Chapter

III External Viability

Author(s):
Charalambos Christofides, Atish Ghosh, Uma Ramakrishnan, Alun Thomas, Laura Papi, Juan Zalduendo, and Jun Kim
Published Date:
September 2005
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IMF resources are made available to member countries to correct balance of payments imbalances while easing the burden of adjustment (Box 2.3). An obvious starting point for judging program success is therefore the record on external adjustment—in particular, whether programs have achieved an appropriate mix between adjustment and financing. This naturally raises the question of the best metric for assessing external adjustment. A first measure is given by a comparison between program projections and outcomes, on grounds that in designing economic programs, the authorities would have targeted a current account balance that was appropriate to the country’s circumstances. Going beyond this comparison, this section first discusses some of the shortcomings of traditional flow financing measures of adjustment and proposes medium-term debt sustainability as an alternative metric for assessing external adjustment. Next, it examines external adjustment in GRA-supported programs: how outcomes compared to projections, whether planned and actual adjustment was in line with considerations of medium-term debt sustainability, and did IMF support make a difference to the economic impact of the adjustment. Finally, it turns to the low-income countries where, especially for HIPCs the record is in marked contrast to the experience of GRA-supported countries.

Adjustment Versus Financing

Since the use of IMF resources adds to the country’s external obligations as well as to its assets, the IMF’s financial support alters the time profile of the country’s adjustment—defined as the change in the current account balance and net international reserves (NIR)—with little direct effect on the extent of the external adjustment ultimately required. Nevertheless, by providing the country with more time to adjust and enhancing the credibility of policies, IMF support can ease the burden of adjustment because sharp reductions of absorption are likely to be more economically and socially costly and additional time is needed for a positive supply response. This also implies, however, that there is an intertemporal trade-off: to the extent that short-run adjustment is limited and financing is sufficient, the country has more external debt and hence will require greater future adjustment—especially when it starts from a high level of external indebtedness.

The two extremes of this spectrum are best illustrated by the examples of Argentina (1995) and Korea (1997). Argentina in early 1995 faced massive outflows of bank deposits in the aftermath of the Tequila crisis, but was nevertheless able to avoid a devaluation, stabilize capital outflows, and, by the end of the year, was even tapping the international capital markets. As a result, both the external adjustment and the decline in growth, while sizable, were significantly smaller than in many other capital account crises (e.g., Mexico or the Asian crisis countries). By all accounts, therefore, the IMF-supported program was highly successful in dealing with the immediate balance of payments problem. Yet, in retrospect, it is also clear that Argentina failed to tackle the underlying weaknesses of its public finances—and their inconsistency with the currency board arrangement—setting the stage for the growing public and external debt that culminated in late 2001 with an economic and political crisis.15 By contrast, Korea’s (1997) Stand-By Arrangement met with very little initial success in stemming capital outflows or preventing a collapse of the exchange rate and of economic activity, and the economy only began to recover after macroeconomic policies were strengthened, coupled with a rollover agreement with creditors.16 Over the somewhat longer term, however, by enhancing the credibility of macroeconomic policies and instituting structural reforms, the IMF-supported program succeeded in restoring confidence and a return of private capital together with a replenishment of foreign exchange reserves. The experience of these countries suggests that neither extreme is optimal. Korea achieved rapid reduction in its external debt, but at the cost of a wrenching external adjustment and sharp contraction of output. In Argentina, although some of the short-run costs of adjustment were avoided, the insufficient adjustment was extremely disruptive to the economy in the long run.

Box 2.3.Use of IMF Resources: Balance of Payments and Budget Gaps

A common question raised in the context of both GRA- and PRGF-supported programs concerns the relationship between the use of IMF resources and the balance of payments and budget financing gap.1 To get a handle on this question, the terms “balance of payments gap” and “budget financing gap” need to be defined.2 Starting from the balance of payments identity: CA+KA=R˙ or, since the capital account is simply net borrowing by the government (excluding the central bank) or the private sector: CA+B˙*p+B˙*g=R˙, where B˙*p is net external borrowing by the private sector, including the publicly owned financial sector, B˙*g is external borrowing by the nonfinancial public sector, and R˙ is the net change in central bank reserves. Under a fixed exchange rate, a balance of payments gap exists if the country is losing reserves. The corresponding condition under a floating exchange rate is that the country would lose reserves if the exchange rate and output were to remain constant: CA(y¯,e¯)+B˙*p+B˙*g=R˙<0.

Defining a “budget gap” is more tricky: clearly, it is more than just an overall budget deficit. The consolidated nonfinancial public sector can finance itself by borrowing domestically or borrowing from abroad: B˙g+B˙*g=Def. One definition of a budget financing gap, therefore, is that, at a reasonable interest rate, the domestic private sector’s desired level of saving is insufficient to meet the budget financing gap. Monetary policy is assumed geared toward its objectives for inflation and growth.

