## 3. External Adjustment to Terms-of-Trade Shifts

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### Key findings
- Exchange rate flexibility has, to some extent, lowered the output cost of external adjustment to terms-of-trade shocks.
- Composition of external adjustment in Latin America indicates the income effect has been stronger than the expenditure-switching effect, but real depreciation in flexible regimes has supported adjustment by:
  - providing some boost to exports despite weak external demand, and
  - shifting demand from imports to domestic goods, lowering the compression of domestic demand while helping boost domestic production.
- Export elasticities vary widely across products; manufactures and textiles respond more strongly to real depreciations than commodities.
- In much of Latin America, where export baskets are concentrated in commodities, exchange rate flexibility tends to spur diversification and may support structural policies aiming at diversification.

### Historical perspective and stylized facts
- Based on 150 countries over the past half century, external current accounts:
  - deteriorate on impact of a large terms-of-trade decline,
  - then revert to initial levels over a period of three to four years as the real exchange rate depreciates.
- The recent terms-of-trade bust in Latin America:
  - largely driven by a decline in export prices rather than an increase in import prices,
  - featured quantity adjustment through import compression rather than rising exports.
- Country episode start dates cited (recent episode examples):
  - Argentina: September 2012,
  - Brazil, Colombia, Mexico: June 2014,
  - Chile, Peru: March 2013.

### Role of exchange rate regimes
- Countries with flexible exchange rate regimes fared better in the recent bust than those with more rigid regimes:
  - Flexible regimes experienced real depreciation, trade balance improvements, smaller reductions in output, and less reserve loss.
  - Rigid regimes showed large real currency appreciations, widening current account deficits, and substantial reserve losses.
- Decline in exchange rate pass-through to inflation in Latin America is noted as a factor allowing for larger currency depreciations in real terms.

### Quantitative analysis and mechanics of adjustment
- Methodology:
  - A panel vector auto-regression (PVAR) on a panel of 38 economies estimated dynamic relationships between changes in the trade balance, domestic demand, and the real effective exchange rate to terms-of-trade shocks, controlling for external demand.
  - Episodes: a Markov regime-switching methodology identified 59 episodes of terms-of-trade busts over 1960–2016 (source Adler, Magud, and Werner 2017).
- Responses to a 10 percent fall in the terms of trade:
  - Large and significant trade balance improvements after one year across exchange rate regimes.
  - In flexible regimes, real currency depreciation boosted exports and reduced imports, indicating expenditure-switching.
  - A 10 percent reduction in the relative price of exports increased real exports by only 2 percent in one year but lowered real imports by close to 7 percent.
- Contribution of the real exchange rate:
  - The real exchange rate explains close to 50 percent of the response of the trade balance in economies with flexible exchange rate regimes in the recent episode, while playing a negligible role in countries with fixed exchange rate regimes.
- Domestic demand and sacrifice ratios:
  - Domestic demand contracted about two and a half times less in economies with more flexible exchange rates.
  - The sacrifice ratio (domestic demand compression required for the trade balance to improve by 1 percentage point of GDP) for economies with flexible exchange rate regimes is about half the ratio observed during previous episodes.
- Counterfactual analysis:
  - A scenario fixing the real effective exchange rate response at zero isolates the contribution from expenditure switching; comparing this to the unconstrained response quantifies expenditure-switching importance.

### Trade balance: decomposition and sacrifice ratio
- Decomposition of adjustment to a 10 percent reduction in the terms of trade (Latin America, flexible ER regimes, 2000–16):
  - Highlights expenditure switching through imports and through exports.
- Exchange rate flexibility and the sacrifice ratio:
  - Exchange rate flexibility reduces the domestic sacrifice ratio of adjustment in Latin America.
  - The exchange rate acts as a shock absorber: despite large negative income effects during TOT bust episodes, flexibility enables expenditure-switching that eases the burden on domestic demand and output growth.
  - Most of the adjustment observed has come through import compression rather than export expansion.
- Historical decomposition of real exports during recent TOT busts:
  - External demand and terms-of-trade shocks are the main drivers of recent export performance.
  - Except for Mexico and Argentina, exports appear to be underperforming, as suggested by unexplained components in model forecast errors.
  - Country episode windows used in decompositions:
    - Argentina: 2012:Q3 to 2015:Q3,
    - Brazil: 2014:Q2 to 2015:Q4,
    - Chile and Peru: 2013:Q1 to 2015:Q4,
    - Mexico: 2014:Q2 to 2015:Q4.

