CHAPTER 4 Balance of Payments Accounts and Analysis (2024)

Basic Conventions

A country’s balance of payments tracks payments to and receipts from nonresidents. According to the Manual, the balance of payments is “a statistical statement that systematically summarizes, for a specific time period, the economic transactions of an economy with the rest of the world.” Various conventions for recording items in the balance of payments are presented below.

Changes in the Balance of Payments Manual

The Net International Investment Position

A country’s international investment position is its stock of external financial assets minus its stock of external liabilities. The position at the end of a specific period reflects financial transactions during that period (typically one year), valuation changes from movements in exchange rates and prices, and other adjustments that affect the level of assets and liabilities.

Data on balance of payments flows and the international investment position constitute the complete set of international accounts for an economy. Because data on stocks are often used to determine income receipts, consistent classifications of the income component of the current account, the financial account of the balance of payments, and the international investment position are essential for reconciling stocks and flows and for performing a meaningful analysis of yields and rates of return on external investments.

Main Components

A coherent structure for classifying balance of payments transactions facilitates the process of adapting the data for various purposes, including analyzing recent trends and developing projections. The Manual’s standard classification system has two key accounts: the current account and the capital and financial account. Their major components are presented in Box 4.3.

In selecting the standard components, the following criteria have been given the greatest weight. Each item should:

• Exhibit distinctive behavior, that is, its economic influences should be unique;

• Be important in a number of countries;

• Be measurable, requiring regular collection of statistics; and

• Coordinate with other statistical systems (especially the SNA).

(i) Current account

The current account comprises “real” transactions—goods, services, income, and current transfers. Transactions classified under “goods” relate to the movement of merchandise—exports and imports—and generally involve a change of ownership. “Services” can be of many different types. “Income” may be derived from labor (wages paid to employees living in neighboring countries) or from financial assets or liabilities (for example, interest payments on external debt).

Most current account entries show gross debits or credits, but entries in the capital and financial account are typically net. Net entries are shown only as credits or debits, according to the conventions.

(ii) Capital and financial account

Box 4.3 shows the two major categories of the capital and financial account. The main item in the capital account is capital transfers. The financial account has four functional categories.

• Direct investment, which is further divided into equity capital, reinvested earnings, and other capital. Direct investment is classified primarily on a directional basis (investment in the domestic economy by residents abroad and by nonresidents).

• Portfolio investment, which includes long-term debt and equity securities, money market debt instruments, and tradable financial derivatives, including currency and interest rate swaps.

• Other investment, such as trade credits and borrowing, including IMF credit and loans. Although transactions are classified primarily by instrument, they may also be classified according to their maturity structure, which is important in the analysis of indebtedness.

• Reserve assets that are available to meet immediate needs. Despite the name, reserve assets in the standard balance of payments accounts are not stocks but changes in gross external assets. These assets include foreign exchange (currency, deposits, and securities), monetary gold, SDRs, and the country’s reserve position in the IMF.4 Reserve assets are under the effective control of the monetary authorities and can be used either directly (to finance payment imbalances), or indirectly (to regulate imbalances by, for instance, intervening in foreign exchange markets to support the value of the currency). Transactions with the IMF affect both reserve assets and reserve liabilities (see Box 4.4).

According to the Fifth Edition of the Manual, reserve asset flows exclude those that are not attributable to transactions. Thus, valuation changes resulting from fluctuations in the exchange rate, and the creation of new reserve assets (the monetization of gold or allocations of SDRs) are not included in the data on flows. These items are reflected in the international investment position (the data on stocks).5

Supplementary Information

In the standard presentation of the balance of payments, the financial account does not distinguish between extraordinary and ordinary transactions. As a result, analytical presentations have been developed to highlight items, such as exceptional financing, that may be particularly important in analyses of the balance of payments. Additional data are often prepared for these presentations. The most important supplementary item—exceptional financing—has become increasingly important in recent years, especially in those countries that have experienced debt servicing problems. The main exceptional financing transactions are as follows:

• The rescheduling of existing debt, which involves replacing an existing contract with one that postpones debt service payments. The main balance of payments items affected by rescheduling are interest payments (shown in the current account) and amortization payments (shown in the financial account). Debt restructuring may cover arrears on interest or principal as well as scheduled interest and principal payments.