With these definitions, suppose that the public sector deficit increases by an amount ΔDef: (B˙g+ΔB˙g)+(B*g+ΔB˙*g)=Def+ΔDef. Under the definition of a budget financing gap, ΔB˙g=0 so that the public sector can only finance itself through external borrowing: ΔB*gDef. If, coincidentally, initially the country happens to have precisely the same balance of payments gap: CA(y¯,e¯)+B˙*p+B˙*g=R˙=ΔDef, then closing the budget financing gap through additional external borrowing is entirely consistent with closing the balance of payments gap. Next consider a case in which the country does not have an exante balance of payments gap: CA(y¯,e¯)+B˙*p+B˙*g=R˙=0.

Now additional external borrowing by the public sector will either add to reserves (so that net borrowing by the public sector is zero), or there must be a corresponding decrease in external borrowing by the private sector ΔB˙*p=Δdef (or an increase in the current account deficit, though this is ruled out by the assumption that the exchange rate and macroeconomic policies remain constant). But if the private sector is decreasing its external borrowing, then it is increasing its savings by precisely the amount of the enlarged deficit. In other words, the domestic private sector could, with this increased saving, have financed the budget deficit, but the private sector may choose to hold this additional saving in a foreign asset (rather than using it to finance the government). This may occur when the expected rate of return on foreign assets exceeds the interest rate on public sector debt. In this case the inflow of IMF resources would be offset by capital flight—leaving the country’s net external borrowing unchanged. It follows that external financing can be used (in the sense of effecting a real resource transfer) to close a budget gap only to the extent that there is a corresponding balance of payments gap.

1This is the counterpart to the “international transfer problem” studied by Keynes in the context of reparations by Germany following World War I. As Keynes (1929, pp. 1–7) notes, there are two distinct problems: the budgetary problem and the transfer problem and it is only under very restrictive assumptions that the two become identical.2The central bank acts as the fiscal agent of the government and receives the IMF’s disbursements. By allowing a corresponding increase in central bank credit to the government, however, IMF resources can, in effect, be loaned to the government. The equivalence is not exact because, inter alia, there are different implications for exchange rate and credit risk associated with the IMF purchase.

This suggests that, beyond the flow financing constraint (i.e., whether the country stops losing reserves, and begins replenishing them), considerations of medium-term external debt sustainability may provide a useful benchmark for judging the appropriate current account adjustment. The basic principle is that, to the extent that a country is solvent, it should be able to obtain financing rather than having to adjust its current account balance in response to a temporary shock.17 Therefore, unless the country is constrained in the financing it is able to obtain, the current account balance should adjust by as much as is required to maintain solvency—with two provisos. First, if the country has already a high level of external debt, it would be appropriate to run a smaller current account deficit in order to reduce vulnerability to future balance of payments problems. Second, relatedly, even if the external debt ratio is low, the authorities may wish to run a current account balance that permits foreign exchange reserves to be replenished and reduces vulnerability to liquidity crises.

Of course the mix between financing and adjustment is not always under the direct control of the authorities, depending, inter alia, on the nature of external capital flows on which the country relies. For low-income, PRGF-supported countries, which rely mainly on official financing, a challenge in determining the appropriate path of adjustment is to deal with the uncertainty regarding the magnitude and timing of official aid.18 For countries that rely on private capital flows but that, in stock terms, have relatively small exposure, there may be uncertainty about when capital inflows will resume but only limited risk of massive outflows (though the challenge of tailoring specific macroeconomic policies to induce the desired degree of adjustment remains).

If a capital account crisis erupts, the authorities may have little control over the pace of external adjustment undertaken because of liquidity constraints on external financing. Not only is the availability of official financing (and use of gross international reserves) likely to fall well short of potential capital outflows, official financing could simply facilitate the faster exit of private capital, especially if a sufficient policy response is lacking. Another possibility is to use capital controls or debt standstills to limit the outflows. However, the use of direct controls on capital outflows is highly controversial, may be technically difficult to implement and enforce, and is potentially counterproductive—spurring further outflows as well as delaying the country’s return to the capital markets (Box 2.4).19 In these circumstances, the authorities must rely on trying to restore confidence through the macroeconomic and structural policies they adopt. For the purposes of program design, the usual—if unsatisfactory—practice is that the magnitude of adjustment becomes the residual, given available official financing and expected capital outflows.

