## 070212

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### Global Current Account, 2001-11 — recent evolution and vulnerabilities
- Current account divergences described as "a significant vulnerability" and "about double those estimated as consistent with fundamentals and desirable policies."
- Divergences peaked at "some 3 percent of global GDP in 2006."
- Estimated external imbalances fell after asset price collapses, sudden stops of trade and capital flows, lower commodity prices, and a global recession.
- In the two years prior to the Report, current account divergences "have widened modestly" as commodity price increases raised surpluses for oil exporters.
- Euro area external position: "close to balance" overall but masks "substantial divergences"—notably Germany with a very large surplus and Spain (and to a lesser extent Italy) with deficits—financed primarily from within the union.
- Real effective exchange rates since 2007:
  - "real effective exchange rates of major surplus regions—China, oil producers, and Japan—have tended to appreciate."
  - Most advanced-economy currencies depreciated (except commodity producers such as Canada and Australia); some emerging markets saw higher REERs.
  - Flight-to-safety dynamics produced significant depreciations in some smaller advanced economies and major emerging markets (examples: Australia, Brazil, Mexico, India, Poland, and South Africa), largely offset by appreciations in the yen and, to a lesser extent, the dollar.
- Adjustments and projections:
  - Global current account divergences in 2011 would increase somewhat if adjusted for global output gaps and an expected fall in the price of oil in line with market expectations.
  - WEO (April 2012) projections: rising China surpluses as demand recovers in major advanced economies would more than offset a fall in surpluses of oil producers; recovery-driven larger external deficits in major deficit countries such as the United States would only partly offset lower oil import costs.
  - As of 2011, "many economies covered in this Report would have at least modest estimated external imbalances."
  - Expected medium-term policy changes are likely to have "only modest effects on current account divergences out to 2017."

### Drivers of imbalances
- Mixed drivers: fundamentals, fiscal positions, reserve policies, capital flow management measures.
- Major advanced economies (United States, Euro area, Japan):
  - Differing current accounts, exchange rates, and net capital flows "appear to largely reflect different fundamentals."
  - "Large fiscal deficits" are a primary factor making current accounts weaker-than-desirable and exchange rates somewhat overvalued.
  - Japan: "sending funds abroad to finance the future retirement of a significant share of its population."
  - United States: "a net borrower on world financial markets."
  - Euro area: "somewhere between the two extremes on all counts."
- Emerging market patterns:
  - Private sector typically receives net capital inflows in "1–5 percent of GDP" range, except oil exporters.
  - China and rest of emerging Asia: net private inflows more than offset by reserve accumulation, producing surpluses.
  - Some surpluses reflect high savings or low investment; deficits in emerging Europe, Latin America reflect muted reserve accumulation that only partially offsets private inflows.
  - Oil exporters: large surpluses from high oil prices, offset by private capital outflows and reserve accumulation.

### Mechanisms and amplification of vulnerabilities
- Cheap foreign financing amplified investment booms, creating domestic asset bubbles and subsequent busts.
- Spillovers from financial busts occur principally through financial contagion and through trade channels (especially spending on traded durable goods).
- Estimated external imbalances were "several times those justified by fundamentals and desirable policies" and thus "facilitated the buildup in global vulnerabilities."

### Policy implications and priorities
- Decisive policy actions required; imbalances "likely to remain well above desirable levels without decisive policy actions."
- Deficit economies: rein in fiscal deficits; limit asset-price excesses; address lax financial supervision.
- Surplus economies resisting adjustment: reduce capital controls, end reserve buildup, allow greater exchange rate flexibility, address structural policies (e.g., social protection) reinforcing surplus positions.
- Euro area: "substantial real and financial rebalancing" needed internally across member states; bloc rebalancing with rest of world is "much more modest."

### Strong external positions in Germany, the Nordics, and most of Asia — offsets and regional patterns
- Countries with current accounts stronger than and REERs undervalued compared to fundamentals and desirable policies include:
  - Germany, Sweden, the Netherlands
  - China, Indonesia, Malaysia, Singapore, Thailand, Korea
- These surpluses are offset by weaker current accounts and overvalued REERs in:
  - Brazil, Turkey, Russia, South Africa
  - United States, Japan, United Kingdom, Canada, Australia
  - Within the Euro area: Spain, Italy, France
- Exchange rate regimes and capital flow measures:
  - Emerging Asia: rapid reserve accumulation + supporting capital restrictions; limited nominal effective exchange rate fluctuations.
  - Middle East: pegged exchange rates with limited nominal fluctuations.
  - Latin America and emerging Europe: more open capital accounts and volatile nominal effective exchange rates despite active policies.
  - Volatility measured as standard deviation of monthly log returns; capital flow restrictions based on broad de jure restrictiveness index.

### Net international investment positions and capital flows
- Private sector is a net debtor in all emerging market regions; China’s overall net investment position is in surplus because private sector debts are more than offset by reserve holdings.
- Latin America and emerging Europe: significant debts remain even once reserves are included.
- Main counterpart to large reserve holdings in many emerging markets: substantial net portfolio debts in the United States and in the Euro area.
- Capital flows:
  - Flows have in some cases moved "uphill" from poorer emerging economies to richer advanced economies.
  - Reserves largely comprise liquid short-term paper; buildup created high demand for debt securities supplied by increased fiscal deficits in major advanced economies.

### Policy measures to move current accounts toward fundamentals
- Ambitious medium-term policies and significant real exchange rate realignments likely required.
- Fiscal adjustment in deficit countries of the order of 4 percent of GDP on average is estimated to play a significant role in reducing imbalances.
- Structural policies matter more: more flexible product and labor markets, changing social protection to reduce precautionary saving, reducing foreign exchange intervention and removing unwarranted capital flow management measures where relevant.
- Planning for ambitious policy changes should begin now, even if implementation is gradual.

### Adjustment dynamics, global consumption, and Euro area internal rebalancing
- Exchange rate implications: lowering external imbalances likely implies appreciations in surplus economies relative to deficit ones.
- Post-crisis pattern: consumption fell rapidly in deficit countries with little corresponding boost in surplus countries → large global output gap, smaller observed current account divergences, little change in underlying distortions.
- Euro area specifics:
  - Internal divergences since 1999: region-wide current account near zero masked internal imbalances that peaked at close to 3 percent of Euro area GDP.
  - Germany: unit labor costs fell by almost 20 percent against the rest of the union since 1999.
  - Orderly reversal requires long period of lower inflation, slower output growth, lower wage growth, and higher relative productivity increases in the periphery; surplus countries would need to run relatively higher inflation within the monetary union for some time.
  - Fiscal and structural reforms across the union are required to narrow external imbalances and support transition.