• Arrears on debt servicing, which can be either interest or amortization payments that are past due. Interest arrears are treated as if they have been paid for with a short-term loan—that is, as a scheduled interest payment is recorded as an income debit in the current account, it is offset by a credit in the financial account under short-term liabilities.

• Debt forgiveness, or the voluntary cancellation by an official creditor of all or part of a debt specified by a contractual arrangement. It is recorded as an official transfer under the capital account.6

• Equity investment, especially debt-equity swaps. This type of investment involves the exchange of bank claims on debtors, usually at a discount, for nonresident equity investment in a country.

The next part of the chapter discusses how particular subgroups of transactions—especially exceptional financing—are regrouped for analytical purposes.

Weaknesses in Data

Data may be unreliable because the information is not collected properly or does not provide complete coverage. Customs records are often incomplete because border monitoring is not adequate. Enterprise surveys have seen their coverage deteriorate in the initial phases of transition, perhaps reflecting the greater autonomy given to enterprises (statistics for private enterprises and individual traders are especially deficient). The domestic banking system as a source of data is also weak. While data from the banking system are probably more complete than enterprise survey data, they are not necessarily reported to the central bank in a systematic fashion. More importantly, many financial transactions are settled outside the banking system, reducing the comprehensiveness of these data.

Underreporting

The integrity of data can also be compromised if transactions are not fully reported. Unmeasured capital flight is a major problem in countries where confidence in the domestic currency is low. If the authorities suspect that trade is not being reported, they can often cross-check data on imports (exports) against data on the exports (imports) of trading partners. Cross-checks can also be made with other domestic data for selected items. (For example, motor vehicle registrations can be used to assess the validity of recorded motor vehicle imports.) Crossborder transactions such as enterprise arrears have also been seriously underreported in many countries. The available information usually consists only of arrears notified to banks.

Valuation Problems

Valuation practices vary considerably across countries, especially when it comes to the valuation of barter trade. Although in principle transaction prices should be used, some countries use alternative measures such as world market prices, enterprise producer prices (for exports), and domestic wholesale prices (for imports).

Notions of Balance

Under the double-entry accounting system, the sum of credit items equals the sum of debit items, so that the overall balance is zero. How then is it possible to have imbalances—surpluses or deficits—in the external sector accounts? A surplus or a deficit arises when a given subgroup of external transactions (shown above the line) is distinguished from another subgroup of transactions (shown below the line). If the above-the-line transactions are in deficit, then the below-the-line transactions are in surplus, and vice versa.

One of the primary purposes of the balance of payments accounts is to provide an indication of the need to adjust an external imbalance. The decision on where to draw the dividing line for analytical purposes requires a somewhat subjective judgment concerning the imbalances that best indicate the need for adjustment. One approach involves distinguishing a subgroup of items that are autonomously determined from transactions that are determined by policy.

The trade balance is the difference between exports and imports of goods. From an analytical point of view, it is somewhat arbitrary to distinguish goods from services. For example, a unit of foreign exchange earned by a freight company strengthens the balance of payments to the same extent as the foreign exchange earned by exporters of goods. Nonetheless, the trade balance is useful in practice, since it is often a timely indicator of trends in the current account balance. The customs authorities are often able to provide data on trade in goods long before data on trade in services—which takes longer to collect—is available.

The current account balance, one of the most useful indicators of an external imbalance, is the difference between credits and debits of goods, services, income, and transfers.8 As explained below, the current account measures the component of the change in an economy’s net foreign asset position attributable to transactions in goods and services.

A current account deficit does not necessarily indicate a need for a policy adjustment, since a deficit may be a temporary imbalance caused by a drop in export prices. But a current account deficit that persists necessitates policy adjustments, since a country cannot continue to finance deficits indefinitely by borrowing abroad or running down international reserves.