External Adjustment in GRA-Supported Programs

The foregoing discussion points to three ways in which IMF support may help ease external adjustment. First, for a given net flow of private capital, an arithmetical correspondence exists between external adjustment (or the gross financing requirement) and disbursements of IMF resources. Second, in combination with the policy commitments of the authorities, IMF support may induce a positive response, or “catalytic effect,” such that private capital inflows resume or at least further outflows are stemmed. Third, by inducing better policy choices, a program may help achieve a given external adjustment—that is, improvement in the current account—at lower cost in terms of output contraction or real exchange rate depreciation.

Use of IMF Resources

Conceptually, it is useful to consider first the effects of IMF disbursements on external adjustment abstracting from any induced effects on other resource flows, and then take up the question of catalytic effects on flows separately. In this connection, it is noteworthy that, on average, IMF disbursements cover about 12 percent of the gross external financing gap in GRA-supported programs (Table 2.1). A key question in designing an adjustment strategy is the targeted level of gross (net) international reserves coupled with the envisaged change in the current account balance. IMF-supported programs set targets for gross international reserves (GIR), which are back-stopped by floors for NIR.20 Expected net capital flows need to be allocated between these two objectives. However, the magnitude of flows may themselves be affected by these targets. But judging the effect on other flows is extremely difficult. On the one hand, replenishing reserves may give confidence so that (once the exchange rate has been allowed to adjust) capital outflows are stemmed, while allowing IMF resources to be spent may simply encourage the private sector—domestic or foreign—to exit faster. Higher reserve levels also give the authorities additional breathing space should the economy or external flows respond more slowly than expected. On the other hand, from the balance of payments identity, for a given level of other flows, disbursements of IMF resources that are added to reserves are also not available to moderate the current account adjustment. In any event, the IMF’s financing contribution is not large.21

Table 2.1.Share of IMF Financing and NIR in IMF-Supported Programs
TotalShare of IMF Financing

(In percent)1
Programmed Change in NIR

(In percent of GDP)
Number of Cases with Programmed Decrease in NIRProportion of Cases with Programmed Decrease in NIR
MedianMean
GRA-supported programs7312.00.981.441520.5
Nontransition economies4310.40.981.85511.6
Nonprecautionary2512.01.051.76312.0
Precautionary188.10.981.97211.1
Transition economies3014.20.810.861033.3
Nonprecautionary2018.71.201.03525.0
Precautionary105.2–0.020.52550.0
PRGF-supported programs2447.91.291.13818.2
Nontransition economies367.31.121.18616.7
Transition economies811.01.480.89225.0
Sources: IMF, WEO and MONA databases; and IMF staff estimates.

In relation to the gross financing requirement.

Excluding countries using the CFA franc for the cases of programmed decrease in NIR because no NIR target was set.

Sources: IMF, WEO and MONA databases; and IMF staff estimates.

In relation to the gross financing requirement.

Excluding countries using the CFA franc for the cases of programmed decrease in NIR because no NIR target was set.

Box 2.4.Capital Controls on Outflows in Crises

Capital controls have been used as a tool to address capital outflows during financial crises.1 The controls have taken a variety of forms, ranging from administrative or direct controls (outright prohibitions, or quantitative limits on, or approval procedures for cross-border flows for residents or nonresidents) to more market-based controls that attempt to discourage particular capital movements by making them more costly (including explicit or implicit taxation of cross-border financial flows or dual or multiple exchange rates applicable to different types of international transactions). In many cases, controls on capital outflows have been applied in tandem with other policy measures, rather than in isolation, and in several cases were accompanied by other administrative measures, including exchange controls on transactions in domestic or foreign currency, controls on current international transactions, default on public and/or private external debt, or freezing of bank deposits.

Capital controls have been viewed as a tool to reconcile conflicting policy objectives and direct monetary policy toward domestic objectives while limiting pressure on the exchange rate. In crises, countries have typically imposed these controls to counter volatile speculative flows that undermine the stability of the exchange rate and deplete foreign exchange reserves, and help the authorities to buy time to implement adjustment measures and structural reforms. Controls have been imposed against the background of significant downward pressure on the exchange rate, sharply declining foreign exchange reserves, a sharp loss of access to international capital markets, and limited room to use interest rates to defend the currency reflecting concerns about their adverse impact on economic activity and balance sheets of the public and private sectors. Examples of countries that imposed such controls include Argentina (2001), Indonesia (2001), Malaysia (1998), Pakistan (1998), Russia (1998), Spain (1992), Thailand (1997), and República Bolivariana de Venezuela (1994). In several of them (Argentina, Pakistan, and Russia), the controls were accompanied by more extensive measures, including restrictions on current account transactions, default on debt-service obligations, and restrictions on deposit withdrawals.