### Do depreciations boost short-term export performance? — product-level elasticities
- Method:
  - Uses product-level trade data to estimate elasticity of a country’s share in global exports of each product with respect to movements in its real effective exchange rate (REER); focuses on four-digit SITC products, assuming a single world price.
- Aggregate and cross-country elasticities:
  - The average country-product elasticity is about –0.13.
    - Interpretation: a 10 percent real depreciation increases the average country-product export share by about 1.3 percent with respect to its starting point.
  - The average product displays an elasticity of about –0.1.
  - Elasticities vary substantially across products: about two-thirds of 764 products see a depreciation boost the country’s export share; for most others the impact is statistically indistinguishable from zero.
- Regional patterns:
  - Emerging market economies display less responsiveness than advanced economies on average.
  - Latin America and emerging Asia, as well as advanced economies, show statistically significant responsiveness.
  - Emerging Asia’s estimated elasticity is about twice as large as that of the LA5 (LA5 defined as Brazil, Chile, Colombia, Mexico, Peru).
- Product-category patterns:
  - Manufactures and textiles display higher market share responsiveness than commodities, which respond little to REER movements.
  - Subcomponents of manufactures (chemicals, machinery and transport equipment, other manufactures) show broad-based responsiveness.
- Implications of export composition and GVC integration:
  - Economies specialized in commodities generally observe weaker responses to real depreciation than those concentrated in manufactured goods.
  - Manufactures have made up approximately 40 percent of total exports in Latin America and the Caribbean since 1990; their share in emerging Asia’s total exports has risen to 80 percent over the same period.
  - Participation in GVCs can reduce manufacturing export REER elasticity (Ahmed, Appendino, and Ruta (2016) estimate a 22 percent average reduction); deeper GVC integration in emerging Asia partly explains larger elasticities there. However, participation in GVCs would, all else equal, tend to raise the relative export sensitivity of Latin America and the Caribbean versus emerging Asia, and thus is unlikely to account fully for the observed regional differences.

### Measured effects of recent depreciations on exports
- Estimated contributions of REER movements during 2013–15 to export values in 2014–16 (expressed as percent of 2012 export value):
  - Real depreciation of the Colombian peso since 2013 has boosted exports by 7.5 percentage points since 2012, contrasted with a fall of nearly 40 percent in export value observed over this period.
  - Ecuador’s real appreciation has placed a drag on exports of more than 4 percentage points since 2013.
- Within-country heterogeneity:
  - Even when aggregate export responsiveness is low (e.g., Brazil), depreciations lead to larger market shares for many export products, indicating substantial inter-sectoral reallocation potential.

### Policy implications
- Three main policy implications for Latin American economies facing the end of the commodity super-cycle:
  - Exchange rate flexibility reduces the sacrifice ratio of external adjustment.
    - Where currencies have depreciated in real effective terms, adjustment has benefited from somewhat stronger exports and output growth, and redirection of consumer spending from imports to domestically produced goods, reducing the burden on domestic demand compression.
  - The cost of exchange rate rigidity has risen in Latin America.
    - Where currencies move in sync with the U.S. dollar and strengthen against regional partners’ currencies, the sacrifice ratio has increased, implying larger output costs from external adjustment through sharper compression of domestic demand.
  - Exchange rate flexibility can support structural policies aimed at shifting resources to the noncommodity sector.
    - Depreciations boost exports of manufactures more than other goods, especially in regions with higher concentration of manufactures and adequate infrastructure.
    - Closing infrastructure gaps that support a dynamic manufacturing sector would reduce the sacrifice ratio of external adjustment going forward.