The overall balance equals the current account balance plus all capital and financial transactions that are not considered to be financing items. In analytical presentations of the balance of payments, changes in net foreign assets of the monetary authorities and nonautonomous financing items are placed below the line. The overall balance is an important indicator of the external payments position. Deficits are usually financed by a decline in net foreign assets that illustrates the extent to which the central bank has been financing payments imbalances (in the case of a fixed exchange rate regime) or regulating imbalances indirectly by intervening in exchange markets (in the case of a floating exchange rate regime).

Analyzing the Current Account

Therefore, any analysis of the current account of the balance of payments must consider how changes in saving and investment come about. As seen from equation 4.1, a change in the current account position (such as an increase in the surplus or a decrease in the deficit) must be matched by an increase in national saving relative to investment. Thus, it is important to understand how any policy measures designed to alter the current account balance (through, for example, exchange rates, tariffs, quotas, or export incentives) affect saving and investment behavior.

As this relationship indicates, improving a country’s current account balance requires that resources be released either through a decrease in domestic absorption relative to income or through an increase in national income relative to the rise in absorption. It should be noted, however, that equations 4.1 and 4.2 by themselves do not provide sufficient information for an analysis of the current account, because they do not reflect the various interactions and behavior of agents in the economy. For example, changes in absorption are influenced by changes in disposable income, so that equation 4.2 cannot be used to analyze directly the impact of a change in income on the external current account. The two equations nevertheless incorporate the basic macroeconomic framework in which the current account is embedded.

By definition, the current account balance is always matched by net claims on the rest of the world—in other words, the change in net foreign assets of nonbank entities or nonmonetary financial flows (ΔFI) and the change in net foreign assets of the banking system or monetary financial flows (ΔRES). This relationship, which is summarized below, derives from the balance of payments identity, which states that the sum of all credit items must be offset exactly by the sum of all debit items. Therefore,

−CAB = ΔFI + ΔRES

Equation 4.3 shows that the net provision of resources to or from the rest of the world—as measured by the current account balance9—is matched by a corresponding change in net claims on the rest of the world. For example, a current account surplus is reflected either in an increase in net official or private claims on nonresidents or in the acquisition of reserve assets by the monetary authorities. But a current account deficit implies that the net acquisition of resources from the rest of the world must be paid for by either liquidating the country’s foreign assets or by increasing its liabilities to nonresidents. Thus, the balance of payments identity shown in equation 4.3 can be viewed as the budget constraint for the entire economy.

As we have seen above, the current account reflects saving and investment of the government and nongovernment sectors. A given current account balance may be consistent with a number of combinations of private and public saving and investment behavior. For example, a deficit in the current account could stem from a private consumption boom or a sharp rise in investment or it could be brought about by a sharp deterioration in the fiscal position, with or without an improvement in private sector saving. Thus the current account balance per se, while an important indicator, is not, by itself, indicative of the need for policy action and even less of the appropriate policy response. It is nevertheless useful as a warning signal—a “red flag”—that alerts policymakers to the possibility of unsound policy. In all cases, the need for policy response and the choice of the appropriate policy will depend on a closer examination of the source of the imbalance.

The conventional view that a large current account deficit, whether originating in decisions of the private or the public sector, is a cause for concern and appropriate corrective action on the part of the government has recently come under some scrutiny in an influential paper. Max Corden10 analyzed the validity of the “new view” of the current account, viz. the view that if the current account deficit reflects entirely the decisions of private savers and investors, then it should not call forth any governmental policy response. As Corden noted, while the new view has an apparent plausibility in a world dominated by private capital flows, it needs to be heavily qualified on several counts. A private spending boom financed by capital inflows could be based on unsound judgments and could end abruptly. Private external borrowing can have spillover effects on other domestic borrowers, in effect, contaminating all debts by residents and therefore the risks of such contamination need to be watched by the authorities. The changes in the real exchange rate brought about as a result of the current account balance also need to be watched carefully by the authorities because they could reverse themselves and lead to general macroeconomic instability. In sum, the macroeconomic consequences of unsustainable current account imbalances are too severe for the authorities to take a “hands-off” attitude toward such imbalances. As a general rule, therefore, the “new view,” sometimes called the “Lawson doctrine,” is not valid.