The effectiveness of capital controls during crises has been a subject of controversy. There is as yet no firm conclusion on their effectiveness, reflecting a number of factors, not least the challenge of constructing an appropriate counterfactual against which the controls can be evaluated and the difficulty of disentangling the impact of the controls from that of other factors (e.g., the accompanying measures or favorable external factors). Nevertheless, it is possible to make a number of observations on the basis of country experiences:

  • Temporary controls may provide a temporary breathing space, but not a lasting protection if there are incentives for circumvention (e.g., attractive return differentials in the offshore markets and strong market expectations of exchange rate depreciation) and these are large relative to the expected costs of circumvention.

  • The use of capital controls must be weighed against the possibility that their imposition may itself undermine confidence and engender capital outflows. If they are used, they must be comprehensive (so as to limit circumvention), implemented by authorities with strong enforcement capacity (to detect and close loopholes), and accompanied by policy adjustments and reforms to restore macroeconomic stability. Over time, the authorities should do their utmost to reduce the need for these controls, and hence, reduce incentives to circumvent them.

  • However, comprehensive controls are more distortionary, interfering with desirable transactions (such as foreign direct investment, long-term portfolio flows, and trade-related financial transactions), and strong enforcement capacity entails nontrivial administrative costs, particularly when measures have to be broadened to close potential loopholes for circumvention.

  • Controls may give rise to negative market perceptions and damage countries’ creditworthiness, thereby making it more difficult and costly to reaccess international markets.

1The box draws on Ariyoshi and others (2000).

Most IMF-supported programs targeted an increase in NIR.22 Indeed, over the sample period, only in 12 percent of GRA-supported programs in nontransition countries was NIR programmed to decline during the first program year (Table 2.1), with a slightly smaller proportion for precautionary programs and a rather larger proportion for programs in transition economies.23 For the median program country, the floor set on net international reserves required the central bank to accumulate NIR of about 1 percent of GDP during the first program year. This substantial planned accumulation of NIR indicates the importance that the authorities attach to reducing vulnerabilities through increasing reserves.24

Establishing whether IMF support has a catalytic effect on capital flows—or, indeed, simply finances larger outflows—is difficult because the counterfactual is unknown. Indeed, the existing empirical literature shows mixed results on the extent to which IMF endorsement of a country’s macroeconomic strategy helps to mobilize private external financing.25 In this study, we do not attempt to tackle this issue directly. Rather, a related but slightly different issue is explored—to what extent do IMF-supported programs accurately project capital flows? Program projections for the current account (or capital flows) are compared against outcomes. To the extent that outcomes are worse than projected—capital flows are smaller and the improvement in the current account balance is larger—the catalytic effect may not be as large as projected—though it is also possible that other developments—such as favorable terms of trade—are the source of the projection error in the current account balance. The difference between actual outcomes and projections of the current account balance are substantial in the first program year. In some cases, the authorities created an additional buffer against vulnerabilities through sizable increases in international reserves (see below).

A scatter plot of projections versus outcomes of the current account balance in the first program year for GRA-supported programs (Figure 2.6, top panel) shows that almost 60 percent of observations lie above the 45 degree line. On average, the current account deficit narrowed by (a statistically significant) 1.3 percent of GDP more than originally projected (though the median difference is only 0.3 percent of GDP). Private capital flows fell short of expectations by a comparable amount (but by as much as 5 to 15 percentage points of GDP in some capital account crises). This first year projection error is subsequently reversed; over the three-year period, the cumulative difference between the actual and projected current account deficits largely disappears (Figure 2.6, bottom panel). By contrast, precautionary programs saw the first year current account deficit narrow by 0.5 percent of GDP less than originally projected, and, over the three-year period, the deviation remained on average at about 0.5 percent of GDP.

Figure 2.6.Current Account Balance in GRA-Supported Programs: Projections and Outcomes1

(In percent of GDP)

Sources: IMF, MONA and WEO databases; and IMF staff estimates.

Note. See Appendix I for a list of countries.

1Capital account crisis countries are depicted by triangles.

These smaller current account deficits than projected do not reflect unexpectedly tight fiscal policy; on the contrary, the fiscal balance was weaker than targeted by 0.6 percentage point of GDP (Figure 2.7, top panel). The weakness in the fiscal position, however, was more than offset by the shortfall in investment relative to its projection, with the difference averaging about 1.8 percentage points of GDP (Figure 2.7, bottom panel).26

Figure 2.7.Fiscal Balance and Investment in GRA-Supported Programs: Projections and Outcomes1

(In percent of GDP)

Sources: IMF, MONA and WEO databases; and IMF staff estimates.

Note. See Appendix I for a list of countries.

1Fiscal balance includes grants.