### Financial risks, capital flow volatility, and push factors
- Gross cross-border capital flows dropped by around 15 percent of advanced and emerging market GDP after Lehman’s collapse.
- Four-fifths of capital flows involve transactions between major advanced economies.
- Net emerging market inflows (excluding reserve accumulation) peaked at some 4 percent of emerging market GDP before the crisis, experienced a sudden stop, then surged back close to pre-crisis 2007 levels before tailing off.
- Expansionary monetary policy in the United States and elsewhere reduces domestic credit crunch risks but "leaks abroad," causing negative spillovers via risk-on/risk-off capital flows that amplify fluctuations in emerging market capital flows.
- Destinations and composition:
  - Inflows cluster: Brazil, China, India, Mexico and Turkey accounted for about 90 percent of net flows to emerging markets in 2010–11.
  - China receives about one-third of global flows to emerging markets.
  - Bond market inflows to emerging markets rebounded to record levels; net "other" inflows (bank loans) reversed and turned positive after the crisis before falling again in late 2011 as Euro area banks deleveraged.
  - Growing share of debt-creating flows increases vulnerability to credit booms and sudden stops.
- Regional notes:
  - Latin America and China: preeminent recipients of post-crisis flows; Latin American inflows at a record.
  - Central and Eastern Europe: inflows remain depressed—only half the value seen at end of the boom.
  - Russia: capital outflows since 2008 due to political uncertainty, weak investment climate, and global risk aversion.

### Policy issues and recommendations
- Fiscal consolidation and structural reforms can alter global external positions and reduce imbalances.
- Fiscal consolidation in many advanced economies will strengthen their current accounts and reduce divergences; relative adjustment of structural fiscal balances matters for medium-term external imbalances.
- In the Euro area:
  - Current plans involve larger medium-term consolidations in deficit countries than in surplus countries.
  - Surplus countries could help support demand through a slower pace of fiscal consolidation.
  - Restoring competitiveness in the periphery requires wage adjustment, labor and product market reform in deficit countries, surplus countries running relatively higher inflation for some time, and financial reforms to develop effective financial stability frameworks.
- Reserves and exchange rate policy:
  - In many emerging markets reserve levels appear more than adequate; one-way intervention should likely end.
  - One-way intervention should be replaced by greater exchange rate flexibility combined, if appropriate, with some two-way intervention to smooth currency fluctuations.
  - Policy responses to surges and volatility should consider a country’s cyclical position, exchange rate valuation, and reserves adequacy.
  - Most emerging markets appear to have adequate reserves, exchange rates not clearly overvalued, and few signs of overheating—suggesting use of monetary policy and exchange rate flexibility, supported by medium-term fiscal plans; capital flow measures and prudential measures can be appropriate in some circumstances but should not substitute for macroeconomic adjustment.
- Structural policies and social protection:
  - Limited social protection drives precautionary household saving and larger national saving.
  - After adjusting for development and demographics, countries with lower social protection (proxied by public health spending) tend to have significantly larger external surpluses.
  - For some major surplus countries, improving social protection over the medium term is an important priority to reduce precautionary household saving and lower global imbalances.
- Capital account liberalization:
  - Carefully loosening capital account restrictions over time can reduce external imbalances if accompanied by stronger global financial regulation, deepening of local financial markets, and appropriate supervision and regulation.
  - Medium-term impact depends on country circumstances; careful reduction with supervision and financial deepening should improve allocation of global saving and lower vulnerabilities.

### Other policy distortions and examples
- Other distortions beyond exchange rate policy explain unsustainably large surpluses and deficits:
  - Need comprehensive labor and product market improvements to boost productivity (example: Euro area periphery).
  - Improve investment environment (example: parts of Southeast Asia).
  - Reduce subsidies to factor inputs (example: China).
- Euro area single currency example: reduced real interest rates in peripheral countries produced booms without equivalent improvements in market flexibility or financial supervision, contributing to large imbalances and crisis.

### EBA Methodologies — overview and mechanics
- EBA comprises three methods: two regression-based methods and one model-free sustainability approach.
- Fundamental innovation: sharper distinction between positive (descriptive) and normative evaluations:
  - Stage 1 (descriptive): panel regressions to understand current accounts and real exchange rates.
  - Stage 2 (normative): uses regression results to estimate contributions of several "policy gaps" to current accounts and real exchange rates.
- Current account regression-based approach produces Total CA Gaps; real exchange rate regression-based approach produces Total RER Gaps.

### Current account panel regression (Stage 1) — sample, key regressors, and findings
- Sample: panel regression of current account/GDP ratios for some 50 advanced and emerging market economies, accounting for about 90 percent of world GDP; estimation sample 1986–2010.
- Cyclical and structural regressors included: demographics, relative per capita income, income growth, lagged ratio of net foreign assets (NFA) to GDP, output gap, commodity terms of trade gap, global capital market conditions (VOX index).
- Policy variables included: cyclically-adjusted fiscal balance, social protection spending (proxied by public health spending/GDP), capital controls, FX market intervention (proxied by changes in foreign exchange reserves).
- Empirical regularities:
  - Countries aging more rapidly, richer, and growing more slowly are more likely to have a current account surplus.
  - L. NFA/GDP coefficient positive but small.
  - Output Gap coefficient negative: Output Gap -0.4 ***
  - Cyclically Adjusted Fiscal Balance, instrumented 0.40 ***
  - L.Public Health Spending/GDP -0.7 ***
  - Capital Control Index ("Kcontrol") 0.03 ***
  - L. (NFA/GDP)*(dum=1 if NFA/GDP < -60%) -0.03 **
  - Oil Trade Balance/GDP (if >10%) 0.5 ***
  - L.VOX*(1-Kcontrol) 0.06 ***
  - L.VOX*(1-Kcontrol)*(currency’s share in world reserves stock) -0.2 ***
  - Own currency’s share in world reserve stock 0.003
  - Terms of Trade gap*Trade Openness 0.3 ***
  - Kcontrol*(Changes in Reserves)/GDP, instrumented 0.4 **
  - Financial Center Dummy 0.04 ***
  - L. Own per capita GDP/US per capita GDP (PPP) 0.04 ***
  - Dependency Ratio -0.03
  - Population Growth -0.4
  - Aging Speed 0.1 ***
  - Real GDP growth, 5-year ahead forecast -0.4 ***
  - Constant 0.003
- Regression statistics:
  - Observations 1099
  - R-Squared 0.61
  - Number of countries 50
  - Estimation: 1/ GLS with panel heteroskedasticity corrected standard errors.