This framework for analyzing the current account balance can be used in many situations independently of the exchange rate regime. For example, if the exchange rate is pegged, then the net demand or supply of foreign exchange at the pegged exchange rate will determine the reserve assets transactions (ΔRES). At the other extreme, under a pure float and with no official intervention, ΔRES = 0, and so CAB = −ΔFI. With a managed float, foreign exchange is bought or sold by the central bank in order to adjust the path of the exchange rate.11 Under a fixed-exchange regime and little capital mobility, countries can afford to run current account deficits only for a limited time period. If a country continues to run a deficit beyond what can be financed through sustainable capital inflows, sooner or later, expectations about an exchange rate devaluation will trigger a foreign exchange crisis well before international reserves are exhausted.12 This suggests that in the absence of capital mobility and under an exchange rate peg, the current account must be monitored closely so as to avoid a sudden speculative attack on a currency and a balance of payments crisis.

For a discussion of the issue of how to assess the sustainability of a current account position, see Box 4.6.

Analyzing the Trade Account

Services, Income, and Transfers

Service transactions are a heterogeneous group, comprising 11 different categories in the standard presentation of the balance of payments. The major subgroups include transportation and travel (credits reflecting tourist receipts and debits reflecting spending abroad by residents), insurance, financial, and consultancy services.

Income covers both labor income and financial income flows. Labor income refers to earnings of nonresident workers. Financial income (or “investment income, net”) represents receipts from and payments on financial assets and liabilities. For indebted countries, interest payments due on external foreign debt often constitute the largest income subitem. This negative item is also one of the two components of debt servicing. The important credit items are interest earned on foreign exchange reserves and, for creditor countries, interest received on loans.

Changes in general government current transfers are largely dependent on decisions made by donor countries and therefore can be less predictable. The main component of private current transfers is usually workers’ remittances, which reflect the number of workers living abroad permanently and the incentives for transferring funds, particularly expectations concerning the exchange rate and the taxation of such income.17

To the extent that a country modifies its restrictions on service transactions by liberalizing the amounts of foreign exchange provided for foreign travel abroad, it is appropriate to identify the impact of such policy changes.18

The capital and financial account records an economy’s net foreign borrowing and capital transfers. The nonmonetary financial flows (ΔFI) that make up the account are the sum of foreign direct investment (FDI) and net foreign borrowing (NFB) and, together with monetary financing (ΔRES), equal the current account balance.20 Thus, the sources of current account financing can be summarized as

$CAB+FDI+NFB+\mathrm{\Delta }RES\equiv 0.\left(4.4\right)$

Debt Stocks and Debt-Creating Flows

The stock of gross external debt can be defined as the amount of outstanding contractual liabilities to nonresidents. The amount of debt outstanding covers only that part of a loan that has actually been disbursed. Any undisbursed loan commitments are not part of gross debt and are not recorded in balance of payments data until disbursem*nt takes place. The term contractual is also an important part of the definition of gross debt. Debt instruments such as long-term loans, bonds, short-term loans, and trade credits involve contractual obligations to pay interest (either at a fixed or variable rate) and principal. Incurring these obligations adds to a country’s gross debt.

where

This equation states that debt at the end of a given year is broadly equal to debt at the end of the previous year, augmented by net debt-creating flows—that is, by new disbursem*nts minus amortization (repayments of principal).

Equation 4.5 can be only a rough approximation, for many reasons. First, debt stocks are subject to valuation adjustments owing to the fact that debt is contracted in various currencies. The stock of debt, measured (for example) in U.S. dollars, may change because the value of debt denominated in another currency (such as the deutsche mark) changes in dollar terms when the dollar depreciates or appreciates against that currency. Second, interest is sometimes capitalized, adding to the stock of debt any unpaid interest obligations (interest arrears). Third, outstanding debt is sometimes canceled or written off.