2Not shown is Gabon 2000 (16.2 percent of GDP, projection).

3Not shown are Lesotho 1995 (59.9 percent of GDP, actual) and Lesotho 1996 (52.2 percent of GDP, actual).

Adjustment in Relation to Medium-Term Debt Sustainability

While the comparison between programmed and actual current account balances provides one measure of whether the proper mix between financing and adjustment was achieved, it necessarily relies on the program projection capturing the appropriate extent of adjustment. It is possible, however, that because sufficient financing was not available, the program projection incorporated greater adjustment than was considered economically desirable. It is therefore useful to complement this analysis by considering the current account balance against the metric of medium-term debt sustainability. Although a full assessment of debt sustainability is beyond the scope of this paper, a useful benchmark is the debt-stabilizing balance. For countries starting with high levels of external debt, a larger balance (than the debt-stabilizing balance) would be called for in order to lower the debt ratio and reduce future vulnerability, although the proper pace—and thus the appropriate current account balance—is unclear. Stabilizing the debt ratio should suffice for countries with moderate levels of external debt,27 while for countries with low initial external debt ratios, it would not be necessary to stabilize the debt ratio immediately. These considerations imply that the current account balance (relative to the debt-stabilizing balance) should be an increasing function of the initial external debt ratio.

Figure 2.8 (top panel) plots the difference between the programmed and debt-stabilizing current account balance28 (and in percent of GDP) net of foreign direct investment (FDI) during the first program year against the initial external debt (as a percent of GDP). As suggested by considerations of debt sustainability, a positive (and statistically significant) relationship exists between the programmed current account balance (relative to the debt-stabilizing balance) and the initial debt ratio. The relationship implies that, for example, a program in a country with an initial external debt ratio of 50 percent of GDP would seek to reduce the debt ratio to 40 percent of GDP within five years.

Figure 2.8.Projected, Actual, and Debt-Stabilizing Current Account Balances in GRA-Supported Programs1

(In percent of GDP)

Sources: IMF, MONA and WEO databases; and IMF staff estimates.

Note. See Appendix I for a list of countries.

The bottom panel of Figure 2.8 reports outcomes. As indicated in the panel, in three-quarters of the 75 GRA-supported programs, the current account balance was larger than would have been necessary to stabilize the external debt ratio given the historical performance of the economy (i.e., these observations lie above the horizontal axis). Again, there is a positive and statistically significant relationship between the actual current account balance (relative to the debt-stabilizing balance) and the initial external debt ratio. Reflecting the finding above that GRA-supported programs, on average, run larger current account balances than programmed, both the slope and intercept of the line are higher than the programmed relationship. While it is difficult to establish precise thresholds at which debt levels may become problematic, the existing empirical literature suggests that there is an appreciable increase in the likelihood of a debt crisis at external debt ratios above 40–60 percent of GDP.29 At an external debt ratio of 40 percent, the actual current account balance is larger than the debt-stabilizing balance by some 2¾ percent of GDP. Of course, this estimate is heavily influenced by the capital account crisis countries and by countries that experienced positive external shocks over this period. Excluding both of these categories (defining positive external shocks as positive changes in oil exports) reduces this difference to slightly above 1 percent of GDP, for the remaining GRA-supported programs.

A useful way to characterize the results is to divide Figure 3.3 into six segments, according to the initial debt ratios and whether the current account balance exceeds the debt-stabilizing balance. For observations in Section I (23 percent of the GRA-supported programs, 40 percent of which were precautionary), the current account balance exceeds the debt-stabilizing balance even though the initial debt ratio, at less than 40 percent of GDP, is relatively low.30 A further 20 percent of programs (40 percent of precautionary programs) are in the intermediate range for external debt (Section II, with debt ratios of 40–60 percent of GDP), including some notable capital account crises such as Korea (1997) and Mexico (1995), whose initial debt levels were 41 percent and 46 percent of GDP, respectively. These countries have current account balances that would reduce their debt ratios over the medium term although the debt ratios are in a gray zone. While a reduction in their debt ratios may be considered appropriate for such countries, it is unclear that this reduction—as opposed to simply stabilizing the debt ratio—should take place immediately. Countries in Section III (32 percent of the total) are generating larger current account balances than would stabilize debt but they start from debt levels that are high so that there is a strong case for a decline in the debt ratio to reduce vulnerability to an external debt crisis.

Countries in Sections IV, V, and VI have current account balances that are smaller than the debt-stabilizing balances. For 15 percent of cases (Section VI), the low initial debt ratio (below 40 percent of GDP) meant that there was no pressing need to reduce the country’s external indebtedness. A further 11 percent of such cases were in the gray zone (i.e., an initial debt ratio of 40–60 percent of GDP) and only 5 percent of programs (Section IV) had current account balances that were clearly insufficient given their high initial external debt ratio. All of these findings are robust to alternative assumptions underlying the calculations for the debt-stabilizing balance (Appendix II).

