trade balance and income shocks: experience of transition economies

WORLD TRANSITION E CONOMY RESEARCH

Trade Balance and Income Shocks: Experienceof Transition Economies

Marcela Veselkova Æ Julius Horvath

Received: 17 March 2008 / Accepted: 12 April 2008 / Published online: 10 July 2008

� Springer-Verlag 2008

Abstract This paper investigates the major sources of changes in the trade balance

of four Central European and three Baltic transition economies with an emphasis on

the difference between permanent and transitory disturbances to income. In all

seven countries the findings support the hypothesis that transitory disturbances to

income are the main determinants of changes in the trade balance. These results

seem to be fairly consistent with inter-temporal models of trade balance, which view

transitory shocks to income as the main source of variations in the trade balance.

These results do not seem to support the view that productivity shocks alone gen-

erate most of the variation in the trade balance.

Keywords Trade balance � Transition economies �Transitory and permanent shocks

JEL Classification F32 � F41

Introduction

Before the collapse of socialism, the trade of the four Central European (Visegrad)

countries (Poland, Hungary, the Czech Republic, Slovakia) and the three Baltic

countries (Estonia, Lithuania, Latvia) was mostly oriented towards Eastern markets.

M. Veselkova (&)

Department of International Relations and European Studies,

Central European University, Budapest, Hungary

e-mail: [email protected]

J. Horvath

Department of Economics, Central European University,

Budapest, Hungary

e-mail: [email protected]

123

Transit Stud Rev (2008) 15:241–249

DOI 10.1007/s11300-008-0001-x

However, after the collapse of the socialist system most of these markets collapsed

and it was only from the early and mid 1990s, following trade liberalization and

opening to international capital markets, that these countries experienced huge

capital inflows. Especially from the second half of the 1990s shifts in investment

opportunities led to corresponding shifts in the current account and to predominant

trade balance deficit in these countries.

Typically, papers on trade balance in transition countries concentrate on the

sustainability of trade deficits, especially having in mind monetary integration

requirements. This paper adds to understanding of the behavior of trade balance in

these countries in a different way. We investigate factors that determine changes in

the trade balance from the perspective of inter-temporal models which put an

emphasis on the stochastic character of these processes, and thus emphasize the

importance of different type of shocks in explaining the behavior of the trade

balance.

After a short presentation of the issue we review empirical evidence dealing with

current accounts of non-transition economies, in ‘‘Data, Methodology and Results’’

we present the data, the methodology and the results of empirical investigation. In

‘‘Conclusion’’ we discuss and conclude.

Literature Review

We distinguish two contrasting approaches concerning the extent to which the

changes in the trade balance are associated with permanent or transitory changes to

income.

In the first approach, transitory and permanent shocks to income have different

effects on the trade balance. An increase in permanent income does not affect the

trade balance because income and consumption increase by the same proportion. On

the other hand, transitory shocks to income lead to changes in the trade balance.

Temporary supply-side shocks lead to an increase in both the income and current

account. Alternatively, temporary demand-side shocks, result in the fall of the

current account and a rise in income. Sachs (1981: 214) writes that ‘‘modern

theories of saving and investment emphasize that the responses of C and I to various

disturbances depend crucially on expectations of how current shocks affect key

future economic variables. Thus the response of C to an exogenous drop in Y is

crucially affected by how permanent the Y shift is expected to be (assuming that

real interest rates are constant). A temporary drop in Y will not be matched by an

equal fall in C, while a permanent drop in Y will. Similarly, investment should

move little if the dip in Y is temporary, but should fall if the slump is expected to be

permanent. Clearly CA = Y–C–I–G tends to worsen in the first case, but not in the

second. Thus to forecast the magnitude of the effects of a disturbance on the current

account, one must ask whether that disturbance is temporary or permanent,

unanticipated or anticipated’’.

In contrast to inter-temporal models, in real business cycle models—as for

example in Mendoza (1991)—productivity disturbances motivate economic agents

to adjust savings and investment in order to smooth consumption. As a result the

242 M. Veselkova, J. Horvath

123

productivity-rising (real supply) shock explains both long-term growth in income

and cyclical variations in income and the trade balance. Here, the countercyclical

behavior of the trade balance is compatible with permanent productivity shocks, and

does not stem from the demand disturbances.

