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The project: current account sustainability
It is not unusual for countries to run current account deficits.
Among the 43 countries for which the Economist provides macroeconomic data each week 17 are forecasted to have current account deficits for 2022
Four of those countries – Colombia, Greece, Egypt, and Pakistan – have deficits expected to exceed 4% of GDP this year.
What determines whether a country’s current account is sustainable?
Two approaches exist for analyzing current account sustainability.
— One is to consider whether a country is inter- temporally solvent. This will occur if the discounted present value of future “primary trade balances” is sufficient to repay a country’s external debt.
— The other approach is to ask if the government’s current policy stance is sustainable.
(See Luis Carranza, “Current Account Sustainability” IMF (2002) in the course packet.)
External debt is the debt a country owes to foreigners. The World bank’s measure includes private and public debt, long-term and short-term debt, and debt to the IMF.
— It is measured using gross external debt figures because history has shown central bank reserves and other cash items generally do not become available to service external debt following a financial crisis.
— Private debt is included because such debt often becomes a public obligation as governments bail out firms or offer them foreign exchange guarantees in a crisis.
— External debt burdens are often measured using the external debt-to-exports ratio. The idea is that the foreign exchange needed to service the debt must come from exports.
Financing the current account:
The starting point in understanding intertemporal solvency is to consider the financing of the current account deficit, which is given by:
(1) PTBt = DDt + iDt-1
where: PTBt is the “primary trade balance” – the deficit on the trade account (goods), services account, and transfers (but not interest);
DDt is the change in a country’s external debt (debt held by foreigners); and
Dt-1 is existing external debt, and i is the interest rate.
Note that iDt-1 is the primary income balance – interest payments received or paid by a country.
Rearranging the financing constraint:
Dividing by GDP (Yt) and re-arranging:
ptbt + (1+i)(Dt-1/Yt ) = dt
where: ptbt is TBt/Yt and dt is Dt-/Yt .
Multiplying the numerator and denominator of
(1+ i)(Dt-1/Yt ) by 1/Yt-1 gives:
ptbt + (1+i)dt-1 = dt
where g is the growth rate of Yt , such that 1+ g = Yt/Yt-1
External debt dynamics
The main equation governing the dynamics of external debt is:
(1+i)dt-1 – ptbt = dt
It tells us what drives the growth or decline of dt , the external debt-to-GDP ratio.
The primary trade balance, PTBt is a misnomer in that it includes
services and transfers (secondary income). It does not include primary
income – interest received on past overseas investments. (We are
ignoring dividends). Measured as a ratio to GDP it is denoted as ptbt.
External debt dynamics
(1+ i)dt-1 – ptbt = dt
For a country’s external debt-to-GDP ratio, dt, to decline either it must run a primary trade surplus (ptbt > 0)*, the interest rate it pays on its external debt must be less than the growth rate of GDP, or both.
Suppose the primary trade balance is zero.
(1+ i) = dt Taking logs i – g ≈ Dlndt = growth rate of dt
Then the external debt-to-GDP ratio will rise if the interest rate exceeds the growth rate of GDP, and vice versa.**
*A primary surplus occurs when exports exceed imports and ptbt > 0 is a positive number.
**This works for real interest rates and real GDP growth rates, too.
Getting a handle on solvency
The equation describing the dynamics of a country’s external debt can be solved forward to express the external debt-to-GDP ratio as a function of all future primary trade balances. This requires forecasts of future trade balances for many periods in the future, which is not practical.
But: one can look at a country’s interest rate, GDP growth rate, forecasted primary (noninterest) trade balance, and external debt and get a pretty good idea about whether its external debt is growing rapidly or not.
The notion of inter-temporal sustainability is theoretically correct, but does not provide much insight into what policies are contributing to a widening trade deficit.
If, for example, a country is pursuing expansionary fiscal and monetary policies and its GDP is on track to exceed potential GDP, they will eventually lead to higher inflation, a rising real exchange rate, and a widening current account deficit.
Normally, contractionary fiscal and/or monetary policy would be needed to reduce the current account deficit, at the risk of a recession.
A recession might be avoided, however, if a country’s trading partners are growing rapidly and its exports are growing rapidly.
Potential sources of data and analysis
Potential sources of data and analysis:
1. The World Bank’s debt data (found easily online).
2. The EIU Country reports
3. IMF Country Reports and Consultation Reports.
4. Bloomberg (especially for consensus forecasts).
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