Overall, the results suggest that external adjustment was largely consistent with that required by medium-term sustainability of external debt. As noted above, however, the actual current account position was better than necessary to stabilize the external debt ratio despite initial debt ratios that were either low or in the gray zone. In part, national authorities may have chosen to run larger current account balances to reduce vulnerability to future liquidity crises by accumulating foreign exchange reserves. However, for countries with debt ratios below 40 percent of GDP, the difference between the actual and debt-stabilizing balance amounted to 2.8 percent of GDP against a programmed increase in reserves of 1.5 percent of GDP (Table 2.2 and Figure 2.9). For countries whose initial debt ratios were in the gray zone of 40–60 percent of GDP, the difference between the current account balance and the debt-stabilizing balance is 8.7 percent of GDP—against a programmed increase in reserves of 1.6 percent of GDP. This suggests that, in these cases, capital outflows were underestimated in the original program design. At the same time, it is noteworthy that national authorities chose to accumulate more reserves than originally programmed—by about 0.2 percent of GDP for countries with low initial debt ratios but almost 1 percent of GDP for countries whose initial debt was 40–60 percent of GDP. This may have reflected a need to accumulate reserves in order to restore confidence as well as differences in the precise timing between current account adjustment and reserve accumulation.31

Table 2.2.Indicators of GRA-Supported Countries with External Debt Below 60 Percent of GDP and Current Account Balances Above the Debt-Stabilizing Value
Debt Ratio Less Than 40 PercentDebt Ratio Between 40 and 50 PercentDebt Ratio Between 50 and 60 Percent
MeanMedianMeanMedianMeanMedian
In percent of GDP
A. Actual minus debt-stabilizing current account2.82.28.73.75.64.2
B. Programmed increase in reserves1.51.31.61.51.00.7
C. Actual increase in reserves1.72.42.51.82.51.9
A – B1.47.1**4.7**
C – B0.20.9*1.5**
Proportion of countries with positive values
Programmed increase in reserves92.392.388.9
Actual increase in reserves69.277.888.9
A – B69.288.977.8
C – B61.566.777.8
Sources: IMF, WEO and MONA databases; and IMF staff estimates.Note. * indicates significance at the 10 percent level; ** indicates significance at the 5 percent level.
Sources: IMF, WEO and MONA databases; and IMF staff estimates.Note. * indicates significance at the 10 percent level; ** indicates significance at the 5 percent level.

Figure 2.9.Decomposition of Actual Minus Debt-Stabilizing Current Account

(In percent of GDP)

Sources: IMF, MONA, and WEO databases; and IMF staff estimates.

Economic Impact of External Adjustment

Beyond the extent of external adjustment, it is also important to consider the economic impact of that adjustment. In particular, for a given improvement of the current account balance, does IMF support help mitigate the negative impact on growth of expenditure reducing policies? There are at least a couple of reasons for believing it might do so. One possibility is that the member makes better policy choices when undertaking adjustment under an IMF-supported program. For instance, to the extent that some fiscal expenditures are less productive, achieving the necessary current account improvement through adjustment in the public rather than private sector may be less harmful to growth. Another mechanism is the policy credibility that IMF support might impart. Efficient external adjustment requires domestic factors of production—capital and labor—to move from the nontradable to the tradable sector. The willingness of these factors to shift will likely depend on their confidence in the government’s intention to carry through the planned adjustment and sustain it, making expenditure-switching policies more effective. The precommitment that IMF support and conditionality afford, in turn, can help solve time-consistency problems and provide the additional confidence. Whatever the precise mechanism, preliminary findings (documented in Box 2.5) suggest that, controlling for movements in the current account balance and of the real exchange rate, countries with IMF-supported programs grow by about 1 percentage point a year faster than countries undertaking the same current account adjustment (with the same real exchange rate movement) without the benefit of an IMF-supported program. While these results are robust (estimated using instrumental variables, including fixed effects, and controlling for transition countries), the problem of endogeneity in program participation remains,32 and therefore the results must be viewed with caution.

