magnitude or likelihood of the relative price change required to facilitate this adjustment. Drawing on a new probabilistic framework of external sustainability, this paper estimates the likelihood that a real effective depreciation is needed to lower Portugal’s net external liabilities to more prudent levels. Contrary to conventional thinking, we find that the NIIP is sustainable without real depreciation with fairly high probability, estimated between 32 and 43 percent. We highlight the predominance of financial account shocks over current account shocks in this assessment. To provide context to the assessment, we also apply the framework to Ireland. Despite a weaker NIIP than in Portugal, the probability that the external position is sustainable in Ireland is higher, estimated between 54 and 60 percent, predominantly reflecting forecasts of large and sustained trade surpluses.Supplementary informationThe online version contains supplementary material available at 10.1007/s10258-021-00201-y.

The Nexus Of Foreign Reserves, Exchange Rate And Inflation: Recent Empirical Evidence From Sri Lanka

The conventional mandates of the central banks on meeting stability objectives and maintaining a growth-maximizing inflation rate have come under some criticism since the global financial crises. Maintaining adequate foreign reserves is seen as a viable solution to foreign exchange liquidity needs during crisis periods. Since the end of 2011, many Asian economies, including China and Japan, led from the forefront in central bank-led reserves build-up. However, reserves build-up remains challenging and sensitive for small open economies. Such policies help create ‘risk-neutral’ buffers for monetary and fiscal authorities to absorb transitory current account shocks and foreign exchange stress to smoothen the balance of payments. This study is motivated by the importance of identifying the inflation–foreign reserves nexus that may affect inflation in a manner counterproductive to the central bank mandate of maintaining price stability. It probes the debate of the sustainability of reserves build-up in the long and the short term. The outcome of the study poses several vital questions for fiscal and monetary policymakers concerning their respective mandates. The reserves–inflation nexus and its magnitude is determined using monthly data spanning two decades, through engaging an autoregressive distributed lag (ARDL) model and relevant bounds-testing techniques proposed by Pesaran et al. The vector autoregression (VAR), error correction and Johansen cointegration methods supplement the robustness checks. Exchange rate is introduced to enrich the discussion on the reserves–inflation nexus and shows a cointegration relationship in the long run. The study provides an insight into the influence of exchange rate on reserves and inflation. The variance decomposition shows the presence of a lukewarm response from foreign reserves and exchange rate on inflation. Policymakers concerned with inflationary expectations in the medium-to-long term need to consider these signals, as reserves build-up is one of the important policy-driven objectives for a number of economies. JEL: C50, C32, E31, E52, E58, F30, F31, F39

Hypothesis of Twin Deficits in Cote d’Ivoire: The Nonlinear Effect Analysis with a Smooth Transition Autoregression Model (STAR)

This paper tests the hypothesis of double deficit in Côte d'Ivoire in non-linear aid framework, using an autoregressive smooth transition model (STAR). The main results validate the hypothesis of double deficit in Côte d' Ivoire. The effect of current balance on budget balance is greater than budget balance on current balance. Moreover, the rapid effects of current account instability on fiscal balance reveal the lack of expectation by economic agents that leads to current account deterioration compared to the deterioration of budget balance. Thus, economic policies aimed at influencing the effect on current balance would be more effective than those aimed at the effect on budget balance. In other words, Ivorian economy adopts a Keynesian performance in the event of current account shocks and performance that tend to be more or less Ricardian in presence of fiscal policy shock.

ASIAN CURRENT ACCOUNT BALANCES AND SPILLOVERS FROM A FOREIGN COUNTRY, A REGION AND THE UNITED STATES

This paper provides an overall picture on the influence of domestic and foreign shockson the current account of selected Asian countries over the period 1978 to 2012. Thepresent value model of the current account theory states that forward looking andconsumption smoothing behaviour of economic agents can promote sustainablecurrent account balances, as long as these are maintained by transitory unanticipatedshocks to the current account. The unexpected transitory domestic and foreign shocksare sourced, respectively, from the domestic and foreign current account. Foreignshocks are developed from an Asian country, a region, and the US. Our empiricalanalysis of the impact of foreign and domestic current account shocks shows thatunexpected domestic shocks, rather than unexpected foreign shocks, matter for thecurrent accounts of Asian countries.