It is clear from the above discussion that debt-creating flows contained in the capital and financial account of the balance of payments should be viewed in the context of a country’s gross external indebtedness.21

Indicators of External Debt

When a country borrows abroad, it must “service” the loan by paying interest at a rate specified in the loan contract and by paying back principal (amortization) over an agreed time period. The interest component is found in the current account (under “income, debits”), while amortization is recorded in the capital and financial account. In general, countries that have borrowed heavily abroad in the past must devote a sizable portion of their export receipts to servicing foreign debt, limiting the amount of foreign exchange left for financing imports. In assessing the cost of debt servicing, it is useful to relate these costs to total exports of goods and services.

Measuring the debt burden raises a number of complex issues. Conventionally, the debt burden is calculated as the stock of debt in relation to an index of available resources, such as exports of goods and services or gross domestic product (GDP). But such indices do not capture the impact of debt relief or of lower interest rates on the cost of servicing the debt. Conceptually, analysts should compare the present value of future debt servicing obligations with the present value of future export receipts. This approach requires a certain amount of information and can be sensitive to the discount rate used to calculate the present value. In practice, then, three ratios are used to analyze the debt burden:

• the ratio of scheduled debt service payments to exports of goods and services, which measures the impact of debt servicing obligations on the foreign exchange cash flow;

• the ratio of scheduled (or actual) interest payments to exports of goods and services, which measures the current cost of the debt stock; and

• total outstanding debt as a ratio of GDP (or of exports of goods and services), which reflects the long-term sustainability of the debt burden.

The World Bank’s debt reporting system uses critical values of two debt indicators to classify countries according to the severity of their indebtedness: the ratio of the present value of total debt service (PV) to GNP, and the ratio of the present value of total debt service to total exports.22 The indicators are based on the present value concept rather than the value of scheduled debt service in order to account for differences in the terms of the loans. A country is regarded as severely indebted if the present value of total debt service to GNP exceeds 80 percent or if the present value of total debt service to exports exceeds 220 percent.

Although these ratios may be helpful in signaling possible debt problems, the economic circ*mstances of countries with similar ratios may differ. These ratios should therefore be used with caution and only as a starting point for a country-specific analysis of debt sustainability. A full assessment of a country’s debt position must take into account the overall macroeconomic situation and balance of payments prospects. Box 4.9 discusses the sustainability of external debt.

An issue of increasing concern has been the fiscal burden of external debt. In many countries with external debt difficulties, scheduled debt service payments absorb a major proportion of government revenues, reducing the government’s room to maneuver in terms of fiscal adjustment. External debt sustainability is therefore closely linked to fiscal sustainability.

Direct Foreign Investment and Capital Flows

Gross and Net Reserve Assets

The use of gross reserves has traditionally been the main source of financing balance of payments deficits and for supporting an exchange rate peg. In today’s world of floating exchange rates, however, many countries find other means of financing imbalances, including foreign borrowing or changing domestic policies. Thus, as they are acquired and used, gross reserve assets do not necessarily reflect the size of a payments imbalance. The monetary authorities may also have other motives for holding reserves—for instance, to maintain confidence in the domestic currency and economy, to satisfy domestic legal requirements, or to serve as a basis for foreign borrowing. Analysts should keep these considerations in mind in examining the reasons for changes in reserves. Net foreign assets are calculated as gross foreign assets minus foreign liabilities of the banking system.

Reserve Adequacy

Although conventionally, the level of reserves has been assessed in relation to the projected total import bill of goods and services, more recent indicators of reserve adequacy have focused on financial vulnerability.28 Whichever indicator of foreign exchange adequacy is used, it is important to keep in mind that the nature of the exchange rate regime plays a part in determining the adequacy of the reserve level. Traditionally, as we have seen, the presumption has been that a country with a fixed exchange rate needs larger reserves than a country with a floating exchange rate regime, since reserves are the only cushion against shocks. However, in practice, if confidence in the authorities’ ability to maintain supporting policies is high, a country with a fixed exchange rate may not require large reserves to defend its currency. For example, the Polish authorities were able to maintain a fixed exchange rate in the early stages of their reform program in 1991 despite only a moderate level of reserves, because their economic policies commanded a high degree of confidence in financial markets. Even with a managed float, a lack of credible economic policies can quickly lead to capital flight and may deplete reserves, even if the authorities allow the exchange rate to depreciate. Thus, at a fundamental level, the credibility of the authorities’ economic policies and the confidence that market participants place in them are key to assessing the adequacy of reserves. Indeed, it is credible policies that allow the authorities to augment reserves by borrowing abroad at favorable terms; such borrowed reserves can potentially provide a major supplement to the country’s own reserves. In the case of Poland, the stabilization fund provided by the IMF played an important role in boosting the credibility of policies, although the fund was never used.