In sum, consistent with considerations of debt sustainability and reducing vulnerabilities in future crises, both programmed and actual current account balances are higher relative to their debt-stabilizing levels, the greater the initial external debt ratio. Preliminary evidence suggests that more efficient policy choices and program credibility that IMF support affords help mitigate the impact on growth of current account adjustment, subject to the qualifiers mentioned above regarding the endogeneity of the sample. However, on average, current account balances initially improve by more than programmed (although fiscal balances are weaker than programmed), and for a significant portion (23 percent) of GRA-supported programs, current account balances were larger than necessary to stabilize the initial debt ratio even when that ratio was relatively low. Moreover, in a further 20 percent of cases, including some notable capital account crises, countries are in a gray zone (debt ratios between 40 percent and 60 percent of GDP) with current account balances larger than necessary for stabilizing the external debt ratio.

ESAF- and PRGF-Supported Programs

Use of IMF Resources

IMF disbursements in relation to GDP for PRGF countries broadly correspond to the magnitude of IMF disbursements in GRA-supported programs, amounting to about 0.9 percent of GDP (17 percent of the current account deficit) and, in about 80 percent of the cases, the program targeted an increase in net international reserves of about 1.3 percent of GDP (Table 2.1).

IMF support has an important catalytic role in low-income countries, albeit on official rather than on private flows. In particular, official creditors and donors often rely on the IMF for an assessment of the member’s macroeconomic policies, and condition their support on adherence to the policies set under the IMF-supported program. As with private capital flows, however, uncertainty remains about the exact magnitude and timing of official transfers, either because the country does not fulfill the associated policy conditions (including instances where the IMF-supported program goes off-track) or because of shifting priorities of donors or their own budgetary constraints.

Box 2.5.Economic Impact of External Adjustment

IMF-supported programs may have an effect on the economic impact of any given adjustment, for instance, because the program results in better policy choices or has other beneficial confidence effects.

Consider a standard model for the current account in which the current account balance is posited to depend negatively on income (since higher income raises demand for imports and thus causes the current account balance to deteriorate) and positively on the real exchange rate (where an increase is a depreciation of the real exchange rate) through competitiveness effects: ca = ca(y, q), cay < 0, and caq > 0. Differentiating:

Therefore, a given improvement in the current account dca < 0 will be associated with lower activity or growth except to the extent that the country takes part of the adjustment through a real exchange rate depreciation dq > 0. The model, as stated, does not allow for any effects of policies or IMF support on the economic impact of a given external adjustment. To examine this possibility, the empirical analog to (1) is estimated, controlling for whether the country undertook the external adjustment in the context of an IMF-supported program. Specifically, a regression of the change in growth rates among middle-income countries on the changes in the current account balance and the real effective exchange rate (both of which are instrumented by their lagged values to address problems of endogeneity), as well as a dummy for an IMF-supported program is estimated. The dependent variable is defined as the change in growth rates between period t+1 and period t–1 to avoid problems of the exact timing of the program.

The econometric results suggest that the existence of an IMF-supported program eases the impact on real growth. This is reflected in the sign and statistical significance of the program dummy. The coefficient is also economically significant: an IMF-supported program leads to growth rates in period t+1 that are, on average, 1 percentage point higher than would have prevailed for a similar external adjustment without an IMF-supported program.

Economic Impact of External Adjustment1
Dependent variable: change in growth between t–1 and t+1
(1)(2)
Change in current account–0.0021**–0.0018*
(–2.07)(–1.91)
Change in real effective exchange rate0.5010*0.4216*
(1.90)(1.75)
Program dummy0.0129***0.0093***
(3.02)(2.66)
Change in growth of major trading partners0.5626***
(8.49)
Constant0.00290.0029
(0.52)(0.57)
Number of observations682670
F statistic5.8***31.3***
Standard error of the regression0.0580.058

An heteroscedastic error structure is assumed (GLS regression). The t-statistics are in parentheses. Significance at **** 1 percent, ** 5 percent, and * 10 percent levels.

An heteroscedastic error structure is assumed (GLS regression). The t-statistics are in parentheses. Significance at **** 1 percent, ** 5 percent, and * 10 percent levels.

Adjustment in Relation to Medium-Term Debt Sustainability

As highlighted earlier, in PRGF-supported programs, the structural transformation of the economy and the promotion of growth and of poverty reduction are key objectives, with the need to maintain external viability acting as an overarching constraint. This is underscored by the inclusion in the programs of some measures such as liberalizing import restrictions that tend to widen the current account deficit in the short run but that help put the economy on a more sustainable path for growth and the balance of payments over the longer term. Outcomes for the external balance in these countries must be viewed in light of these considerations.

Indeed, in terms of the comparison between projections and outcomes for the current account balance, the results for Heavily Indebted Poor Countries (HIPCs) stand in sharp contrast to the experience of GRA-supported programs.33 The current account balance is generally weaker than projected (about 60 percent of observations are below the 45 degree (line). In the first program year, the difference amounts to 1.7 percent of GDP (Figure 2.10, top panel). Moreover, in contrast with the GRA-supported programs, the difference increases with the time horizon; by the third year it is over 3 percent of GDP. Therefore, averaged over the three program years (Figure 2.10, bottom panel), the current account balance is 2.6 percent of GDP weaker than expected (deficit outcome of 9.2 percent of GDP against a projected deficit of 6.5 percent of GDP).