Optimal reserves in financially closed economies

Financially closed economies insure themselves against current-account shocks using international reserves. We characterize the optimal management of reserves using an open-economy model of precautionary savings and emphasize several results. First, the welfare-based opportunity cost of reserves differs from the measures often used in the literature. Second, under plausible calibrations the model is consistent with the rule of thumb that reserves should be close to three months of imports. Third, optimal linear rules can capture most of the welfare gains from optimal reserve management, but significantly differ from certainty equivalence. Fourth, policymakers should place more emphasis on how to use reserves in response to shocks than on the reserve target itself.

외화예금의 역할과 정책적 시사점 (The Role of Foreign Currency Deposits and Its Policy Implications)

This report looks at the current state of foreign currency deposits (FCDs) in Korea and identifies determinants of the foreign currency deposits and the relationship between foreign currency deposit and exchange rate stability. Based on empirical analysis and surveys of experts, this paper proposes a scheme to activate foreign currency deposits. Korea's foreign currency deposits have increased significantly since the global financial crisis, thanks to the continuation of the current account surplus. At the end of 2010, FCDs were $24 billion, and as of the end of 2017, FCDs increased to $87 billion. Accordingly, the role of FCDs as a source of foreign currency funds for domestic banks has increased significantly. In 2010–18, when looking at changes in the composition of foreign currency liabilities of domestic banks, the share of foreign borrowing decreased from 40.7% to 24.8%, while the reliance on FCDs rose from 20.1% to 35.3%. However, as corporations’ share of FCDs account for about 80%, Korea's FCDs are highly volatile depending on the size of imports and exports, exchange rate fluctuations, etc. In fact, during March–April 2019, the size of FCDs decreased sharply due to an increase in the exchange rate. In order to identify the determining factors of Korea’s FCDs, a structural VAR (vector autoregressive) model was used. When analyzed for the entire period, FCDs were found to respond significantly to the exchange rate shock, but were not significantly affected by the current account shocks. However, the impact of the two variables on FCDs varied significantly before and after the global financial crisis. Before the global financial crisis, while the effect of currency shocks on FCDs was not statistically significant, the impact of the current account balance on FCDs was significant. However, since the global financial crisis, the effect of commercial accounts on FCDs has been greatly weakened, while exchange rates have played an important role as a variable affecting FCDs. In addition, the report found that increased FCDs have a positive effect on exchange rate stability, thus increasing the legitimacy of policy efforts to expand FCDs. Using panel data from 21 countries, the impact of foreign exchange reserves and foreign currency deposits on exchange rate stability was demonstrated. It was confirmed that an increase in foreign currency deposits in countries or periods where foreign exchange reserves are relatively low reduces exchange rate volatility. Based on empirical findings and interviews with commercial bank officials and experts, the report provides several suggestions on how to raise FCDs. In order for FCDs to function as a stable source of foreign currency liquidity, banks must be given incentives in their management and procurement of FCDs. First of all, the current system where sell and buy transactions in the swap market lead to a reduction in foreign currency liquidity coverage ratio (LCR) should be improved. We suggest measures such as regarding foreign currencies that will be returned to the bank within a few days after a sell and buy transaction as cash inflows when conducting 3-month stress test calculations. In regard to the foreign currency LCR and three-month stress test, it will be necessary to check whether regulatory effects are overlapping with existing measures such as the foreign exchange stability levy or regulations on foreign exchange derivatives position, etc. In terms of foreign currency funding, we propose an improvement of the return on foreign currency deposits and the strengthening of global money management services. Should the current account surplus flow be disrupted, it will be difficult for the authorities to pursue the expansion of foreign currency deposits. However, based on the understanding of the incentive structure of the FCDs stakeholders analyzed in this report, it is necessary to promote the expansion of FCDs in a way that increases the attractiveness of FCDs as a financial product.

Shifting Motives: Explaining the Buildup in Official Reserves in Emerging Markets Since the 1980s

Why have emerging market economies (EMEs) been stockpiling international reserves? We find that motives have varied over time; vulnerability to current account shocks was relatively important in the 1980s but, as EMEs became more financially integrated, factors related to the magnitude of potential capital outflows gained importance. Reserve accumulation as a by-product of undervalued currencies has also become more important since the Asian crisis. Correspondingly, using quantile regressions, we find that the reason for holding reserves varies according to the country’s position in the global reserves distribution. High-reserve holders, who tend to be more financially integrated, are motivated by insurance against capital account rather than current account shocks and are more sensitive to the cost of holding reserves than are low-reserve holders. Currency undervaluation is a significant determinant across the reserves distribution, albeit for different reasons.

