Impacts of External Shocks on Nations’ Policy Responses and

Economic growth

—World Economic Synchronization

World Economic Synchronization

World Economic Synchronization

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High income World LDC

World Economic Synchronization

-External Shocks

-Policy Responses

-Trade as a ‘gear’

Methodology

-External Shock Accounting-Differenced-Data Models-Multiple Linear Dynamic Models-Cointegration Test and Chow Test

Bacha’s model-- for External Shock Accounting

Basic form of the model isChanges in Ratio of Current Account Deficit to GDP =

+ Changes in External Shocks

- Changes in Policy Responses

+ Error Term

Bacha’s Model Derivation

Dt (Mt - Et) + (Vt - Tt) (1)

Dt/Yt = PtmjtCt/Yt+ PtmjtIt/Yt + rtFt-1/Yt+ Vt/Yt- Rt/Yt -P

txxtWt/Yt - Tt/Yt (2)

d(Dt/Yt) = jtAt/Ztd(rtm) - xtWt/Ztd(rtx) + Ft-1/Ytd(rt)

- Xtrtxd(Wt/Zt) + rtd(Ft-1/Yt) + d(Vt/Yt) - (Rt/Yt)

- d(Tt/Yt) + jttmd(Ct/Zt) + jttmd(It/Zt) +tmAt/Ztd(jt) -

txWt/Ztd(xt) + ε (3)

Model Components: External Shocks

• [js(As/Zs)dpmt - xs(Ws/Zs)dpxt]… Terms of trade deterioration

• [ - Fs-1/Ysdrt ] … interest rate shock

• [- xspxsd(Wt/Zt)]… retardation of world trade

growth.• [ rsd(Ft-1/Yt)]… burden of debt accumulation• [d(Vd

t/Yt)]… change in net direct investment income to

abroad • [- d(Rt/Yt)]… change in workers'

remittances• [- d(Tt/Yt)]… change in unrequited

transfers

Model Components: Policy Responses

• [ jspmsd(Ct/Zt)]… consumption contraction

• [ jspmsd(It/Zt)]… investment reduction

• [ pms(As/Zs )djt]… import replacement

• [ - pxs(Ws/Zs)dxt]… export penetration

• [+ ε] … interaction effects and adding-up errors.

External Shocks

-- Attribution to LDC Economic Performance

Measured Impact of in External Shocks

Unfavorable Shocks Impacts on GDP

(1991-2005)

Terms-of-trade, 4%

Intereste Rate, 1%

World Trade, -3%

Other Ex. Shocks , 0.01%

Measured Impact of in External Shocks

A Comparison of External Shocks Impacts on GDP Growth

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1987-91 1992-1995 1996-2000 2001-2005

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Terms of Trade Interest Rate World Trade Remaining 4 Minor Shocks

Counterintuitive Relationship between

External Shocks and GDP Growth GDP Growth Comparison

LDC Having Favorable vs. Unfavorable External Shocks

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1973-77 1978-82 1982-86 1987-91 1992-95 1996-2000 2001-2005

Years

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favorable unfavorable

Policy Responses

-- Attribution to LDC Economic Performance

Policy Response Roles• Synchronization Transmission Mechanism• Reducing External Shock Impact by

Improving Current Account Balance• ↑ measure of adverse external shocks,

↑ favorable impacts of policy responses• Policy responses correlate with the cycles

in LDC economic growth • Policy responses to the shocks might

cause future structural adjustments

Policy Response to External Shocks

Policy Responses as Economic adjustment

75%

58%

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80%

Improve Trade Ratio decreasing spending

Policy Responses

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LD

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Policy Response to External Shocks

A Comparison of Policy Response Impacts

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1987-91 1992-95 1996-00 2001-05

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By Improving export penetration By Raising import replacement By Consumption contraction By Investment reduction

Policy Response to External Shocks

• The primary policy response was export penetration, averaging from 4.1% to 6.4%;

• The secondary policy response was import substitution, averaging from 2% to 3.9%;

• The investment reduction was the third and the consumption contraction the fourth;

• ‘Belt-tightening’ would sacrifice economic growth in both the long-run and short-term;

• Trade policies, served as a “gear” of economic synchronization.