Review of Empirical Evidence

Kim (1996) investigates the income effects on the trade balance of the United

States, Japan, Germany and the United Kingdom for the period 1957:1 through

1993:3. Transitory changes in income explain most of trade balance. Within the

two-year horizon, transitory income changes account for nearly 90% of movements

in the trade balance in all countries except for Germany, where they still explain

over 70%.

Hossain (1999) examines how transitory and permanent components in income

and terms of trade affect the current account of the US and of Japan vis-a-vis the rest

of the world for the period 1973:1-1995:4. He concludes that permanent component

of income has statistically insignificant long-run effects on US current account

balance. In contrast, these effects are statistically significant in Japan.

Miljkovic and Paul (2000) investigate the role of permanent and transitory

changes in income in determining trade balance in five European economies for the

period 1970:1-1996: 4. Their main finding is that transitory income shocks are the

major reason for changes in the trade balance.

Hoffmann (2001) measures the permanent component of country-specific shocks

to examine the dynamics of the current account and investment. In most G-7

countries for the period from 1960 till 1991, country-specific shocks are

predominantly transitory. On average, around 20% of the variance of country-

specific shocks are explained by permanent factors.

Kano (2003) uses post-war quarterly Canadian and UK current account data to

reveal that the response of the current account to a country-specific transitory shock

is large and that the fluctuations in the current account are dominantly transitory.

Lee and Chinn (2006) examine the exchange rate and current account dynamics

of the G-7 countries from 1979 till 2000. They find that with the exception of the

US, temporary shocks play a larger role in explaining the variation in the current

account, while permanent shocks play a larger role in explaining the variation in the

real exchange rate.

Data, Methodology and Results

In this paper we concentrate on the permanent and transitory shocks to income and

their effect on the trade balance in the framework characterized by Eq. (1).

Xt ¼ lþX1

k¼0

GkUt�k ð1Þ

Xt = (Dyt, bt)0 and Ut = (ut

p, utt)0.

Trade Balance and Income Shocks 243

123

where yt is the real income and bt is the trade balance expressed as a ratio to

income. D denotes the first difference operator, l is a vector of deterministic

components and Gk’s are matrices of coefficients. utp denotes the structural shock

generating permanent changes in income and utt denotes the structural shock

generating transitory changes in income.

In order to estimate (1) we follow the structural vector auto-regressive (VAR)

methodology developed by Blanchard and Quah (1989). The long-run identifying

restriction is defined as a zero effect of a transitory shock on real income. Blanchard

and Quah (1989) interpret the disturbances that have a temporary effect on income

as representing mostly demand disturbances, and those with the permanent effect on

income as mostly supply disturbances. Examples of demand disturbances would

thus include changes in monetary or fiscal policy or autonomous changes in

consumption. Examples of supply disturbances might include technological

improvements or oil price shocks.

The objective of this paper is to determine the major source of changes in the

trade balance of the Visegrad and Baltic economies, namely the Czech Republic

(CZ), Hungary (HU), Poland (PL), Slovakia (SK), Estonia (ES), Latvia (LA) and

Lithuania (LI). We use quarterly data with the end period as 2006:3 in all the cases,

except of Lithuania, where the end period is 2006:1. The beginning period varies as

follows: 1992:1 for Latvia, 1993:1 for Estonia and Slovakia, 1994:1 for the Czech

Republic, 1995:1 for Hungary, Poland and Lithuania. The data are obtained from

International Financial Statistics. Real income is measured as a natural log of real

GDP at constant 2,000 prices. The trade balance is measured as the ratio of nominal

net exports to nominal GDP.

All of the income series and some of the trade balance series exhibit seasonal

fluctuations. We include seasonal dummies in all the vector-autoregressive

equations. Integration of the series is considered before estimation. Based on

Dickey-Fuller and Phillips-Perron tests, we consider the GDP series to be integrated

of order one and all the trade balance series to be integrated of order zero. We use

standard lag order selection criteria to determine the lag order. In estimation, we use

four lags for the Czech data, three for Hungary, two for Estonia, Latvia, Lithuania

and Poland and one for Slovakia. We have also experimented with all combinations

of one, two, three and four lags for all countries. We did not obtain substantial

differences which would change the main results of the paper. [These results are not

reported here and are available upon request.].