### Stage 2 — policy gaps, benchmarks, and Total CA Gap calculation
- Policy benchmarks:
  - Fiscal policy: recommended cyclically-adjusted fiscal balance from country desk.
  - Social protection: benchmark from regression of public health spending/GDP on PPP per capita and old age dependency ratio.
  - Capital controls: benchmark is cross-country average level of capital controls index (0.15 in 2010) or country’s actual level, whichever smaller.
  - Change in international reserves: observed 2011 change presumed appropriate except where reserves far exceed adequacy—there appropriate change set to zero.
- Calculation steps:
  - Policy gaps = observed policy − policy benchmark.
  - Contributions to current account = regression coefficients × policy gaps.
  - Total CA Gap = sum of policy gap contributions + regression residual.
  - Multilateral consistency checks adjust EBA results uniformly if small discrepancies arise (typically 0.2 percent of GDP).

### External sustainability (ES) approach — model-free method
- ES CA gap = projected medium-term CA (2017) − CA level that would stabilize NFA/GDP at a benchmark level.
- Benchmark practice: NFA/GDP set at latest observed (2010) for majority of countries, with exceptions for extreme cases.
- Steps:
  - Calculate CA/GDP that would stabilize NFA/GDP at benchmark.
  - CA/GDP gap = WEO projected (2017) CA/GDP (assuming closed output gaps, current real exchange rates, and current policies) less the NFA benchmark-stabilizing CA/GDP.
- ES approach is complementary to regression-based gaps but not directly comparable; both typically point in same direction for a country.

### Strengths, limitations, interpretation, and judgment
- Current account regression approach: often most informative but limited for countries with dominant special sectors (oil exporters, small financial centers); can yield large residuals.
- RER regression approach: useful when CA regression faces difficulties but can understate gaps due to forcing country gaps to average zero; sensitive to sample period and short-term currency movements.
- ES approach: most relevant for large NFA imbalances where appropriate NFA benchmark is clear.
- Residuals and judgment:
  - Regression residuals may reflect omitted policy distortions (e.g., financial regulation) and require country-level judgment to interpret.
  - EBA is a tool to inform assessments; it is not a mechanical assessment.

### Selection of economies and reserve adequacy metric
- 28 systemic economies plus Euro area analyzed (list of economies included in Appendix II provided in the Report).
- Reserve adequacy composite metric for emerging markets:
  - Potential drains included: short-term debt (STD), other portfolio liabilities (OPL), medium- and long-term debt and equity liabilities, broad money (M2), and exports (X).
  - Composite metric formulas:
    - Fixed: 30% of STD + 15% of OPL + 10% of M2 + 10% of X
    - Floating: 30% of STD + 10% of OPL + 5% of M2 + 5% of X
  - Interpretation: Reserves in the range of 100–150 percent of the composite metric are considered adequate for precautionary purposes; reserves much below 100 percent associated with larger consumption falls post-Lehman; levels above 150 percent result in minimal additional reduction in probability of exchange market pressure.

*External Sector Report, International Monetary Fund (excerpts summarized from content unit _070212)*

### 1.  Global Current Account, 2001-11 ____________________________________________________________ 4

### 1.  Global Current Account, 2001-11

### Background: recent evolution and vulnerabilities
- Current account divergences across countries are described as "a significant vulnerability" and "about double those estimated as consistent with fundamentals and desirable policies."
- After rising fairly continuously since the mid-1990s, current account divergences peaked at "some 3 percent of global GDP in 2006."
- Estimated external imbalances fell following asset price collapses that led to financial instability, sudden stops of trade and capital flows, lower commodity prices, and a global recession.
- In the last two years (relative to the Report), current account divergences "have widened modestly" as commodity price increases raised surpluses for oil exporters.
- The external position of the Euro area as a whole has been "close to balance" but masks "substantial divergences across the Euro area"—notably Germany with a very large surplus and Spain (and to a lesser extent Italy) with deficits—financed primarily from within the union and amplifying global financial instability.
- Real effective exchange rates since 2007: "real effective exchange rates of major surplus regions—China, oil producers, and Japan—have tended to appreciate." Most advanced-economy currencies depreciated (except commodity producers such as Canada and Australia), while some emerging markets saw higher REERs. Recent flight-to-safety dynamics produced significant depreciations in some smaller advanced economies and major emerging markets (examples given: Australia, Brazil, Mexico, India, Poland, and South Africa), largely offset by appreciations in the yen and, to a lesser extent, the dollar.
- Global current account divergences in 2011 would increase somewhat if adjusted for global output gaps and an expected fall in the price of oil in line with market expectations.
- WEO (April 2012) projections: rising China surpluses as demand recovers in major advanced economies would more than offset a fall in surpluses of oil producers; recovery-driven larger external deficits in major deficit countries such as the United States would only partly offset lower oil import costs.
- As of 2011, "many economies covered in this Report would have at least modest estimated external imbalances."
- Expected medium-term policy changes (announced policy actions such as fiscal consolidation) are likely to have "only modest effects on current account divergences out to 2017."

### Drivers of imbalances
- Current account divergences reflect a mixture of fundamentals, fiscal positions, reserve policies, and capital flow management measures.
- Among major advanced economies (United States, Euro area, Japan), differing current accounts, exchange rates, and net capital flows "appear to largely reflect different fundamentals" and "large fiscal deficits" are a primary factor making current accounts somewhat weaker-than-desirable and exchange rates somewhat overvalued.
  - Japan is characterized as appropriately "sending funds abroad to finance the future retirement of a significant share of its population."
  - The United States, with a younger population and better investment opportunities, is "a net borrower on world financial markets."
  - The Euro area is "somewhere between the two extremes on all counts."
- Emerging market regions display more diverse patterns not easily explained solely by fundamentals:
  - Emerging market private sector typically receives net capital inflows in a fairly narrow range ("1–5 percent of GDP"), except oil exporters recently.
  - Current account surpluses in China and (to a lesser extent) the rest of emerging Asia reflect that net private inflows have been more than offset by reserve accumulation.
  - In some countries surpluses reflect high savings (possibly from policies shielding the financial sector from competition) or low investment.
  - Current account deficits in emerging Europe, Latin America, and other emerging markets reflect more muted reserve accumulation that only partially offsets private inflows.
  - Oil exporters have large current account surpluses generated by high oil prices, offset by a combination of private capital outflows and reserve accumulation.