### Box summaries and country experiences
- Box 3.1 (Expenditure-Switching versus Income Effects):
  - A permanent negative terms-of-trade shock implies a negative income effect and, in equilibrium, a real exchange rate decrease.
  - The expenditure-switching effect: relative price changes increase exports and shift domestic consumption toward domestic tradable and nontradable goods, while overall consumption falls due to the income shock.
  - If expenditure-switching offsets the income shock, real depreciation can be expansionary; if income effects dominate, expenditure-switching only partially offsets the contraction.
- Country experiences (Chile, Colombia, Brazil, Ecuador, Bolivia):
  - Adjustment mechanics differ by exchange rate regime, access to external financing, and availability of fiscal space/buffers.
  - Chile and Colombia: exchange rate depreciation (real effective terms) supported expenditure-switching and cushioned the adjustment.
    - Currencies depreciated by 10 percent in Chile and 30 percent in Colombia in a two-year window from the onset of their shocks.
  - Brazil and Ecuador: narrowing of imbalances occurred via deep contractions in domestic demand; Ecuador relied on fiscal consolidation and import restrictions due to dollarization and limited access to financing.
  - Bolivia: accommodative fiscal policy and rapid credit growth smoothed the collapse in export prices but eroded buffers; some adjustment via import compression has started.
  - Conclusion: the extent of necessary adjustment depends on shock size, exchange rate regime, access to international markets, and fiscal buffers.

### Box 3.2 — Comparative analysis of external adjustment in South America (selected points)
- Period t denotes the year in which the terms of trade begin to fall: t = 2012 for Chile, 2013 for Brazil, and 2014 for Bolivia, Colombia, and Ecuador.
- Example: the 32 percent depreciation of the Chilean peso against the U.S. dollar translated into a real effective depreciation of about 10 percent over the March 2013–March 2016 period.
- REER decomposition (equation (3.3.2)) identifies three sources of REER variation:
  - own nominal exchange rate change (ėi),
  - trading partners’ exchange rates (Σj wij ėj),
  - relative inflation dynamics (Σj wij ( ṗi − ṗj )).
- Empirical findings (March 2013 to March 2016):
  - Large bilateral depreciations against the U.S. dollar translated into proportionally smaller multilateral depreciations.
  - Countries maintaining stable nominal exchange rates against the dollar often experienced substantial real appreciation.
  - Venezuela: inflation explains an overwhelming share of the country’s REER appreciation.
- Alternative REER weights and competitiveness:
  - INS weights, direct export trade weights, and competitor-based weights produce different REER trajectories; e.g., Chile’s REER depreciation generally only half the magnitude when computed with respect to competitors rather than export destinations.
- Effects of depreciations on sectoral growth (Box 3.4):
  - Channels: export channel, cost channel (imported inputs), import-penetration channel.
  - Main quantitative result: a 10 percent real depreciation would increase growth of nontraditional sectors by 0.6 to 2 percentage points over three years (depending on the country), mostly through the export channel.
  - Cost channel evidence: inconclusive; import-penetration channel: statistically significant but small.
  - Comparative note: impact in Latin America is generally lower than in other regions but suggests depreciations can help diversification away from commodities.