Optimal Reserves in Financially Closed Economies

Financially closed economies insure themselves against current-account shocks using international reserves. We characterize the optimal management of reserves using an open-economy model of precautionary savings and emphasize several results. First, the welfare-based opportunity cost of reserves differs from the measures often used by practitioners. Second, under plausible calibrations the model is consistent with the rule of thumb that reserves should be close to three months of imports. Third, simple linear rules can capture most of the welfare gains from optimal reserve management. Fourth, policymakers should place more emphasis on how to use reserves in response to shocks than on the reserve target itself.

DETERMINING KEY DETERMINANTS OF DEMAND FOR INTERNATIONAL RESERVES IN UKRAINE: COINTEGRATION ANALYSIS

In this paper we searched for the most important determinants of reserve holdings inUkraineusing quarterly data from 2000 to 2013 years. We evaluated their importance using two econometric techniques: autoregressive distributed lag (ARDL) approach and Vector Error Correction model (VECM) approach. We find that the ratio of imports to GDP, the ratio of broad money to GDP, ratio of net foreign direct investment to GDP, the ratio of short term debt to GDP and GDP determine Ukraine’s long-run reserves demand function. Our empirical results show that shocks associated with the financial account is more dangerous for the Ukrainian economy than current account shocks. The low speed of adjustment coefficient of error correction model suggests that National Bank ofUkrainehas to carry out more active reserve management policy. Results denied the precautionary motive of reserves accumulation over the long term.

Development of composite indicator of Ukraine’s international reserves adequacy

This paper develops an indicator for estimating international reserves adequacy in Ukraine taking into account its unique characteristics. The proposed indicator was constructed based on the modification of IMF adequacy metric by changing weighting coefficients of potential balance of payments vulnerabilities based on historical data for Ukraine and by the inclusion of import as an additional component. In comparison to the IMF metric our indicator implies greater international reserves. This is due to the fact that balance of payments of Ukraine is very sensitive to current account shocks such as worsening terms of trade so our indicator except import component has increased weighting coefficient of export earnings. Also, compared to the IMF metrics our indicator provides more weighting coefficients of the other portfolio liabilities and the money supply that represents the sensitivity to financial account shocks. Reduced weighting coefficient of the short-term debt could be explained by the partial refinancing of external debt. This new indicator suggests that the accumulated levels of reserves of Ukraine have been inadequate at 1 April 2015.

Accounting for emerging market countries' international reserves: Are Pacific Rim countries different?

Popular perception is that emerging market economies (EMEs), and Asian Pacific Rim countries—China, Indonesia, Korea, Malaysia, Philippines, Thailand, and Vietnam (RIMs)—in particular, have been rapidly accumulating reserves, perhaps beyond what is justified by precautionary motives. This paper compares and contrasts the determinants of the demand for international reserves in the RIM countries with other EMEs over the last three decades, based on current and capital account risks, mercantilism, and other motives. Our findings suggest that the motives for holding reserves has shifted from insurance against current account shocks (mostly in the 1980s) to insurance against capital account shocks (in the 1990s) and as the by-product of possible mercantilism (in the 2000s). We also find some differences between country groups: RIM countries tend to hold more reserves against current account vulnerabilities and fewer reserves against capital account vulnerabilities, but more reserves overall. There is also greater evidence of mercantilist motives being at play for RIM countries, though this motive accounts for only a small fraction of the rise in reserve holdings in recent years, peaking in 2004 and declining thereafter.

Shifting Motives: Explaining the Buildup in official Reserves in Emerging Markets Since the 1980's

Why have emerging market economies (EMEs) been stockpiling international reserves? We find that motives have varied over time?vulnerability to current account shocks was relatively important in the 1980s but, as EMEs have become more financially integrated, factors related to the magnitude of potential capital outflows have gained in importance. Reserve accumulation as a by-product of undervalued currencies has also become more important since the Asian crisis. Correspondingly, using quantile regressions, we find that the reason for holding reserves varies according to the country's position in the global reserves distribution. High reserve holders, who tend to be more financially integrated, are motivated by insurance against capital account rather than current account shocks, and are more sensitive to the cost of holding reserves than are low-reserve holders. Currency undervaluation is a significant determinant across the reserves distribution, albeit for different reasons.

Shifting Motives: Explaining the Buildup in Official Reserves in Emerging Markets Since the 1980s

Why have emerging market economies (EMEs) been stockpiling international reserves? We find that motives have varied over time?vulnerability to current account shocks was relatively important in the 1980s but, as EMEs have become more financially integrated, factors related to the magnitude of potential capital outflows have gained in importance. Reserve accumulation as a by-product of undervalued currencies has also become more important since the Asian crisis. Correspondingly, using quantile regressions, we find that the reason for holding reserves varies according to the country's position in the global reserves distribution. High reserve holders, who tend to be more financially integrated, are motivated by insurance against capital account rather than current account shocks, and are more sensitive to the cost of holding reserves than are low-reserve holders. Currency undervaluation is a significant determinant across the reserves distribution, albeit for different reasons.