### Mechanisms and amplification
- External imbalances contributed to global vulnerabilities by reinforcing domestic asset booms and busts:
  - Cheap foreign financing amplified investment booms that created domestic asset bubbles and subsequent busts.
  - Spillovers from financial busts occur principally through financial contagion (see reference to a "2012 Spillover Report, forthcoming") and also through trade channels (especially spending on traded durable goods).
- The Report highlights that estimated external imbalances were "several times those justified by fundamentals and desirable policies" and thus "facilitated the buildup in global vulnerabilities."

### Conceptual framework and assessment approach
- Key definitions used in the Report:
  - Current account divergences: surpluses/deficits that differ across countries; may be appropriate or inappropriate.
  - External imbalances: the gap between actual current account balances and those estimated by staff to be consistent with fundamentals and desirable policies; they "reflect distortions and should be eliminated."
  - External position: overall assessment from external indicators used in the Report—current balances (and counterpart capital and financial account balance), international investment positions and exchange rates. Note: "for an external position weaker (stronger) than expected the exchange rate is stronger (weaker)."
- The Report adopts a multilateral and multistep approach (see Box 2 thought experiment):
  - First stage: compute cyclically-adjusted current account balances to account for output gaps.
  - Second stage: adjust for policies out of line with desirable policies (explicitly identified policies include fiscal deficits, capital controls, foreign exchange intervention and reserve accumulation; financial policy laxity may be captured as residual distortions).
  - The approach distinguishes between distortions arising in deficit countries and those arising when surplus countries resist adjustment (e.g., through capital controls or intervention), noting that reinforcing policies across countries can magnify imbalances.
- The Pilot External Sector Report combines bilateral staff analysis with multilateral models and aims to identify:
  - Which imbalances will abate over the cycle;
  - Which reflect policy distortions and potential vulnerabilities; and
  - Which are warranted by fundamentals.

### Illustrative quantitative points and charts referenced
- Figure 1: "Global Current Account, 2001–11" (All Countries: Actual Unadjusted Current Account, 2001–11) plotted as percent of world GDP and showing country/region series including China, Japan, Oil Exporters, Euro Area Surplus, United States, Euro Area Deficit, Other Surplus Countries, Other Deficit Countries, ROW & Discrepancy.
- Figure 2: Real Effective Exchange Rates (Jan 2007 – Jun 2012) for regional REERs weighted by market GDP, showing series for Advanced Economies (Japan, Other Advanced, Euro Area, United States), Emerging Asia & Oil Exporters (China, EM Asia excl China, Oil Exporters), and Other Emerging Markets (EM Latin America, EM Europe, Other EMs). Axes run approximately from 80 to 130 on the index over 2007–2012.
- Figure 3: Patterns of Current Account Balances and Capital Flows, 2005–11, showing Current Account, Capital Account, and Change in Reserves as percent of each country’s or region’s GDP for groupings including Euro Area, United States, Japan, Emerging Europe, Emerging Latin America, China, Emerging Asia excl China, Other Emerging Markets, Other Advanced Economies, Oil Exporters. (Source: IMF World Economic Outlook Database.)

### Key implications for policy (as discussed)
- Decisive policy actions are required to reduce estimated external imbalances, which are "likely to remain well above desirable levels without decisive policy actions."
- Policy priorities differ by country type:
  - Deficit economies: focus on reining in fiscal deficits and limiting asset-price excesses; address lax financial supervision.
  - Surplus economies that resist adjustment: reduce capital controls, end reserve buildup, allow greater exchange rate flexibility, and address structural policies (e.g., social protection) that may be reinforcing surplus positions.
- Within the Euro area: "substantial real and financial rebalancing" is needed internally across member states, while the bloc's rebalancing with the rest of the world is "much more modest."

*External Sector Report, International Monetary Fund (sections summarized: "Global Current Account, 2001-11")*

### 8.      Strong external positions estimated for Germany, the Nordics, and most of Asia offset

### 8.      Strong external positions estimated for Germany, the Nordics, and most of Asia offset weak positions in most non-Asia emerging markets and advanced economies

### Key findings on external positions
- Current accounts and real effective exchange rates (REERs):
  - Current accounts are estimated to be stronger than, and REERs undervalued compared to, levels consistent with estimated fundamentals and desirable policies in:
    - Germany, Sweden, the Netherlands
    - China, Indonesia, Malaysia, Singapore, Thailand, Korea
  - These surpluses are fully offset by weaker current accounts and overvalued REERs in:
    - Brazil, Turkey, Russia, South Africa
    - United States, Japan, United Kingdom, Canada, Australia
    - Within the Euro area: Spain, Italy, France
- Regional aggregation (Figure 4 and Figure 5):
  - ESR estimates reflect a range of bilateral and multilateral inputs, including models such as the External Balances Assessment and CGER.
  - Individual economy estimates show ranges of estimated differences for cyclically-adjusted current accounts (percent of GDP) and REERs (percent).

### Regional divergences in exchange rate regimes and capital flow measures
- Exchange rate and capital flow patterns (Figure 6):
  - Much of emerging Asia: rapid reserve accumulation plus supporting capital restrictions; limited nominal effective exchange rate fluctuations.
  - Middle East: pegged exchange rates have limited nominal effective exchange rate fluctuations.
  - Latin America and emerging Europe: more open capital accounts; experienced volatile nominal effective exchange rates despite active exchange rate policies.
  - Possible drivers of larger volatility in some emerging markets: shallower domestic financial markets.
  - Differences in capital market openness across countries may distort capital flows.
- Measurement notes:
  - Volatility measured as standard deviation of monthly log returns.
  - Restrictions on capital flows based on staff’s broad de jure restrictiveness index.

### Net international investment positions and reserve roles
- Persistence of surpluses and deficits visible in net international investment positions (Figure 7):
  - Private sector is a net debtor in all emerging market regions.
  - China: overall net investment position is in surplus because private sector debts are more than offset by reserve holdings.
  - Latin America and emerging Europe: significant debts remain even once reserves are included.
  - In other regions: private sector net positions and reserve holdings largely offset each other.
  - Main counterpart to large reserve holdings in many emerging markets: substantial net portfolio debts in the United States and in the Euro area.
- Figure 7 displays regional NIIP components in billions of US dollars for 2010:
  - Components shown include FDI, Portfolio, Reserves, Other for Advanced Economies and Emerging Markets subgroups (e.g., China, Oil Exporters, EM Asia excl China, EM Europe, EM Latin America, Other EMs, Euro Area, Japan, United States, Other Advanced).

### Capital flows and global allocation of savings
- Capital flows have in some cases flowed "uphill" from poorer emerging economies to richer advanced economies—difficult to justify by fundamentals and desirable policies.
- Reserve accumulation composition and effects:
  - Reserves largely comprise liquid short-term paper.
  - Buildup of reserves has created a high demand for debt securities.
  - Increased fiscal deficits in major advanced economies provided a ready supply of such securities.