### Empirical methodology and data (Annex highlights)
- PVAR framework details:
  - Vector of exogenous variables y_t* = (DD_i,t* , ToT_i,t), where DD_i,t* denotes quarter-over-quarter real GDP growth of G7 economies and China (PPP GDP-weighted average), and ToT_i,t denotes log first difference of terms of trade.
  - Domestic vector y_t = (DD_i,t , REER_i,t , TB_i,t ), where DD and REER denote log first differences of real final domestic demand and CPI-based REER, and TB is first difference of real trade balance as share of real GDP.
  - Panel: 38 countries covering 2000–16 at quarterly frequency.
  - Exchange rate classification based on 2015 IMF Annual Report on Exchange Arrangements and Exchange Restrictions.
- Export shares model and data treatment:
  - Trade data: UN Comtrade, SITC Revision 2, four-digit level, 1995–2015, using mirrored export data reported as imports (CIF) by destination.
  - Market share definition: S_ikt = ln( X_ikt / Σ_j∈J X_jkt ).
  - Final estimation sample: 134 countries; 761 four-digit products; total of 716,325 observations over 35,117 country-product groups.
  - Data cleaning exclusions: thresholds include $500,000 minimum flows, annual growth/shrinkage caps (growth > 1,000 percent, shrinkage > 95 percent), global market share percentiles (below first percentile –77 percent or above 99th percentile +579 percent), population cutoff (population < 1 million in 2010), and presence for at least 15 years between 1995 and 2015. These criteria exclude approximately 10 percent of available observations and less than 1 percent of total export value.

*Source: Regional Economic Outlook: Western Hemisphere, Chapter 3 (3. External Adjustment to Terms-of-Trade Shifts). International Monetary Fund | April 2017*

### 3. External Adjustment to Terms-of-Trade Shifts

### 3. External Adjustment to Terms-of-Trade Shifts

### Key findings
- Exchange rate flexibility has, to some extent, lowered the output cost of external adjustment to terms-of-trade shocks.
- The composition of external adjustment in Latin America indicates the income effect has been stronger than the expenditure-switching effect, but real depreciation in flexible regimes has supported adjustment by:
  - providing some boost to exports despite weak external demand, and
  - shifting demand from imports to domestic goods, lowering the compression of domestic demand while helping boost domestic production.
- Export elasticities vary widely across products; manufactures and textiles respond more strongly to real depreciations than commodities.
- In much of Latin America, where export baskets are concentrated in commodities, exchange rate flexibility tends to spur diversification and may support structural policies aiming at diversification.

### Historical perspective and stylized facts
- Based on 150 countries over the past half century, external current accounts:
  - deteriorate on impact of a large terms-of-trade decline,
  - then revert to initial levels over a period of three to four years as the real exchange rate depreciates.
- The recent terms-of-trade bust in Latin America:
  - largely driven by a decline in export prices rather than an increase in import prices,
  - featured quantity adjustment through import compression rather than rising exports.
- Argentina, Brazil, Chile, Colombia, Mexico, Peru exhibit differing historical trajectories; recent episode start dates cited include:
  - Argentina: September 2012,
  - Brazil, Colombia, Mexico: June 2014,
  - Chile, Peru: March 2013.

### Role of exchange rate regimes
- Countries with flexible exchange rate regimes fared better in the recent bust than those with more rigid regimes:
  - Countries with flexible regimes experienced real depreciation, trade balance improvements, smaller reductions in output, and less reserve loss.
  - More rigid regimes showed large real currency appreciations, widening current account deficits, and substantial reserve losses.
- The decline in exchange rate pass-through to inflation in Latin America may allow for larger currency depreciations in real terms (referenced as a factor).

### Quantitative analysis and mechanics of adjustment
- Methodology:
  - A panel vector auto-regression on a panel of 38 economies was used to estimate dynamic relationships between changes in the trade balance, domestic demand, and the real effective exchange rate to terms-of-trade shocks, controlling for external demand.
  - Episodes: a Markov regime-switching methodology identified 59 episodes of terms-of-trade busts over 1960–2016 (source Adler, Magud, and Werner 2017).
- Responses to a 10 percent fall in the terms of trade:
  - Large and significant trade balance improvements after one year across exchange rate regimes.
  - In flexible regimes, real currency depreciation boosted exports and reduced imports, indicating expenditure-switching.
  - A 10 percent reduction in the relative price of exports increased real exports by only 2 percent in one year but lowered real imports by close to 7 percent.
- Contribution of the real exchange rate:
  - The real exchange rate explains close to 50 percent of the response of the trade balance in economies with flexible exchange rate regimes in the recent episode, while playing a negligible role in countries with fixed exchange rate regimes.
- Domestic demand and sacrifice ratios:
  - Domestic demand contracted about two and a half times less in economies with more flexible exchange rates.
  - The sacrifice ratio (domestic demand compression required for the trade balance to improve by 1 percentage point of GDP) for economies with flexible exchange rate regimes is about half the ratio observed during previous episodes.
- Counterfactual analysis:
  - A scenario fixing the real effective exchange rate response at zero isolates the contribution from expenditure switching; comparing this to the unconstrained response quantifies expenditure-switching importance.