Precautionary Reserves: An Application to Bolivia

Using precautionary savings models we compute levels of optimal reserves for Bolivia. Because of Bolivia's reliance on commodity exports and little integration with capital markets, we focus on current account shocks as the key balance of payments risk. These models generate an optimal level of net foreign assets ranging from 29 to 37 percent of GDP. For comparison purposes, we contrasted these results with standard rule of thumb measures of reserve adequacy, which in the case of Bolivia resulted in substantially lower levels of adequate reserves. These differing results emphasize the need to appropriately account for country-specific risks in order to derive adequate measures of reserve buffers.

Precautionary Reserves: An Application to Bolivia

Using precautionary savings models we compute levels of optimal reserves for Bolivia. Because of Bolivia's reliance on commodity exports and little integration with capital markets, we focus on current account shocks as the key balance of payments risk. These models generate an optimal level of net foreign assets ranging from 29 to 37 percent of GDP. For comparison purposes, we contrasted these results with standard rule of thumb measures of reserve adequacy, which in the case of Bolivia resulted in substantially lower levels of adequate reserves. These differing results emphasize the need to appropriately account for country-specific risks in order to derive adequate measures of reserve buffers.

International Reserve Adequacy in The Gambia

This paper applies intertemporal models of precautionary saving to compute an optimal level of international reserves for The Gambia. The analysis focuses on current account shocks specific to a low-income economy with a significant import component and complements a more standard, rule-of-thumb reserve adequacy assessment. The results suggest a central range from 4.5 months to 7 months of imports, which is broadly aligned with the recent actual coverage. Notwithstanding parameter sensitivity, the simulations allow for more informed policy decisions that balance flexibility with a prudent approach to reserve use.

Current Accounts in a Currency Union

A fear about EMU was that in the absence of national currencies, country-specific shocks would result in greater current account divergences between member states. This paper finds that divergences across euro-area countries are smaller and have not risen relative to those across 13 other advanced economies with more flexible exchange rates. Also, the size of country-specific current account shocks in EMU countries is smaller and their persistence is greater than in the other advanced economies. However, these differences in current account dynamics do not appear related to different exchange rate dynamics.

Explaining the Real Exchange Rate during Sudden Stops and Tranquil Periods

This paper tries to untangle the causes behind the recent real exchange rate overshooting events with particular attention paid to the effects of sudden reversals of capital flows. We examine whether the negative reversals of flows lead to real exchange rate overshooting as Calvo (1999) and others suggest. By utilizing impulse response function and variance decomposition analysis, we argue that there is the asymmetric responses across Sudden Stop and tranquil times. However, this appears to be true in Asia, but not so in Latin America. In Asia, the real exchange rate is driven by supply, demand, and current account shocks in Sudden Stop time, while it is due to monetary and demand shocks in Latin America. The response to monetary shock reveals asymmetric in Latin America while it is not the case in Asia. Furthermore, our result reveals that foreign interest rate contributes more in Latin America than in Asia.

Analyzing and Simulating Terms of Trade Shocks on Ivorian Macro-Economic Variables: An Error Corrected-Var Approach

This article examines the impact of terms of trade shocks on Ivorian macroeconomic variables, in the context of an open economy. The results show that shocks in terms of trade have a more significant effect on revenues than they have on expenditures and the current account. On the other hand, current account shocks are greater in magnitude and last longer than non-fiscal revenue shocks. In addition, impacts of terms of trade shocks are significant at the beginning, but decline over time to a rather modest level. In general, it is found that terms of trade shocks exert more significant and persistent effects on Ivorian macroeconomic variables. The results are interesting because they suggest that Côte-d’Ivoire can increase its exports of commodities more effectively by expending efforts on international macroeconomy policy coordination rather than on domestic sectoral policy.

Imperfect information: Some implications for modelling the exchange rate

Within a broader setting of rational expectations, where agents do not fully know the parameter values of the model, expectations errors from past observable and persistent shocks will lead to systematic effects. In particular, observable lagged current account shocks will affect the exchange rate within a Mundell-Flemming model even where there is perfect capital mobility. Moreover, the process of agents learning unknown parameter values and revising the values of the forecast parameters would suggest the use of a variable coefficient estimation method to capture the data-generating process outside strong-form rational expectations.