Figure 2.10.Current Account Balance in PRGF-Supported Programs: Projections and Outcomes1

(In percent of GDP)

Sources: IMF, MONA and WEO databases; and IMF staff estimates.

Note. See Appendix I for a list of countries.

1Non-HIPCs are depicted by triangles.

In large part, the current account balance is weaker than projected because official grants that were expected at the time of the original program failed to materialize in the amounts originally envisioned, although debt-creating official flows were correspondingly higher than expected.34 Indeed, averaged over the three-year period, the shortfall of official grants to HIPCs amounted to 1.7 percent of GDP a year. This cumulative shortfall was about 1 percentage point of GDP less than the error in projecting the cumulative current account deficits. Thus, notwithstanding a shortfall in official grants, these countries were able to run larger current account deficits than programmed through accumulating external debt.35

The larger current account deficit than projected among the PRGF countries resulted from larger government deficits rather than from higher private investment. The difference between the actual and projected fiscal balance amounted to 1.1 percent of GDP, while the domestic investment rate was about ½ percent of GDP lower than programmed, partly offsetting the effects on the current account of the worse-than-expected fiscal position (Figure 2.11). Since the current account shortfall between programmed and actual amounts was estimated at 2.6 percent of GDP, these figures imply that private saving was likely lower than projected.

Figure 2.11.Fiscal Balance and Investment in PRGF-Supported Programs: Projections and Outcomes1

(In percent of GDP)

Sources: IMF, MONA and WEO databases; and IMF staff estimates.

Note. See Appendix I for a list of countries.

1Fiscal balance includes grants.

2Not shown is São Tomé and Príncipe (–21.6 percent of GDP, actual)

This finding of weaker external adjustment than programmed is reinforced by the comparison of the projected and debt-stabilizing current account balances (Figure 2.12, top panel).36 These programs did not envisage generating current account balances that could be expected—given the historical performance of the economy—to stabilize the external debt ratio. Indeed the relationship between initial external debt and projected (or actual) current account adjustment is actually negative, and these results are robust to changes in assumptions (Appendix II). A comparison of the actual and debt-stabilizing current account balances likewise shows that about one-third of HIPCs failed to generate current account balances sufficient to stabilize the external debt ratio (most observations are below the horizontal axis), even though the external debt ratio was already at elevated levels (Figure 2.12, bottom panel).37 This negative relationship for programs with HIPCs contrasts with the positive relationship for GRA-supported programs. It could be argued, of course, that these calculations do not incorporate anticipated external debt relief under the HIPC Initiative which could be the prime vehicle for achieving external debt stability over this period.38

Figure 2.12.Projected, Actual, and Debt-Stabilizing Current Account Balances in PRGF-Supported Programs1

(In percent of GDP)

Sources: IMF, MONA and WEO databases; and IMF staff estimates.

Note. See Appendix I for a list of countries.

1Non-HIPCs are depicted by triangles; ***significant at 1 percent level.

This raises the question of whether IMF-supported programs have paid sufficient attention to debt dynamics. Indeed, even controlling for the debt relief associated with the HIPC Initiative by taking an NPV debt estimate as of end-2004, the results are unchanged. Current account deficits among HIPCs were too large to stabilize their external debt ratios at the lower levels that would prevail following HIPC debt relief, assuming unchanged concessionality rates (Figure 2.13, top panel).39 On the other hand, if the degree of concessionality rises following the HIPC completion point, the NPV of debt would decline (see Appendix III for more details).

Figure 2.13.External Adjustment and Debt Relief in PRGF-Supported Programs

(In percent of GDP)

Sources: IMF, MONA and WEO databases; and IMF staff estimates.

Note. See Appendix I for a list of countries.

Accordingly, while external debt stocks for PRGF-eligible countries have been declining in relation to GDP during the past decade, this is mostly because of debt relief and debt reductions. The bottom panel of Figure 2.13 compares the actual external debt stock averaged across PRGF countries to the external debt stock implied by cumulating current account deficits (net of FDI)—that is, abstracting from the effects of debt reschedulings or debt relief.40 For HIPCs, the difference amounts to over 50 percent of GDP by 2002—thus, in absence of debt relief, debt ratios would, on average, have been at least 50 percent of GDP higher. For non-HIPCs with PRGF-supported programs, both the actual debt stock and the implied debt stock follow each other closely.41

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