1. Balance of Payments Forecasting Thorvaldur Gylfason

2. Three parts 1)Introduce financial programming framework and role of forecasting 2)Apply framework and forecasting to a particular case 3)Explore methods of forecasting individual components of the balance of payments Outline

3. Task at hand  Develop financial program for 1998  Use information available up 1997 Two steps  Prepare baseline scenario assuming unchanged economic policy  If baseline scenario is unsatisfactory, then design financial program with better policies and better results Financial programming framework 1 The baseline scenario is a financial program, based on policies already in place

4. To prepare baseline scenario, need to complete four sets of forecasts  National income accounts Inflation, growth Inflation, growth  Balance of payments accounts Exports, imports, capital flows, reserves Exports, imports, capital flows, reserves  Fiscal accounts Government spending, tax revenues, credit Government spending, tax revenues, credit  Monetary accounts Money, credit, foreign reserves Money, credit, foreign reserves Financial programming framework Mutually consistent, or interlocking, forecasts

5. For example, based on what we know in 1997, what will BOP be in 1998?  Exports  Imports Including interest payments on foreign debt Including interest payments on foreign debt  Capital flows Including foreign borrowing and FDI Including foreign borrowing and FDI  Reserve movements Including target for reserves Including target for reserves Financial programming framework Look at individual components in Part 4

6. Exogenous vs. endogenous variables  All variables are endogenous, but some are more endogenous than others Key exogenous BOP variables  Exports  Capital inflows  Reserves (target) Chief endogenous BOP variable  Imports Role of forecasting

7. Forecasts of exogenous variables enable us to forecast endogenous variables For example, once we have forecast X, F, and  R, we can derive the forecast of Z as a residual: Z = X + F –  R Forecast of Z needs to be consistent with forecasts of inflation and growth Role of forecasting

8. History and targets  Record history, establish targets Forecasting  Make forecasts for balance of payments, output and inflation, money Policy decisions  Set domestic credit at a level that is consistent with forecasts as well as foreign reserve target Application: Case study 2

9. 1)Make forecasts, set reserve target R * –E.g., reserves at 3 months of imports 2)Compute permissible imports from BOP –More imports will jeopardize reserve target 3)Infer permissible increase in nominal income from import equation 4)Infer monetary expansion consistent with increase in nominal income 5)Derive domestic credit as a residual D = M – R * Financial programming step by step Do this in the right order

10. Known at beginning of program period: M -1 = 800, D -1 = 650, R -1 = 150 Recall: M = D + R X -1 = 700, Z -1 = 800, F -1 = 150 Recall:  R = X – Z + F So,  R -1 = 700 – 800 + 150 = 50 So,  R -1 = 700 – 800 + 150 = 50 Current account deficit, overall surplus Current account deficit, overall surplus R -1 /Z -1 = 150/800 = 0.1875 Equivalent to 2.25 months of imports Equivalent to 2.25 months of imports Weak reserve position Weak reserve position History 2.25 months = 9 weeks

11. X grows by 10%, so X = 770 F increases by 20%, so F = 180 Suppose R * is set at 220, up from 150 Level of imports is consistent with R * is Z = X + F + R -1 – R * = 770 + 180 + 150 – 220 = 880 Reserve target is equivalent to 3 months of imports R * /Z = 220/880 = 0.25 Forecast for balance of payments BOP fore- casts

12. Increase in Z from 800 to 880, i.e., by 10%, is consistent with R * equivalent to 3 months of imports Now, recall that Z depends on PY where P is price level and Y is output Hence, if income elasticity of import demand is 1, PY can increase by 10% E.g., 3% growth and 7% inflation E.g., 3% growth and 7% inflation  Depends on aggregate supply schedule Forecast for real sector

13. If PY can increase by 10%, then, if income elasticity of money demand is 1, M can also increase by 10% Recall quantity theory of money MV = PY Constant velocity means that %  M = %  PY = %  P + %  Y Hence, M can expand from 800 to 880 Forecast for money ˜ M = D + R Recall M = D + R

14. Having set reserve target at R * = 220 and forecast M at 880, we can now compute level of credit that is consistent with our reserve target So, D = 880 – 220 = 660, up from 650  D/D -1 = 10/650 = 1.5% Restrictive: implies decline in real terms Restrictive: implies decline in real terms Need to divide permissible credit expansion between public sector and private sector Need to divide permissible credit expansion between public sector and private sector Determination of credit

15. Financial programming step by step: Recap Sequence of steps R * Z Y M D Z = X + F + R -1 – R * Z = mPY MV = PY D = M – R * Notice that Z now means nominal imports, not real imports as in Lecture 1 on Macroeconomic Adjustment and Structural Reform Forecasts of X and F play a key role: Lower forecasts mean lower D for given R *

16. Need BOP forecasts to be able to design financial programs Specifically, need forecasts of  Exports (exogenous)  Imports (endogenous)  Capital movements (exogenous) Forecasts must be consistent with economic developments at home and abroad, and with one another Forecasting 3

17. From supply side, disaggregate View main categories of exports separately View main categories of exports separately Obtain price forecasts from international organizations, industry groups Obtain volume forecasts by surveying domestic producers. Recall that supply depends on price  Exports of coffee: P c X c  Exports of tea: P t X t  Exports of rice: P r X r Total exports: PX = P c X c + P t X t + P r X r Total exports: PX = P c X c + P t X t + P r X r Forecasting exports 1 Small country assumption: Export prices are exogenous