### Implications and interpretation
- Exchange rate flexibility has increasingly contributed to external adjustment by enabling expenditure-switching; its contribution has risen in recent years compared with the past when the income effect dominated.
- Exchange rate rigidity has become costlier for Latin American economies because real appreciations against major trading partners and regional competitors require larger domestic demand compressions for external adjustment.
- Given the predominance of commodity concentrations in many countries’ export baskets, exchange rate flexibility can support export diversification toward noncommodity products, which tend to be more responsive to real depreciations.

*Source: Regional Economic Outlook: Western Hemisphere, Chapter 3 (3. External Adjustment to Terms-of-Trade Shifts). International Monetary Fund | April 2017*

### 1. Trade Balance

### 1. Trade Balance

### Decomposition of Adjustment to a 10 Percent Reduction in the Terms of Trade
- Figure 3.7 decomposes responses among Latin American economies with flexible exchange rate regimes, 2000–16, to a 10 percent reduction in the terms of trade (TOT). Key components:
  - Expenditure switching through imports and through exports are highlighted as channels.
  - Sources used: Haver Analytics; IMF, World Economic Outlook database; and IMF staff calculations.
  - Note: ER = exchange rate; TOT = terms of trade.

### Exchange Rate Flexibility and the Sacrifice Ratio
- Exchange rate flexibility reduces the domestic sacrifice ratio of adjustment in Latin America (Figure 3.8).
- Reduction in domestic demand necessary to reduce external deficit by one percentage point of GDP (four quarters; percent) differs by regime:
  - Flexible ER regimes versus Managed ER regimes (figure axis values include –2.1 to 0.0).
- Contribution of income and expenditure switching effects to the sacrifice ratio (recent episode, countries with flexible exchange rate regimes) is illustrated:
  - Counterfactual scenario, Sacrifice ratio, Unconstrained scenario, Difference (figure axis values include –2.1 to 0.0).
- Findings:
  - The exchange rate acts as a shock absorber: despite large negative income effects during TOT bust episodes, exchange rate flexibility enables expenditure-switching effects that ease the burden on domestic demand and output growth.
  - Most of the adjustment observed has come through import compression rather than export expansion.

### Historical Decomposition of Real Exports During Recent TOT Bust
- Figure 3.9 shows historical decompositions of real exports during recent TOT busts with sizable unexplained factors.
  - For Argentina the period corresponds to 2012:Q3 to 2015:Q3; for Brazil from 2014:Q2 to 2015:Q4; for Chile and Peru from 2013:Q1 to 2015:Q4; and for Mexico from 2014:Q2 to 2015:Q4.
- Results:
  - External demand and terms-of-trade shocks are main drivers of recent export performance.
  - Except for Mexico and Argentina, exports appear to be underperforming, as suggested by unexplained components in model forecast errors.