### Policy implications for moving current accounts toward fundamentals
- Ambitious medium-term policies and significant real exchange rate realignments likely required (Figure 8; Figures 9 and 10 show individual economy results):
  - Fiscal adjustment in deficit countries of the order of 4 percent of GDP on average is estimated to play a significant role in reducing imbalances.
  - Structural policies play an even larger role: more flexible product and labor markets, changing social protection to reduce precautionary saving, and, in some cases, reducing foreign exchange intervention and removing unwarranted capital flow management measures.
  - Planning for ambitious policy changes should begin now, even if implementation is gradual.
- Quantitative summary from Figure 8 (group-level, 2011, percent of surplus or deficit countries’ GDP, based on mid-points of staff estimates):
  - Charts compare Actual, Cyclically Adjusted, and Desirable: Adjusted for Policies for Surplus Economies and Deficit Economies.
  - Policy contribution categories include Fiscal, Social Protection, Cap Controls & Intervention, and Other Distortions (policy contributions shown in a small range around -0.6% to 0.8% for groups).
- Individual-economy impacts (Figure 9):
  - Charts for each ESR economy show Actual, Cyclically Adjusted, and Desirable: Adjusted for Policies on 2011 current accounts (scale in percent of GDP; examples of axis breakpoints preserved exactly as in source charts: -5.0%, -2.5%, 0.0%, 2.5%, 5.0%, and larger scales for some economies such as Singapore, Malaysia, Netherlands, Russia, Sweden, Switzerland, etc.).
- Policy contributions to current account gaps (Figure 10):
  - Shows contributions by Fiscal, Social Protection, Cap Controls & Intervention, Other Distortions as percent of GDP (based on mid-point of staff estimates).

### Adjustment dynamics and global consumption patterns
- Likely exchange rate implications:
  - Lowering external imbalances is likely to imply appreciations of exchange rates in surplus economies relative to deficit ones.
- Post-crisis adjustment pattern:
  - Since the crisis, global adjustment followed a lopsided pattern: consumption fell rapidly in deficit countries with little corresponding boost in consumption in surplus countries (Figure 11).
  - Result: large global output gap, smaller observed current account divergences, but little change in underlying distortions.
- Policy emphasis:
  - With fiscal consolidation and private sector debt retrenchment slowing consumption recovery in deficit economies, surplus countries should embrace market signals that support domestic and global demand—one market signal being upward pressure on many surplus economies’ exchange rates to rebalance global consumption.

### Euro area: need for internal rebalancing and long adjustment
- Growing internal current account divergences within the Euro area since 1999:
  - Region-wide current account near zero masked internal imbalances; deficits in some periphery countries (e.g., Spain, Italy) and surpluses in core countries (e.g., Germany, Netherlands) peaked before the crisis at close to 3 percent of Euro area GDP.
  - Divergences evident in stretched gross and net external stock positions of periphery economies.
  - Some compression after the crisis due to import compression in deficit countries, but imbalances remain large (Figure 12).
- Adjustment constraints and required policies:
  - Absence of exchange rate channel implies prolonged and costly adjustment for output.
  - Persistent inflation and productivity differentials across countries noted (Figure 13).
    - Germany: unit labor costs fell by almost 20 percent against the rest of the union since 1999.
  - Orderly reversal requires long period of lower inflation, slower output growth, lower wage growth, and higher relative productivity increases in the periphery, even with supporting policies.
  - Surplus countries would need to run relatively higher inflation within the monetary union for some time to support rebalancing.
  - Fiscal policy: narrowing the gap in structural fiscal deficits between deficit and surplus countries would help close external imbalances.
  - Structural reforms: improve efficiency of labor and product markets to improve wage and inflation dynamics, make periphery more competitive, and raise growth.
  - Transition smoother if structural improvements in deficit countries are complemented by surplus countries allowing asset prices to respond to market signals and pursuing deregulation in the service sector.

### Financial risks: volatile capital flows driven by "push" factors
- Gross cross-border capital flows and crisis impact:
  - After Lehman’s collapse, gross cross-border capital flows dropped by around 15 percent of advanced and emerging market GDP.
  - This drop provided a conduit for spillovers to the rest of the world (Figure 14).
- Push factors and volatile flows to emerging markets:
  - Continued financial instability in core advanced economies (weak banks, high debt, slow recoveries, policy indecision) dampens desire to invest in core markets despite generous liquidity.
  - Flipside: plentiful but volatile capital flows to emerging markets attracted by better growth prospects, higher interest rates, and relatively stable financial systems.
  - Net emerging market inflows (excluding reserve accumulation) peaked at some 4 percent of emerging market GDP before the crisis, experienced a spectacular sudden stop, then a rapid surge back close to pre-crisis 2007 levels before tailing off (Figure 15).
  - Gross flows show similar patterns; inflows have come with unusually high market volatility.
- Role of expansionary monetary policy:
  - Expansionary monetary policy in the United States and elsewhere reduces domestic credit crunch risks but leaks abroad, causing negative spillovers via risk-on/risk-off capital flows as investors switch into or out of riskier assets, amplifying fluctuations in emerging market capital flows.
  - Providing incentives to invest in riskier assets, domestic and foreign, is an important channel through which expansionary monetary policy operates.
- Data sources referenced:
  - Figures use IMF International Financial Statistics, World Economic Outlook Database, EPFR Global, Annual Report on Exchange Arrangements and Exchange Restrictions, and staff calculations.

