- Jaewoo Lee, Jonathan Ostry, Alessandro Prati, Luca Ricci, and Gian Milesi-Ferretti
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- April 2008
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See Isard and Faruqee (1998) and Isard, Kincaid, and Fetherston (2001). The broader country coverage being implemented here requires a greater variety of fundamentals to “explain” the current account than when the exercise covered only advanced countries.
The fundamentals are expected to play a role over the medium term even though exchange rates are essentially unpredictable in the near term (Meese and Rogoff, 1983). Hence, short-term effects of capital flows would eventually disappear, while their medium-term effect should be captured by the underlying fundamentals.
The euro area countries are treated as separate entities in the estimation. Previously, information for 21 industrial countries was used to estimate norms for the exchange rate assessments of the 11 advanced economies covered in the exchange rate assessments produced by the CGER.
Although the quantitative effect of the age profile on the current account may differ across countries depending on financial development and the characteristics of the retirement system, it is not possible to accurately estimate country-specific coefficients for all countries.
If this were not the case, there would be a tendency for NFA to systematically decline in creditor countries and increase in debtor countries, which is at odds with what the data show.
All three approaches discussed in this paper use the NFA variable in the revised database on external assets and liabilities of Lane and Milesi-Ferretti (2007b), which has a broader coverage of NFA data across countries and time than the data used in previous studies.
The inclusion of relative economic growth was statistically important only for nonindustrial countries, reflecting greater heterogeneity in their growth performance.
The estimation treats the 12 euro area countries as separate economies for two reasons: (1) although these countries now share a common currency, their real exchange rates can still behave differently depending on relative inflation; and (2) the sample spans also the pre-euro period, when the countries had their own currencies. While the estimation treats the euro area countries separately, the planned exchange rate assessments going forward would continue to be made only for the euro area as a whole. Finally, it is worth noting that the country coverage used here is broader and more heterogeneous than that of Debelle and Faruqee (1996), who examined 21 industrial countries. Compared with Chinn and Prasad (2003), who examined 99 countries including 71 nonindustrial countries, the country coverage here is more homogeneous and provides sharper statistical results.
The regressions presented in Table 1 also include a limited number of country-specific variables capturing (1) the effect of the euro adoption on several member countries; (2) country-specific effects of aging in selected advanced economies where long-run changes in the demographic structure are more dramatic; and (3) the effect of the oil balance for Norway, whose oil reserves are to be depleted in the foreseeable future.
For resource exporters, the effect of an increase in the price of nonrenewable resources on domestic saving, and hence on the current account, should be larger in countries where the stock of remaining reserves is smaller, as spending should rise in proportion to the increase in the annuity value of existing reserves. Indeed, the country-specific coefficient on the oil balance for Norway, whose remaining oil reserves are relatively limited, is higher than for the rest of the sample.
Since the current account equals the saving-investment (S–I) balance, the current account norms referred to here used to be called S–I norms in previous CGER notes.
In countries where the 2012 current account projection is predicated on substantial real exchange rate adjustment, this adjustment is taken into account in the calculation of the implied exchange rate misalignment.
This final step is unchanged from previous versions of the MB approach described in Isard and Faruqee (1998) and Isard, Kincaid, and Fetherston (2001), which assume that the trade balance is the sole source of current account adjustment.
See Isard and Faruqee (1998) for a detailed discussion of the “nth” currency problem. In principle, if current account gaps and elasticities reflect all aspects of the complex web of bilateral trade relations, this correction should be very small. In past CGER assessments, this correction has amounted to some 1–4 percentage points.
The sample of countries is smaller than in Section II, owing to the difficulty in obtaining data for some determinants of real exchange rates, such as sector-level productivity measures. See Appendix 3.1 for the list of countries.
For a recent application to the exchange rate assessment of Central and Eastern European countries, see Maeso-Fernandez, Osbat, and Schnatz (2004).
Appendix 3.1 describes the construction of each variable and discusses some remaining limitations of the data.
The net effect of investment income ensures that creditor countries would still run current account surpluses and debtor countries, current account deficits. The economic literature also refers to this long-standing issue as the “transfer problem.” Previous analyses of the impact of the NFA position on the ERER include Faruqee (1995), who focused on the United States and Japan; Gagnon (1996), who used the cumulative current account as an approximation of net foreign assets; Bayoumi, Faruqee, and Lee (2005), who use trend net investment income; and Lane and Milesi-Ferretti (2002, 2004).
This section uses new measures of productivity in tradables and nontradables, constructed on the basis of a six-sector classification of output and employment. For earlier studies using advanced-economy data, see Canzoneri, Cumby, and Diba (1999), Choudhri and Khan (2005), MacDonald and Ricci (2005, 2007), and Lee and Tang (2007).