### Do Depreciations Boost Short-Term Export Performance? — Product-Level Elasticities
- Method:
  - Uses product-level trade data to estimate elasticity of a country’s share in global exports of each product with respect to movements in its real effective exchange rate (REER).
  - Focuses on global market shares for four-digit products, assumed to have a single world price.
- Aggregate and cross-country elasticities:
  - The average country-product elasticity is about –0.13.
    - Interpretation: a 10 percent real depreciation increases the average country-product export share by about 1.3 percent with respect to its starting point.
  - The average product displays an elasticity of about –0.1.
  - Elasticities vary substantially across products: about two-thirds of 764 products see a depreciation boost the country’s export share; for most others the impact is statistically indistinguishable from zero.
- Regional patterns (Figure 3.10):
  - Emerging market economies display less responsiveness than advanced economies on average.
  - Latin America and emerging Asia, as well as advanced economies, show statistically significant responsiveness.
  - Emerging Asia’s estimated elasticity is about twice as large as that of the LA5.
    - LA5 defined as Brazil, Chile, Colombia, Mexico, Peru.
- Product-category patterns (Figure 3.11):
  - Manufactures and textiles display higher market share responsiveness than commodities, which respond little to REER movements.
  - Subcomponents of manufactures (chemicals, machinery and transport equipment, other manufactures) show broad-based responsiveness.
- Implications of export composition and GVC integration:
  - Economies specialized in commodities generally observe weaker responses to real depreciation than those concentrated in manufactured goods.
  - Manufactures have made up approximately 40 percent of total exports in Latin America and the Caribbean since 1990; their share in emerging Asia’s total exports has risen to 80 percent over the same period.
  - Participation in GVCs can reduce manufacturing export REER elasticity (Ahmed, Appendino, and Ruta (2016) estimate a 22 percent average reduction), and deeper GVC integration in emerging Asia partly explains larger elasticities there. However, participation in GVCs would, all else equal, tend to raise the relative export sensitivity of Latin America and the Caribbean versus emerging Asia, and thus is unlikely to account fully for the observed regional differences.

### Measured Effects of Recent Depreciations on Exports
- Estimated contributions of REER movements during 2013–15 to export values in 2014–16 (Figure 3.12), expressed as percent of 2012 export value:
  - Example outcomes:
    - Real depreciation of the Colombian peso since 2013 has boosted exports by 7.5 percentage points since 2012.
      - This boost is contrasted with a fall of nearly 40 percent in export value observed over this period.
    - Ecuador’s real appreciation has placed a drag on exports of more than 4 percentage points since 2013.
- Within-country heterogeneity:
  - Even when aggregate export responsiveness is low (e.g., Brazil), depreciations lead to larger market shares for many export products (Figure 3.13), indicating substantial inter-sectoral reallocation potential.

### Policy Implications
- Three main policy implications for Latin American economies facing the end of the commodity super-cycle:
  - Exchange rate flexibility reduces the sacrifice ratio of external adjustment.
    - Where currencies have depreciated in real effective terms, adjustment has benefited from somewhat stronger exports and output growth, and redirection of consumer spending from imports to domestically produced goods, reducing the burden on domestic demand compression.
  - The cost of exchange rate rigidity has risen in Latin America.
    - Where currencies move in sync with the U.S. dollar and strengthen against regional partners’ currencies, the sacrifice ratio has increased, implying larger output costs from external adjustment through sharper compression of domestic demand.
  - Exchange rate flexibility can support structural policies aimed at shifting resources to the noncommodity sector.
    - Depreciations boost exports of manufactures more than other goods, especially in regions with higher concentration of manufactures and adequate infrastructure.
    - Closing infrastructure gaps that support a dynamic manufacturing sector would reduce the sacrifice ratio of external adjustment going forward.

### Box Summaries
- Box 3.1 (Expenditure-Switching versus Income Effects):
  - A permanent negative terms-of-trade shock implies a negative income effect and, in equilibrium, a real exchange rate decrease.
  - The expenditure-switching effect: relative price changes increase exports and shift domestic consumption toward domestic tradable and nontradable goods, while overall consumption falls due to the income shock.
  - If expenditure-switching offsets the income shock, real depreciation can be expansionary; if income effects dominate, expenditure-switching only partially offsets the contraction.
- Box on Country Experiences (Chile, Colombia, Brazil, Ecuador, Bolivia):
  - Adjustment mechanics differ by exchange rate regime, access to external financing, and availability of fiscal space/buffers.
  - Chile and Colombia: exchange rate depreciation (real effective terms) supported expenditure-switching and cushioned the adjustment.
    - Currencies depreciated by 10 percent in Chile and 30 percent in Colombia in a two-year window from the onset of their shocks (figure references).
  - Brazil and Ecuador: narrowing of imbalances occurred via deep contractions in domestic demand; Ecuador relied on fiscal consolidation and import restrictions due to dollarization and limited access to financing.
  - Bolivia: accommodative fiscal policy and rapid credit growth smoothed the collapse in export prices but eroded buffers; some adjustment via import compression has started.
  - Conclusion: the extent of necessary adjustment depends on shock size, exchange rate regime, access to international markets, and fiscal buffers.