*Source: IMF Staff Calculations and figures as presented in the External Sector Report excerpt.*

### 19.      The macroeconomic impact and policy dilemmas from recent capital market instability

### 19.      The macroeconomic impact and policy dilemmas from recent capital market instability

### Key findings on incidence and channels
- Four-fifths of capital flows involve transactions between the major advanced economies.
- The macroeconomic effects of changes in sentiment are felt most keenly in smaller markets because they have shallower markets, smaller dedicated investor bases, less flexible exchange rates, and higher ratios of foreign ownership.
- Volatile flows mainly impact emerging market economies; the scale of inflows can pose substantial macroeconomic policy challenges requiring a wide range of policy tools, including, in some cases, capital flow management measures.
- Portfolio diversification, carry trades, and safe haven inflows have materially affected financial conditions in some advanced countries:
  - Advanced commodity producers with strong growth prospects and higher interest rates (Australia and Canada) have allowed their currencies to appreciate.
  - Japan has intervened on occasion to lower short-term volatility.
  - Switzerland switched from a floating regime to a one-sided peg—intervening to prevent the exchange rate from appreciating above €1.20—after a very sharp appreciation, with inflation turning negative and massive inflows; the credibility of the peg reduced the need for intervention and the external position appears broadly consistent with underlying fundamentals and desired policies.
- Bond market inflows to emerging markets rebounded to record levels as low bond yields in advanced markets prompted fixed income investors to move up the risk curve.
- Net “other” inflows (dominated by bank loans) reversed and turned positive after the crisis before falling again in late 2011 as Euro area banks deleveraged.
- The rise in bond inflows and the resumption of net bank inflows represent a shift away from the historical trend of a declining share of such “debt-creating” flows going to emerging markets.
- The growing share of debt-creating flows exacerbates possible future vulnerabilities: credit booms backed by cheap foreign money could be followed by sharp asset price corrections and sudden stops in foreign inflows with significant spillovers.
- Record inflows into Latin America and China appear to reflect market views of their relative attractiveness—“pull” factors.

### Destinations, composition, and regional concentration
- Inflows tend to cluster: Brazil, China, India, Mexico and Turkey accounted for about 90 percent of net flows to emerging markets in 2010–11.
- China now receives about one-third of global flows to emerging markets.
- Latin America and China are preeminent recipients of post-crisis flows—their share of gross inflows has more than doubled relative to the pre-crisis surge; Latin American inflows are at a record.
- Central and Eastern Europe: inflows remain depressed compared to the pre-crisis surge; inflows into central and eastern Europe are only half the value seen at the end of the boom.
- Russia has experienced capital outflows since 2008 reflecting political uncertainty, the weak investment climate, and changes in global risk aversion.
- Debt inflows show signs of diversion from the United States and the United Kingdom to smaller markets (Canada, Mexico, Australia, Sweden, Korea, Turkey), pushing up their exchange rates.
- Bank flows appear to have been diverted from the United Kingdom and Euro area to other advanced economies and emerging markets with relatively open capital accounts; Euro area banks’ repatriation of funds can create potential future instability (as happened in late 2011).
- Within the Euro area, reluctance of private investors to fund some governments and banks has resulted in major outflows of foreign private capital from the periphery, substituted by ECB liquidity through temporary repurchase agreements, producing large imbalances within the ECB’s Target 2 clearing system.
- Foreign direct investment flows have shifted within Asia: inflows have risen in China and India while Japan, Korea, Malaysia, and Thailand show increasing net FDI outflows—suggesting capital flows from middle and high income Asian economies to perceived new power houses within the Asian supply chain.

### Policy issues — overview
- Policy actions—including fiscal adjustment and structural reforms—can alter the global constellation of external positions and help to reduce external imbalances.
- Fiscal consolidation in many advanced economies will strengthen their own current accounts and reduce current account divergences in countries with large surpluses.
- In some emerging markets, reserves already appear adequate and greater exchange rate and macroeconomic flexibility would be appropriate.
- Structural reforms will be the most important factor in moving external imbalances toward fundamentals; like fiscal consolidation, structural reforms take time to implement and produce results.
- Strengthening financial regulation and supervision with cross-border coordination would help address imbalances.
- Changes in structural policies (including social protection) in China and a shift to greater exchange rate flexibility could have significant effects on other members of the Asian supply chain.

### A. Fiscal consolidation and external adjustments
- What matters for medium-term external imbalances is the relative adjustment of structural fiscal balances.
- The United States, Japan, the Euro area, and the United Kingdom represent well over half of world nominal output; improvements in their current accounts as fiscal consolidation boosts national saving will be offset by lower current account balances in countries that implement more modest consolidation.
- Adjustments should occur gradually over time; the rest of the world can probably absorb these spillovers relatively smoothly.
- In the Euro area:
  - Current plans involve larger medium-term consolidations in deficit countries than in surplus countries.
  - Surplus countries could help support demand through a slower pace of fiscal consolidation.
  - Restoring competitiveness in the periphery will require wage adjustment, labor and product market reform in deficit countries, surplus countries running relatively higher inflation for some time, and financial reforms geared towards developing an effective financial stability framework.

### B. Reserves, monetary and exchange rate policy, and capital flow measures
- In many emerging markets reserve levels appear more than adequate for precautionary purposes, and one-way intervention should likely end.
- With major advanced economies likely to maintain—and possibly expand—monetary easing, financial conditions are likely to remain choppy globally.
- Responses to surges and volatility in capital inflows have varied: emerging Asia is most prone to using intervention and longstanding capital flow management measures, followed by Latin America.
- In many ESR economies reserves are now either above, or at the upper end of, the Fund’s country-specific metric; one-way intervention should be replaced by greater exchange rate flexibility combined, if appropriate, with some two-way intervention to smooth currency fluctuations.
- There is scope to use macroeconomic policies, including exchange rate flexibility, to manage choppy capital inflows. Policies should consider:
  - a country’s cyclical position,
  - exchange rate valuation,
  - reserves adequacy.
- Many emerging markets appear to have adequate reserves, exchange rates that are not clearly overvalued, and few signs of overheating—placing most countries in sections a, b and e of the policy framework—suggesting:
  - use monetary policy and exchange rate flexibility to help manage capital flows;
  - support with appropriate medium-term fiscal plans;
  - capital flow measures and prudential measures can be appropriate in some circumstances as part of a toolkit, but should not substitute for adjustment in macroeconomic policies.

### C. Structural policies, social protection, and capital account liberalization
- Adjustments in social protection policies can help lower vulnerabilities from global external imbalances:
  - Limited social protection is an important driver of precautionary household saving, and hence national saving.
  - After adjusting for development and demographics, countries with lower social protection (proxied by spending on public health care) tend to have significantly larger external surpluses than those with higher protection.
  - For some major surplus countries, improving social protection over the medium term is an important policy priority; reducing precautionary household saving could lower global imbalances.
- Carefully loosening capital account restrictions over time can play a role in reducing external imbalances if accompanied by:
  - strengthening of global financial regulation,
  - deepening of local financial markets,
  - appropriate supervision and regulation.
- The medium-term impact of lifting capital account barriers depends on country circumstances; a careful reduction accompanied by supervision, regulation, and financial deepening should improve allocation of global saving and lower potential vulnerabilities.