Exceptional Financing

By definition, the overall balance ex post is always in balance. Therefore, any disequilibrium will necessarily be financed by one of several methods. Besides using reserve assets and/or drawing on the IMF, countries may resort to exceptional financing arrangements to finance external payments imbalances. Exceptional financing arrangements include the following:

• exceptional grants, including debt forgiveness;

• the rescheduling of external debt obligations;

• the accumulation of arrears of principal and interest on foreign debt; and

• debt/equity swaps (exceptional direct investment).

Exceptional financing is not autonomous, since governments are often involved in negotiations to arrange it, especially in debt-burdened countries. Nor is it likely to be repeated year after year in predictable amounts. For these reasons, and since exceptional financing is controlled in part by the government and in part by foreign creditors, it is usual to isolate such transactions below the line in analyzing balance of payments developments—that is, to consider them as a special type of financing that will not be repeated on a regular basis.31

The Current Account

It is important to note that Poland’s official balance of payments statistics show a deficit on the current account for 1991–94. However, as noted above, there is substantial evidence that a significant amount of cross-border trade and tourism receipts have gone unrecorded. Foreigners have made millions of visits to—and transactions in—the numerous formal and informal markets on Poland’s borders. If reasonable estimates of nonresidents’ unrecorded purchases of Polish goods and services are included, the “true” current account shows a sizeable surplus (see Chart 4.1).

These “unofficial” transactions are not captured in the current account, but two types of “official” transactions can provide an idea of the extent of the underreporting. First, the official data classify sales of foreign currency for zloty in the small foreign exchange bureaus (known as kantors) as short-term capital inflows. These sales more likely reflect receipts from unrecorded exports and tourism receipts; therefore, they should appear under the current account. Second, private transfers are estimated by the change in the households’ foreign exchange deposits. A drop in these deposits (and therefore in net private transfers) during 1991–94 more accurately reflects residents’ sales of dollars for zlotys as confidence in the domestic currency returns.

The inflows underlying these items are generated mainly by transactions involving border trade and tourism, as well as workers’ remittances and other transfers. Adjusted for these changes, the current account shows estimated surpluses of 2–3 percent of GDP in 1991–92 and again in 1994. Independent information based on surveys of border trade and tourism support this reinterpretation of the official statistics.

The Capital Account

External debt restructuring and macroeconomic uncertainty dominated developments in the capital account during 1991–93. Therefore, medium- to long-term inflows, foreign direct investment, and portfolio inflows were relatively small. Overall, the adjusted capital account deficit was equal to almost 4 percent of GDP in 1991 and still stood at the equivalent of 0.5 percent of GDP in 1993–94. After an increase in foreign direct investment and large portfolio inflows, especially on the short-term account, the capital account is estimated to have turned around sharply in 1995, registering a large surplus. There was a sharp pickup in foreign direct investment, and foreign investors also became interested in the equity and Treasury bill markets, reflecting the virtual disappearance of devaluation risk and attractive interest rate differentials.

Exchange Rate Policy

The Polish authorities’ initial choice of a fixed exchange rate was motivated by a desire to provide the economy with a nominal anchor and thus to calm worries about emerging hyperinflation caused by sizable monetary overhang and impending price liberalization. At the same time, the authorities were concerned about maintaining the competitiveness of the traded goods sector, especially in view of the large external imbalance. They fixed the exchange rate at a level that required devaluing the zloty by over 31 percent in U.S. dollar terms. A parallel market responsive to market forces was allowed to operate alongside the official market.

The authorities initially regarded the exchange rate peg as provisional, but it turned out to be more durable than expected because of fiscal and monetary tightening and firm wage restraint. The increase in official reserves and the availability of the $1 billion Stabilization Fund also helped to underpin the exchange rate for over 18 months.