18. Divide through export equation by X to get expression for export price P P = (X c /X)P c + (X t /X) P t + (X r /X) P r Hence, aggregate export price index is a weighted average of export prices for individual commodities, with weights reflecting their relative importance to total exports Forecasting exports 1

19. From supply side, another method without disaggregation Forecasting exports 2 Standard supply equation: Supply depends on relative price as well as output capacity X = export volume (real exports) e = nominal exchange rate (hr/$) p x = price of exports in $ p d = price of domestically produced goods in hr Y = output capacity at home ++

20. Forecasting exports 2 a = income elasticity of exports b = price elasticity of exports General formulation Exponential formulation with price and income effects expressed as elasticities

21. Forecasting exports 2 a = income elasticity of exports b = price elasticity of exports General formulation Exponential formulation with price and income effects expressed as elasticities

22. Forecasting exports 2 Why?

23. So, if x rises by 15%, z rises by 10%, and w rises by 5%, then y rises not by 20% but by 20.5% because (115*110/105) = 120.476 Simpler formula works only for small changes

24. Digression on arithmetic real rate of interest Suppose nominal interest rate is 50% (i = 0.5) and rate of inflation is 200% (  = 2). What, then, is the real rate of interest? No, it is -50% -150% ?!

25. From demand side, yet another method without disaggregation Forecasting exports 3 Standard demand equation: Demand varies inversely with relative price and directly with income X = export volume (real exports) p x = price of exports in $ P w = price of similar goods in world markets in $ Y w = world demand -+

26. Forecasting exports 3 a = income elasticity of exports b = price elasticity of exports Similar story as before Where to get elasticities? Estimate them from available data or borrow them from comparable countries

27. From demand side, without disaggregation Forecasting imports 1 Standard demand equation: Demand varies inversely with relative price and directly with income Z = import volume (real imports) e = nominal exchange rate (hr/$) p z = price of imports in $ p d = price of domestically produced goods in hr Y = domestic demand (GNP) -+

28. Forecasting imports 1 m = income elasticity of imports c = price elasticity of imports

29. Forecasting imports 1 Similar story as before

30. From supply side, without disaggregation Forecasting imports 2 Standard supply equation: Supply varies directly with relative price and with income Z = import volume (real exports) p z = price of imports in $ p w = price of similar goods in world markets in $ Y w = world output capacity ++

31. Principles are the same as for goods Service exports (e.g., travel receipts) depend on income abroad and relative prices Service exports (e.g., travel receipts) depend on income abroad and relative prices Service imports (e.g., transportation) depend on income at home and relative prices Service imports (e.g., transportation) depend on income at home and relative prices Interest payments reflect multiple of foreign debt outstanding and interest rate payable on the debt Interest payments reflect multiple of foreign debt outstanding and interest rate payable on the debt Transfers, private and public, depend on past trends, income abroad, official commitments, special relationships (e.g., EU) Transfers, private and public, depend on past trends, income abroad, official commitments, special relationships (e.g., EU) Forecasting services

32. This is more difficult Foreign borrowing: depends on plans of domestic authorities, commitments of foreign lenders, interest rates at home and abroad Foreign borrowing: depends on plans of domestic authorities, commitments of foreign lenders, interest rates at home and abroad Foreign direct investment: depends on domestic market size, labor skills, investment and export opportunities, macroeconomic stability, track record, growth prospects, stability and transparency of regulations Foreign direct investment: depends on domestic market size, labor skills, investment and export opportunities, macroeconomic stability, track record, growth prospects, stability and transparency of regulations Errors and omissions: depends on trends, political and economic events Errors and omissions: depends on trends, political and economic events Forecasting capital flows

33. Forecasting reserves The End This is easy Baseline scenario: reserve movements are simply the sum of the current account and the capital account: Baseline scenario: reserve movements are simply the sum of the current account and the capital account:  R = X – Z + F Financial program: reserve movements are a policy variable, programmed so as to meet a given target of reserves at the end of the program period, set, e.g., in terms of months of import coverage Financial program: reserve movements are a policy variable, programmed so as to meet a given target of reserves at the end of the program period, set, e.g., in terms of months of import coverage These slides can be viewed on my website: www.hi.is/~gylfason

34. The Marshall-Lerner condition: Theory e T = eX – Z = eX(e) – Z(e) Not obvious that a lower e helps T Let’s do the arithmetic Bottom line is: Devaluation improves the current account as long as Suppose prices are fixed, so that e = Q a = elasticity of exports b = elasticity of imports Valuation effect arises from the ability to affect foreign prices

35. The Marshall-Lerner condition 11 ab - + Export elasticity Importelasticity

36. The Marshall-Lerner condition if X

37. The Marshall-Lerner condition: Evidence Econometric studies indicate that the Marshall-Lerner condition is almost invariably satisfied Industrial countries: a = 1, b = 1 Developing countries: a = 1, b = 1.5 Hence, Devaluation improves the current account

38. Empirical evidence from developing countries Elasticity of exportsimports Argentina0.60.9 Brazil0.41.7 India0.52.2 Kenya1.00.8 Korea2.50.8 Morocco0.71.0 Pakistan1.80.8 Philippines0.92.7 Turkey1.42.7 Average1.11.5

39. Small countries: A special case Small countries are price takers abroad Devaluation has no effect on the foreign currency price of exports and imports So, the valuation effect does not arise Devaluation will, at worst, if exports and imports are insensitive to exchange rates (a = b = 0), leave the current account unchanged Hence, if a > 0 or b > 0, devaluation improves the current account