*Source: IMF External Sector Report — “The macroeconomic impact and policy dilemmas from recent capital market instability”*

### 34.      Other policy distortions help to explain unsustainably large external surpluses and

### 34.      Other policy distortions help to explain unsustainably large external surpluses and deficits.

### Key diagnostic findings on policy distortions and external imbalances
- Other policy distortions—beyond exchange rate policy—help explain unsustainably large external surpluses and deficits.
- Staff identified needs for:
  - comprehensive labor and product market improvements to boost productivity (example: the Euro area periphery),
  - improvements in the investment environment (example: parts of Southeast Asia),
  - reductions in subsidies to factor inputs (example: China).
- The Euro area example: adoption of the single currency reduced real interest rates in peripheral countries, producing booms that were not accompanied by equivalent improvements in product and labor market flexibility (or financial supervision). The resulting external imbalances moved well in excess of those justified by fundamentals and contributed to a crisis with continuing global consequences.

### Appendix I. EBA Methodologies — overview and purpose
- The External Balance Assessment (EBA) methodology is developed by the Research Department as a proposed successor to the CGER exercise, revamping rather than discarding CGER.
- EBA comprises three methods, each based on its corresponding CGER predecessor:
  - two regression-based methods (panel regression-based),
  - one model-free sustainability approach.
- Fundamental innovation: sharper distinction between positive (descriptive) understanding and normative evaluations:
  - Stage 1 (positive/descriptive): estimates panel regressions to understand current accounts and real exchange rates.
  - Stage 2 (normative): uses regression results to estimate contributions of several “policy gaps” to current accounts and real exchange rates.

### EBA’s regression-based approaches — objective and outputs
- Current account regression-based approach → produces Total CA Gaps (sum of estimated contributions of several policy gaps and the regression residual).
- Real exchange rate regression-based approach → produces Total RER Gaps (analogous, based on real effective exchange rate panel regression and additional variables).

### Stage 1 — specification and estimation of the panel regression
- Sample and scope:
  - Panel regression of current account/GDP ratios for some 50 advanced and emerging market economies, accounting for about 90 percent of world GDP.
  - Estimation sample: 1986–2010, using annual data to uncover cyclical sources of current account behavior and to allow cyclical adjustment.
- Key regressors and empirical findings:
  - Demographics, relative per capita income, income growth: countries aging more rapidly, richer, and growing more slowly are more likely to have a current account surplus.
  - Oil trade balance included only if >10 percent of GDP.
  - The CA regression excludes the lagged current account but includes the lagged ratio of net foreign assets (NFA) to GDP.
    - General finding: countries with more positive NFA positions tend to have higher CA balances; the positive coefficient on NFA is small relative to average rates of return.
    - Regression allows nonlinear relationship with NFA; association flattens or disappears when NFA is far into the negative range.
  - Cyclical influences included: output gap, commodity terms of trade cycle/gap, global capital market conditions (VOX index).
    - Output gap: positive demand shock → output above potential → current account declines.
    - Rise in commodity terms of trade (cyclical element) → current account improvement.
    - Global capital market conditions (VOX): for non-reserve currency countries, a rise in global risk aversion → rise in current account; for reserve currencies, a rise → decline in current account.
  - Four policy variables included: cyclically-adjusted fiscal balance, social protection spending (proxied by public health spending/GDP), capital controls, FX market intervention (proxied by changes in foreign exchange reserves).
    - Results: higher current account balances associated with stronger fiscal positions, lower social protection, higher capital controls, faster reserves accumulation.
  - Interaction terms: e.g., VOX effect depends on reserve currency status and openness to capital flows; terms of trade effect depends on openness to trade; reserve accumulation effect depends on presence of capital controls.

### Table 1. EBA: Current Account Regression Results (Estimation Period: 1986-2010)
- Regression details and statistics:
  - Observations 1099
  - R-Squared 0.61
  - Number of countries 50
  - 1/ GLS estimates with panel heteroskedasticity corrected standard errors.
  - "L" stands for one-year lag of the respective variable.
  - * significant at 10%; ** significant at 5%; *** significant at 1%
- Estimated coefficients (as presented):
  - L. NFA/GDP 0.04 ***
  - L. (NFA/GDP)*(dum=1 if NFA/GDP < -60%)-0.03 **
  - Financial Center Dummy 0.04 ***
  - L. Own per capita GDP/US per capita GDP (PPP) 0.04 ***
  - Oil Trade Balance/GDP (if >10%) 0.5 ***
  - Dependency Ratio -0.03
  - Population Growth -0.4
  - Aging Speed 0.1 ***
  - Real GDP growth, 5-year ahead forecast -0.4 ***
  - L.Public Health Spending/GDP -0.7 ***
  - L.VOX*(1-Kcontrol) 0.06 ***
  - L.VOX*(1-Kcontrol)*(currency’s share in world reserves stock) -0.2 ***
  - Own currency’s share in world reserve stock 0.003
  - Output Gap -0.4 ***
  - Terms of Trade gap*Trade Openness 0.3 ***
  - Cyclically Adjusted Fiscal Balance, instrumented 0.40 ***
  - Capital Control Index ("Kcontrol") 0.03 ***
  - Kcontrol*(Changes in Reserves)/GDP, instrumented 0.4 **
  - Constant 0.003

### Stage 2 — identification of policy gaps and Total CA Gaps
- Essence: estimate contributions to observed current accounts of “policy gaps” corresponding to the four policy variables in the panel regression.
- Specification of normative policy benchmarks:
  - Fiscal policy: recommended level of the cyclically-adjusted fiscal balance provided by the country desk (typically medium-term recommendation).
  - Social protection/public health spending: benchmark from regression of public health spending/GDP on PPP-based GDP per capita and demographics (PPP per capita and old age dependency ratio explain 80 percent of the variation in health spending).
  - Capital controls: benchmark is the cross-country average level of the capital controls index (0.15 in 2010, out of a range from 0 to 1), or a country’s actual level, whichever is the smaller.
  - Change in international reserves: generally presume observed change in 2011 was appropriate, except for countries with reserves far in excess of suggested adequacy range—appropriate change specified as zero in those cases.
- Calculation:
  - Policy gaps = observed policy − policy benchmark.
  - Contributions of policy gaps to current account = regression coefficients (Stage 1) × corresponding policy gaps.
  - Total CA Gap = sum of policy gap contributions + regression residual.
  - Multilateral consistency check: any discrepancy (typically 0.2 percent of GDP) used to adjust EBA results uniformly across countries for exact consistency; similar checks and small adjustments applied to each of the four policy gap contribution estimates.

### Treatment of omitted policies and multilateral considerations
- Certain policies (e.g., financial regulation) may influence the current account but are not explicitly measured; their effects likely appear in the regression residual and thus in the Total CA Gap.
- Policy gap contributions are measured on a relative basis; a country with no “own” fiscal policy gap could still experience a CA contribution stemming from fiscal policy gaps of other countries. Policy gap contributions may be of foreign and/or domestic origin.