A comparison of LDC GDP growth of adopting export penetration policy

A Comparison of LDC with Favorable vs. Unfavorable Changes of Export-Penetration

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1973-77 1978-82 1982-86 1987-91 1992-95 1996-00 2001-05

YearFavorable Unfavorable

Tests and Analysis on Policy Responses

Methods:-Multiple Linear Dynamic Models-Stability Test and Chow Test

Tests and Analysis on Policy Responses(1)

• A Test of policy sensitivity to external shocks:(PRi = bi + bi ESi + ,)

• Statistic measurements provided by policy parameters

• Export penetration as the primary policy response

A Test of Policy sensitivity to external

shocks: PRi = bi + bi ESi + ,

where PRi = policy responses and ESi = External shocks Export penetration as the primary policy response

Regression Model: PRi = ES + Constant coefficient

(t-ratio for X coefficient)

R Squared

Export-penetration on external shocks

-0.77 -0.43 -6.12 * 0.22

Import-replacement on external shocks

0.5 -0.13 -2.2 0.03

Consumption-contraction on external shocks

-0.01 -0.03 -0.93 0.01

Investment-reduction on external shocks

-0.27 0.04 1.25 0.01

Notes: N = 139; * denotes statistically significant at the 1% level (one tail).

Tests and Analysis on Policy Responses(2)

• Trend analysis of long-run LDC export-penetration responses to external shocks: (EPi = a + bi ESi + )

• The impacts of export penetration policy on current-account balances were rising;

• That response tripled to 91% from 32% through the period of 1992-2005, almost doubled from the period of 1996-00.

LDC export-penetration responses to

external shocks in long-run? Model: EPi = a + bi ESi +

Period Constant (bi ) Coefficient **

(t-ratio) R Squared

1987-91 1.34 -0.32 (-3.04)* 0.22

1992-95 0.9 -0.37 (-4.17)* 0.34

1996-00 -4.84 -0.48 (-2.84)* 0.19

2001-05 -1.18 -0.91 (-5.46)* 0.5

Notes:* denotes statistically significant at the 1% level (one tail); ** Negative sign indicates reactions of domestic policies result in favorable; The impacts of export penetration policy on current-account balances were rising

Tests and Analysis on Policy Responses(3)

• Test the Consistency and the Continuity of Export Orientated Policy:

Chow Test was used:

F = (SSR2/df2)/(SSR1/df1)

Result: No presence of structure break

High-Growth LDC versus Low-Growth LDC(1)

• Export-penetration policy efforts differentiated high-growth LDC (HLDC) from low-growth LDC (LLDC)

• Export-penetration policy was used more by HLDCs than by LLDCs to offset external shocks.

High-Growth LDC versus Low-Growth LDC (2)

• HLDC export oriented policy accounted for 55 cents, offsetting every dollar loss caused by external shocks to the current account balance;

• HLDC export oriented policy measure was 120% greater than the measure of LLDC policy response, accounted for only 25 cents;

• HLDC experienced three times as much external shock as LLDC did in the period 1987-2005.

Why did some LDCs perform better when they were facing more substantial external shocks?

Why..?

• The greater measures of external shocks that LDCs experienced, the more open their economies were

Why..?

• The greater measures of external shocks forced those LDCs to make some necessary economic adjustments, especially, adopting export oriented policies to offset the adverse impact of external shocks.

Why…?

• LLDCs minimized their exposure to external shocks, but also minimized their opportunities.

For Instances:– Lacking of foreign direct investment (FDI)

means lower current-account deficit– Less Trade results less the shock of terms of

trade

Thanks. Questions please.

Martin K. Zhu, Ph.D.

Senior Economist

U.S. Department of Agriculture