*International Monetary Fund | April 2017*

### Box 3.2. A Comparative Analysis of External Adjustment in South America

### Box 3.2. A Comparative Analysis of External Adjustment in South America

### Adjustment to Terms-of-Trade Shocks: Patterns and Examples
- Period t denotes the year in which the terms of trade begin to fall for each country: t = 2012 for Chile, 2013 for Brazil, and 2014 for Bolivia, Colombia, and Ecuador.
- Example: the 32 percent depreciation of the Chilean peso against the U.S. dollar translated into a real effective depreciation of about 10 percent over the March 2013–March 2016 period.
- Hydrocarbon and mineral export series are reported separately:
  - Hydrocarbon exports: Bolivia, Colombia, Ecuador.
  - Minerals exports: Chile.
  - Brazil: hydrocarbon and minerals.
- Non-hydrocarbon and non-minerals export series correspondingly: Bolivia, Colombia, Ecuador (non-hydrocarbon); Chile (non-minerals); Brazil (non-hydrocarbon and non-minerals).

### Real Effective Exchange Rate (REER) Decomposition and Interpretation
- REER measured as weighted average of bilateral real exchange rates; variation arises from three sources according to equation (3.3.2):
  - own nominal exchange rate change (ėi),
  - trading partners’ exchange rates (Σj wij ėj),
  - relative inflation dynamics (Σj wij ( ṗi − ṗj )).
- Key empirical findings (March 2013 to March 2016):
  - Large bilateral depreciations against the U.S. dollar translated into proportionally smaller multilateral depreciations (example above for Chile).
  - Countries maintaining stable nominal exchange rates against the dollar often experienced substantial real appreciation.
  - Contributions to REER changes (IMF decomposition): gray bars = bilateral ER; green bars = partners’ ER; blue bars = deflators.
  - Venezuela: inflation explains an overwhelming share of the country’s REER appreciation.
- Interpretation:
  - Pressure from trading partners (destinations and competitors) has reframed the link between exchange rate policy and competitiveness.
  - In countries with very large nominal depreciations, partners’ actions largely responsible for tapered REER response and relatively muted export response.
  - In countries with stable bilateral rates, large real appreciations reduced competitiveness.

### Alternative REER Weights and Competitiveness
- Alternative weight schemes discussed:
  - INS (Information Notice System) weights: incorporate both direct trade linkages and indirect competition.
  - Direct export trade weights: relative price of exports vs. goods produced in destination country.
  - Competitor-based weights: relative price of exports vs. competing exporters of the same products.
- Empirical pattern:
  - Latin America’s real exchange rates depreciated more with respect to direct trading partners than with respect to indirect competitors.
  - Example: Chile’s REER depreciation generally only half the magnitude when computed with respect to competitors rather than export destinations; for some top export products the Chilean peso has appreciated slightly with respect to competitors since 2013.
  - Contrast: Australia shows similar divergence; Malaysia shows less divergence between partners and competitors.

### Effects of Depreciations on Sectoral Growth (Box 3.4)
- Channels through which REER affects sectoral growth:
  - Export channel: depreciations increase competitiveness and may raise growth via higher exports.
  - Cost channel: depreciations make imported inputs more expensive, potentially reducing growth.
  - Import-penetration channel: depreciations raise the price of imported final goods, encouraging substitution toward domestic production.
- Empirical setup:
  - Difference-in-difference methodology on annual OECD data for 61 countries and 33 sectors, 1995–2011; sample includes Argentina, Brazil, Chile, Colombia, Costa Rica.
- Main quantitative result:
  - A 10 percent real depreciation would increase growth of nontraditional sectors by 0.6 to 2 percentage points over three years (depending on the country), mostly through the export channel.
  - Cost channel evidence: inconclusive.
  - Import-penetration channel: statistically significant but small in magnitude.
- Comparative note: the impact in Latin America is generally lower than in other regions but suggests depreciations can help diversification away from commodities in a low commodity price environment.