The peg to the U.S. dollar was changed to a peg to a basket of currencies in May 1991 in recognition of Europe’s increasing role in Poland’s trade, and the zloty was devalued by over 14 percent against the basket. The authorities soon recognized that because inflation was higher at home than it was among Poland’s trading partners, a fixed exchange rate would severely erode the country’s competitive position and place intolerable pressures on the balance of payments. The exchange rate regime was therefore changed again in October 1991, this time to a preannounced crawling peg. Under this system, the monetary authorities fix a preannounced path for the exchange rate involving periodic and predictable fluctuations. This system is especially suited to a country that does not wish to abandon the discipline of a fixed exchange rate completely but needs to prevent the erosion of competitiveness in the face of a relatively high domestic inflation rate.

An important issue in implementing a crawling peg regime is determining the rate of the crawl, or the rate at which the exchange rate is changed periodically. Matching the rate of depreciation to the projected inflation differential during the period is tantamount to targeting the real exchange rate and is sometimes known as a “passive” crawl. An “active” crawl keeps the rate of depreciation lower than the inflation differential, effectively conceding some loss of competitiveness but still putting downward pressure on the domestic inflation rate. Poland adopted an active crawl in October 1991, setting the rate at 1.8 percent a month, significantly below the projected inflation differential. The corrections were to take place daily rather than monthly to avoid sharp movements in the exchange rate.

As expected, Poland’s inflation rate remained higher than the rates in the countries with which it traded, leading to an appreciation of the real exchange rate under the new regime. To maintain the country’s competitiveness, in late 1991, the authorities adopted a policy of occasional discrete devaluations. In February 1992, the zloty was devalued by 11 percent and in August 1993, by 7.5 percent. The monthly rate of crawl was also reduced in August 1993, from 1.8 percent to 1.6 percent and later to 1.4 percent. Large capital inflows and associated monetary expansion have raised the exchange rate above its projected level recently, forcing the authorities to move to a managed floating regime that permits the rate to float by ±7 percent on either side of the official rate (see Chart 4.2).

In their efforts to reconcile the objectives of lowering inflation and maintaining competitiveness, the Polish authorities moved from a fixed rate pegged to the U.S. dollar to a rate pegged to a basket, then to a preannounced crawling peg, and finally to a managed float. Their exchange rate policy has broadly succeeded in remaining anti-inflationary while maintaining the external balance.

Exercises

1. On the basis of the data in Table 4.11 on international transactions, compile the balance of payments for Transitia in the format of Table 4.12 and according to the Fifth Edition of the Balance of Payments Methodology.

2. How is the balance of payments of Transitia affected if (a) an estimated $2 billion in exports have not been reported and (b) if there is an estimated unreported capital outflow of $1 billion?

3. Consider the effect of tariffs on the shoe industry in a country. Suppose that shoes sell for $10 in the world market (and domestically in the absence of any import restrictions) and that the material input—leather—costs $6 in the world market. Assuming for simplicity that no other costs are involved, compute the nominal and effective rates of protection if 20 percent tariff is levied on the import of shoes and no tariff is levied on leather. What would happen if a 10 percent tariff is now levied on leather? How about a 50 percent tariff on leather? As a producer of shoes, would you support the increase in tariff on leather? Would you, as a consumer of shoes? Would it make sense as a matter of policy for the government to increase the tariff on shoes to 50 percent?

4. A Polish exporter of toys initially faces production costs of 1,000 zlotys and an exchange rate of 100 zlotys per U.S. dollar but is able to export at a profit. Assuming domestic cost inflation of 50 percent and zero foreign inflation, calculate the following:

   • (a) The effect of a pegged exchange rate on exports;

   • (d) The level of the exchange rate that would restore the real exchange rate; and

   • (c) Given an exchange rate depreciation of 25 percent, the change in the real exchange rate and the magnitude of the change in productivity the Polish exporter needs to restore the profitability of his exporting activity.