The results of the variance decomposition are reported in Table 1 for the four

Visegrad countries and in Table 2 for the three Baltic countries. Column Y-P shows

the proportion of the variance in real income explained by permanent shocks to

income. Column TB-T shows the proportion of the variance in trade balance

explained by transitory shocks to income. Period denotes the number of steps in

quarters. These results show that major portion of the variance in real income is

explained by permanent shocks. Within 2-year horizon, permanent changes in

income account for more than 70% of variation in the real income of these

countries.

In Tables 1 and 2 (columns TB-T) we present an important finding of the paper:

the major portion of the variance in trade balance is explained by transitory shocks


123

Tab

le1

Var

iance

dec

om

posi

tion:

Vis

egra

dco

untr

ies

Per

iod

Cze

chR

epub

lic

Hu

ng

ary

Po

lan

dS

lov

akia

Y-P

TB

-TY

-PT

B-T

Y-P

TB

-TY

-PT

B-T

17

4.3

9(0

.00

84

)4

2.0

7(0

.01

40

)8

5.8

0(0

.00

91

)8

6.2

1(0

.01

50

)8

5.1

5(0

.01

82

)7

6.8

1(0

.01

04

)8

8.6

3(0

.01

62

)9

3.9

5(0

.03

74

)

47

3.1

1(0

.00

86

)4

8.7

2(0

.01

82

)8

0.5

6(0

.00

98

)8

4.5

8(0

.02

09

)8

2.9

6(0

.02

11

)8

6.9

7(0

.01

48

)8

6.5

0(0

.01

67

)9

3.3

6(0

.05

22

)

87

5.1

4(0

.00

94

)5

0.3

8(0

.01

86

)8

0.0

3(0

.01

01

)7

9.6

7(0

.02

19

)8

2.8

3(0

.02

13

)8

8.8

1(0

.01

63

)8

6.3

9(0

.01

67

)9

3.3

2(0

.05

43

)

20

75

.19

(0.0

09

5)

50

.18

(0.0

186

)8

0.0

2(0

.01

02

)7

9.5

8(0

.02

20

)8

2.8

1(0

.02

13

)8

9.3

0(0

.01

69

)8

6.3

8(0

.01

67

)9

3.3

2(0

.05

44

)

Colu

mn

Y-P

sho

ws

the

pro

port

ion

of

the

var

ian

cein

real

inco

me

exp

lain

edb

yp

erm

anen

tsh

ock

sto

inco

me.

Colu

mn

TB

-Tsh

ow

sth

ep

rop

ort

ion

of

the

var

ian

cein

trad

e

bal

ance

exp

lain

edb

ytr

ansi

tory

sho

cks

toin

com

e.N

um

ber

sin

par

enth

eses

refe

rto

on

est

andar

der

ror.

Per

iod

den

ote

sth

en

um

ber

of

step

sin

qu

arte

rs


123

to income. Within a 2-year horizon, transitory changes account for 50.39%

movements in the Czech trade balance, 79.68% in the Hungarian, 88.82% in the

Polish, 93.33% in the Slovak, 95.13% in the Estonian, 85.7% in the Latvian and

70.26% movements in the Lithuanian trade balance. Transitory income shocks are

clearly more important for the trade balance than the permanent income shocks.

Figure 1 plots the accumulated responses of income and trade to structural one

standard deviation innovations for the Visegrad-4 countries. Figure 2 plots these

results for the Baltic countries. Figures are organized in pairs. The left figure plots

the impulse response function of the real income; first to shock 1 (shock with

permanent effect on income) and then to shock 2 (shock with transitory effect on

income). The right-side figure plots the impulse response function of the trade

balance to the shock 1 (permanent) and the shock 2 (temporary).

A permanent shock increases the income permanently in all countries. A

transitory change in income is positive in the Czech Republic, Poland, Slovakia,

Estonia and Lithuania and negative in Hungary and Latvia.

Trade balance increases due to a permanent shock to income in the Czech

Republic, Poland, Slovakia, Estonia and Lithuania. A permanent shock to income

reduces the trade balance in Hungary and Latvia. A transitory shock to income

decreases the trade balance in all countries.

Conclusion

The main finding of this paper is that factors determining the changes in the trade

balance are different from those determining changes in the long-run real income. In

other words, transitory shocks to income are the main determinants of changes in

the trade balance, while the permanent shocks to income account only for a small

variation in the trade balance.

We also observe variation in the effect of transitory shocks on the trade balance.