### Empirical Methodology: PVAR and Counterfactuals (Annex 3.1)
- Empirical framework: panel vector autoregression (PVAR) capturing dynamic responses of trade balance (share of GDP), domestic demand, and REER to terms-of-trade shocks.
- Identification assumptions:
  - Terms of trade taken as exogenously given.
  - External domestic demand growth treated as block exogenous.
- Model augmentation:
  - Interaction terms allow coefficients to vary with structural country characteristics (fixed vs flexible exchange rates), regional characteristics (Latin America and the Caribbean vs other economies), and sample periods (before/after recent terms-of-trade bust).
- Counterfactual exercise:
  - Constructed by holding REER response fixed at all forecast horizons to quantify the role of expenditure switching in external adjustment.
- Model specifics and data:
  - Vector of exogenous variables y_t* = (DD_i,t* , ToT_i,t), where DD_i,t* denotes quarter-over-quarter real GDP growth of G7 economies and China (PPP GDP-weighted average), and ToT_i,t denotes log first difference of terms of trade.
  - Domestic vector y_t = (DD_i,t , REER_i,t , TB_i,t ), where DD and REER denote log first differences of real final domestic demand and CPI-based REER, and TB is first difference of real trade balance as share of real GDP.
  - Data sources: national accounts from Haver Analytics; CPI-REER from IMF’s Information Notice System; terms-of-trade from Haver Analytics (Mexico from WEO).
  - Panel: 38 countries (listed in source) covering 2000–16 at quarterly frequency.
  - Exchange rate classification based on 2015 IMF Annual Report on Exchange Arrangements and Exchange Restrictions.

### Export Shares Model and Data Treatment (Annex 3.2)
- Trade data: UN Comtrade, SITC Revision 2, four-digit level, 1995–2015, using mirrored export data reported as imports (CIF) by destination.
- Market share definition: S_ikt = ln( X_ikt / Σ_j∈J X_jkt ).
- Estimated elasticity: relationship between market share and lagged REER (q_i,t−1), with interaction terms for category-specific elasticities.
- Weighting: weighted-least-squares with weights based on average shares in global exports (2009–2015) to obtain consistent granular elasticities.
- Data cleaning and exclusion thresholds:
  - Exclude country-product pairs smaller than $500,000 in a given year.
  - Exclude flows with growth > 1,000 percent or shrinkage > 95 percent in a year.
  - Exclude changes in global market share below first percentile (–77 percent) or above 99th percentile (+579 percent).
  - Exclude exporting countries with population < 1 million in 2010.
  - Exclude country-product pairs with positive export flows for fewer than 15 years between 1995 and 2015.
  - These criteria exclude approximately 10 percent of available observations and less than 1 percent of total export value.
- Final estimation sample: 134 countries; 761 four-digit products; total of 716,325 observations over 35,117 country-product groups.

*Source: Regional Economic Outlook: Western Hemisphere, Box 3.2 and related boxes/annexes, International Monetary Fund, April 2017.*

### 3. ExTERNAL AdjUsTMENT TO TERMs-Of-TRAdE sHIfTs

### 3. ExTERNAL AdjUsTMENT TO TERMs-Of-TRAdE sHIfTs

### References

- Adler, G., N. E. Magud, and A. Werner. 2017. “Terms-of-Trade Cycles and External Adjustment.” IMF Working Paper 17/29, International Monetary Fund, Washington, DC.
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*International Monetary Fund | April 2017*

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_Source: https://www.imf.org/-/media/files/publications/reo/whd/2017/may/wreo0517-chp3.pdf_