The limitation of the trade restriction index is its inability to capture gradual liberalization. Other studies have used trade openness (average export and import share of GDP). Such a measure, however, is only an indirect indicator of the extent of liberalization and is subject to endogeneity when used in exchange rate regressions (as a change in the exchange rate would affect openness for a given trade regime).
Country-specific constant terms are needed because (1) there could be residual country-specific effects that are not captured by the other regressors; and (2) the real exchange rates are index numbers with no natural common anchor across different countries.
The estimated effect for the whole sample is smaller than the amount predicted by theory (which is equal to the share of non-tradables in the CPI), but is in line with recent estimates for a large sample of advanced and developing countries (Choudhri and Khan, 2005, estimate a coefficient of about 0.2).
Net foreign assets are extended by cumulating the projected WEO current accounts. Productivity variables, the trade liberalization index, and the share of administered prices are left unchanged at the latest available observation. An alternative way to calculate the equilibrium exchange rate would be to apply the econometric methodology suggested by Gonzalo and Granger (1995), decomposing fundamentals into a permanent and transitory component and using the permanent component to calculate the ERER.
Our classification follows De Gregorio, Giovannini, and Wolf (1994) and is bound to be imperfect. As the authors acknowledge, every sector has some degree of tradability, which can vary from country to country.
For the euro area prior to 1998, member-country data (which includes intra—euro area trade) is aggregated first; and then area-wide services exports and imports are calculated by assuming that the trade in services outside the euro area is 10 percentage points higher than the trade in goods outside the euro area. The 10 percentage point difference between trade in goods and services is based on observations from 1998 onward, the only period where data is available for services trade both within and outside the euro area.
The programs adopted for testing for panel unit root (STATA routines) and for panel cointegration (NPT1.3 in www.maxwell.syr.edu/maxpages/faculty/cdkao/working/npt.html) require a balanced panel; hence some countries and years are dropped from the sample for these tests. A panel unit root was not rejected for the commodity price index. However, a Phillips-Perron unit root test run on commodity prices for each country separately could not be rejected for the vast majority of countries. Considering the limitation of the panel unit root test in dealing with cross-sectional dependence, which is likely to be very strong for commodity prices, we ignore the panel unit root test results and treat commodity prices as nonstationary.
Plain fixed-effects estimation provides consistent estimates if the residuals are stationary. However, it would generate incorrectly lower standard errors—and misleading inference—if the residuals are correlated with the stationary component of the unit root processes of the explanatory variables, which is generally the case. The dynamic OLS methodology adds leads and lags of first differences of right-hand-side variables to the set of regressors in order to wipe out such correlation (we employ one lead and lag, but we also explore robustness to more leads and lags). As this automatically introduces serial correlation of the residuals, which distorts standard errors, an additional correction is necessary (we use the Newey-West method). The DOLS residuals were found to be stationary using the aforementioned panel unit root tests, a result which is consistent with panel cointegration. The FMOLS panel cointegration estimation based on the routine provided by Kao and Chiang (2000) was used mainly as a robustness exercise as it requires a balance panel like the panel unit root and panel cointegration tests.
See, for example, Lane and Milesi-Ferretti (2007a). The return differential in recent years has been partly due to U.S. dollar depreciation (which has raised the dollar value of U.S. foreign currency returns) and partly due to equity prices, which have risen more slowly in the United States than in the rest of the world.
The appropriate measure of inflation is the domestic one if external assets and liabilities are primarily denominated in domestic currency, or foreign inflation if they are primarily foreign-currency-denominated.
The same trade elasticities are used as in the MB approach, scaled by the openness of each country. As a final step, multilateral consistency is imposed by applying a common correction factor to the estimated exchange rate adjustments (as described in Section II).
The difference between yields and returns is lower for FDI (where reinvested earnings are counted as investment income) but still significant (over 4 percent over the past decade for both assets and liabilities).
Of course the exchange rate is not necessarily the only variable delivering the adjustment. The idea behind assessing an exchange rate misalignment is to evaluate what would be the necessary exchange rate adjustment should all fundamentals be at their projected value.
In a few instances, there can be significant differences between misalignment estimates according to the different methodologies. For example, in the case of China and the United States, the ERER methodology points to a much lower misalignment than the MB or the ES approach as of 2007. One reason is that the two methodologies are based on different measures of external imbalances. ERER is based on the stock of net foreign assets projected for 2012, while the medium-term current account projections that underpin the MB and the ES would result in much higher stock imbalances over the longer run.
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