Transitory shocks have a positive effect on the trade balance over the business cycle

in the case of Hungary and Latvia, while negative effect in case of the Czech

Republic, Poland, Slovakia, Estonia and Lithuania.

These results seem to be fairly consistent with inter-temporal models which view

the aggregate productivity shocks as in charge of the long-run behavior of income,

and view income and trade balance cyclical variations as generated by demand

Table 2 Variance decomposition: Baltic countries

Period Estonia Latvia Lithuania

Y-P TB-T Y-P TB-T Y-P TB-T

1 86.58 (0.0243) 95.16 (0.0316) 98.14 (0.0190) 91.72 (0.0340) 82.66 (0.0262) 65.60 (0.0238)

4 79.64 (0.0265) 95.08 (0.0359) 98.01 (0.0204) 87.76 (0.0416) 74.01 (0.0316) 70.37 (0.0266)

8 79.51 (0.0267) 95.13 (0.0362) 97.92 (0.0206) 85.69 (0.0431) 73.28 (0.0324) 70.25 (0.0267)

20 79.50 (0.0267) 95.13 (0.0362) 97.90 (0.0207) 85.45 (0.0433) 73.23 (0.0325) 70.22 (0.0267)

See Table 1


123

-.002

.000

.002

.004

.006

.008

.010

.012

.014

5 10 15 20 25 30 35 40

Shock1 Shock2

Accumulated Response of CZ_Y to StructuralOne S.D. Innovations

-.03

-.02

-.01

.00

.01

.02

.03

5 10 15 20 25 30 35 40

Shock1 Shock2

Accumulated Response of CZ_TB to StructuralOne S.D. Innovations

-.004

-.002

.000

.002

.004

.006

.008

.010

5 10 15 20 25 30 35 40

Shock1 Shock2

Accumulated Response of HU_Y to StructuralOne S.D. Innovations

-.05

-.04

-.03

-.02

-.01

.00

5 10 15 20 25 30 35 40

Shock1 Shock2

Accumulated Response of HU_TB to StructuralOne S.D. Innovations

.000

.004

.008

.012

.016

.020

5 10 15 20 25 30 35 40

Shock1 Shock2

Accumulated Response of PL_Y to StructuralOne S.D. Innovations

-.06

-.05

-.04

-.03

-.02

-.01

.00

.01

.02

5 10 15 20 25 30 35 40

Shock1 Shock2

Accumulated Response of PL_TB to StructuralOne S.D. Innovations

.000

.004

.008

.012

.016

5 10 15 20 25 30 35 40

Shock1 Shock2

Accumulated Response of SK_Y to StructuralOne S.D. Innovations

-.16

-.12

-.08

-.04

.00

.04

5 10 15 20 25 30 35 40

Shock1 Shock2

Accumulated Response of SK_TB to StructuralOne S.D. Innovations

Fig. 1 Impulse response, Visegrad countries


123

shocks. These results do not seem to support the view that productivity shocks alone

generate most of the cyclical effects in the trade balance.

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Blanchard O, Quah D (1989) The dynamic effects of aggregate demand and supply disturbances. Amer

Econ Rev 79:655–673

.000

.004

.008

.012

.016

.020

.024

5 10 15 20 25 30 35 40

Shock1 Shock2

Accumulated Response of ES_Y to StructuralOne S.D. Innovations

-.07

-.06

-.05

-.04

-.03

-.02

-.01

.00

.01

5 10 15 20 25 30 35 40

Shock1 Shock2

Accumulated Response of ES_TB to StructuralOne S.D. Innovations

-.005

.000

.005

.010

.015

.020

.025

5 10 15 20 25 30 35 40

Shock1 Shock2

Accumulated Response of LA_Y to StructuralOne S.D. Innovations

-.10

-.08

-.06

-.04

-.02

.00

.02

5 10 15 20 25 30 35 40

Shock1 Shock2

Accumulated Response of LA_TB to StructuralOne S.D. Innovations

-.005

.000

.005

.010

.015

.020

.025

5 10 15 20 25 30 35 40

Shock1 Shock2

Accumulated Response of LI_Y to StructuralOne S.D. Innovations

-.04

-.03

-.02

-.01

.00

.01

.02

5 10 15 20 25 30 35 40

Shock1 Shock2

Accumulated Response of LI_TB to StructuralOne S.D. Innovations

Fig. 2 Impulse response, Baltic countries


123

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trade balance and income shocks: experience of transition economies

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