5. Analyze the changing structure of Poland’s foreign trade on the basis of Tables 4.1 and 4.2 with a view toward assessing the sustainability of Poland’s recent export performance, focusing on:

   • (a) The extent of trade created rather than diverted in the shift from the old to the new markets;

   • (b) The impact of growth in partner countries and of foreign protectionism; and

   • (c) The competitiveness of exports.

6. On the basis of Table 4.5, calculate the terms of trade for Poland during 1990–94 and comment on their evolution.

7. On the basis of Table 4.5, calculate the effect of changes in the volumes of exports and imports and of prices, respectively, on the change in the trade balance in 1993.

8. Using the information provided on Polish exchange rate development (Table 4.6), show graphically how the preannounced crawl can be represented. Confine your graph to the period after August 27, 1993. In particular, show how the graph changes with (i) an increase in the rate of crawl; and (ii) a widening in the margin permitted for fluctuation. Contrast this graph with that of (i) a fixed rate regime; and (ii) a fixed band.

9. Based on the balance of payments table for Poland (Table 4.3), discuss the nature and sources of the imbalance in Poland’s external accounts and the way in which this imbalance affects the external debt position of Poland. Like many transition economies, Poland has significant unrecorded cross-border trade. How does the existence of such trade affect your analysis of the balance of payments? Discuss how the current account deficits in 1993 and 1994 were financed, and comment on the differences in financing patterns observed.

10. With reference to Tables 4.9 and 4.10, analyze the external indebtedness of Poland. Construct several indicators of external indebtedness discussed in this chapter and comment on their evolution. Comment on the sustainability of Polish external indebtedness.

11. Discuss the evolution of Poland’s competitiveness during 1991–94 on the basis of Chart 4.1, which shows the movements in Poland’s nominal and real exchange rates (based on consumer and producer prices and unit labor costs) and data given in Table 4.8.

Issues for Discussion

1. Although the balance of payments account is a useful framework for capturing an economy’s transactions with the rest of the world, it is desirable to supplement it with other information, such as data on external debt and arrears and foreign direct investment. Discuss why it is essential to use such supplementary information for Poland in order to obtain a full picture of the country’s external position. What specific supplementary information would you use?

2. One of the differences between the Fourth and the Fifth Editions of the Manual lies in the treatment of valuation changes and new reserve assets created by the monetization of gold and the allocation of SDRs. What is the reasoning behind the exclusion of valuation changes from the balance of payments in the Fifth Edition? How does such a treatment affect the reconciliation of the balance of payments and the monetary accounts?

3. It is sometimes said that a current account surplus is always desirable and a deficit undesirable. Do you agree with this statement? If not, why? Explain your answer with examples from various countries.

4. In cases where a country is subject to internal or external shocks such as a drought or a fall in the price of its main export, the balance of payments outcome—such as a large current account deficit—may not represent the underlying trend. In such cases, how should the underlying current account deficit be estimated? Can you think of other factors affecting the balance of payments that would make it necessary to attempt to estimate the underlying current account?

5. If a country is subject to a terms of trade shock (such as a rise in the price of a major import such as oil or a fall in the price of a major export such as coffee), how should the authorities formulate their policy response? Discuss the factors that need to be taken into account in determining the mix of adjustments and financing and the type of financing that should be used.

6. In recent years, reflecting the increasing integration of world capital markets, the liberalization of controls on the capital account, and policy reforms, many developing and some transition economies are experiencing rising capital inflows. Are such inflows always an unmixed blessing? What difficulties do such inflows raise for the conduct of macroeconomic policy? In particular, should some type of capital inflows be preferred over others and if so, why?

7. This workshop discusses the main issues analysts should consider in assessing reserve adequacy. In view of the liberalization of the capital account in many countries, are the conventional criteria for measuring reserve adequacy still relevant? Why do some countries seem to encounter no difficulties even while holding rather low levels of reserves in relation to their imports?

8. Are the various external debt indicators presented in this chapter sufficient to assess a country’s debt situation? Why do countries such as Italy and Ireland, which have rather high debt ratios, seem not to suffer from a “debt problem,” while others countries with relatively low ratios have debt servicing difficulties?