### External sustainability (ES) approach — model-free perspective
- ES approach: CA gap = projected medium-term CA (2017) − CA level that would stabilize NFA/GDP at a benchmark level.
- Characteristics:
  - Model-free; not based on regression analysis.
  - Does not identify adjustments to bring CA or REER to an “optimal” level, nor does it identify an appropriate NFA/GDP level.
  - Requires assumptions about potential growth, inflation, and rates of return on external assets and liabilities, and selection of an NFA/GDP benchmark.
- Current benchmark practice:
  - NFA/GDP benchmark set at latest observed (2010) level for majority of countries.
  - Exceptions: economies with extremely high external liabilities, low external liabilities, or large exports of non-renewable resources have benchmarks modified (e.g., on basis of regional averages).
- Calculation steps:
  - Step 1: calculate CA/GDP that would stabilize NFA/GDP at the benchmark level.
  - Step 2: CA/GDP gap = WEO projected (2017) CA/GDP (assuming closed output gaps, current real exchange rates, and current policies—including those due to take effect between 2012 and 2017) less the NFA benchmark-stabilizing CA/GDP.
  - Where gap ≠ 0, the projected medium-term CA/GDP will not stabilize the benchmark NFA/GDP position.
- Complementarity and differences with regression-based gaps:
  - ES gap is complementary but not directly comparable to regression-based gaps.
  - Differences may arise from: (a) use of an NFA benchmark not equal to an optimal NFA level, (b) discrepancies between current policies and desirable policy mix, (c) unsatisfactory regression fit.
  - Nevertheless, the two gap types nearly always point in the same direction for a given country, though magnitudes may differ.
- ES approach may be especially informative when countries have large net debtor positions projected to grow over the medium term or when regression approaches face empirical challenges.

*Source: EXTERNAL SECTOR REPORT — Appendix I. EBA Methodologies (excerpts).*

### 30.      The three EBA approaches have relative strengths and limitations. While each can act as a

### The three EBA approaches have relative strengths and limitations. While each can act as a

### Strengths and limitations of the three EBA approaches
- Current account regression-based approach:
  - Often but not always the most informative and reliable of the three EBA approaches.
  - Limitations most apparent for countries with important or dominant “special” sectors, such as large oil exporters and relatively small economies that are financial centers.
  - For some countries, this approach yields very large regression residuals, and thus Total CA Gaps, which require further interpretation.
- Real exchange rate (RER) regression-based approach:
  - Especially useful where the current account regression approach faces particular difficulty.
  - Limitations: reduced reliability in countries with large productivity differentials or other large structural changes, as well as those with short data spans.
  - This method forces gaps for each country to average to zero over time, and the resulting RER gaps may be understated as a consequence.
  - RER gap estimates for the current year can be very sensitive to the length of the prior sample period used to analyze a given country.
  - Measured gaps can fluctuate quickly with short-term currency movements (a common problem across exchange rate assessment approaches).
  - Ongoing work: develop regression analysis based on estimates of real exchange rate levels, rather than time series of exchange rate indices that cannot be compared across countries, for a future EBA round.
- External sustainability (ES) approach:
  - Most relevant and informative for countries with large NFA imbalances and where there is a clear view of what a more appropriate NFA level would be.

### Interpretation, residuals, and role of judgment
- The two regression-based EBA methods are more ambitious than the ES exercise, taking account of many factors in regressions and using those as a base for normative evaluation.
- Despite technical advances, regression-based approaches cannot entirely overcome essential issues: a residual component often remains large and unexplained.
- Key interpretative challenge:
  - Determine whether the regression residual reflects the effects of distortions or of fundamentals on the CA and RER.
  - Additional information and judgment are needed to complete a normative analysis (an assessment) when standardized EBA regressions leave incomplete information.
  - In many cases, missing factors may be well known to experienced country analysts but not feasible to measure and include in the panel regression.
- EBA should be seen as a tool that provides useful estimates to inform assessments, not as a mechanical means of producing assessments themselves.

### Comparison with CGER
- Comparisons between EBA CA Gap estimates and CGER gaps are not straightforward due to methodological and conceptual differences:
  - Timing: EBA analyzes the most recently observed CA (after cyclical adjustments); CGER analyzed the CA five years into the future (as forecasted by country desks).
  - Regressors: EBA CA regression specification includes many more regressors than CGER, including policy and cyclical variables.
  - Lagged CA: CGER regression included the lagged CA itself; EBA regression does not. This is relevant where deficits or surpluses were sustained and unexplained by other variables—one reason CGER gaps may be smaller than EBA gaps in such cases.
  - Policy gaps: Unlike CGER (where the gap arose from the regression residual alone), the EBA Total CA Gap takes account also of the effects of policy gaps.
  - Concept and objective: EBA thus differs from CGER in method, concept, and objective of gap estimates.
- Empirical relationship:
  - There is a strong positive correlation, looking across countries, between EBA and CGER current account gaps, even though the sizes of the two gaps may differ for any one country.

### Appendix II — Selection of Economies Included in the Report (28 systemic economies and Euro area)
- The 28 systemic economies and Euro area analyzed in detail in this Pilot Report:
  - Australia
  - Belgium
  - Brazil
  - Canada
  - China
  - Euro area
  - France
  - Germany
  - Hong Kong SAR
  - India
  - Indonesia
  - Italy
  - Japan
  - Korea
  - Malaysia
  - Mexico
  - Netherlands
  - Poland
  - Russia
  - Saudi Arabia
  - Singapore
  - South Africa
  - Spain
  - Sweden
  - Switzerland
  - Thailand
  - Turkey
  - United Kingdom
  - United States
- Selection criterion: chosen on the basis of an equal weighting of each economy’s global ranking in terms of purchasing power GDP (as used in the Fund’s World Economic Outlook) and in terms of the level of nominal gross trade.

### Appendix III — Assessment of Reserve Adequacy (composite metric for emerging markets)
- Concept:
  - Composite adequacy metric reflects a broad range of potential pressures: external liabilities, current account variables, and a measure of capital flight.
  - The metric includes four specific sources of drains that play separate, essentially non-overlapping, roles.
- Potential sources included and rationale:
  - Exports: reflect potential loss from a drop in external demand or a terms of trade shock.
  - Short-term debt (at remaining maturity), medium- and long-term debt and equity liabilities: account for external liability stocks (short-term debt viewed as riskier; potential balance of payments needs from equity outflows mitigated by depreciation and falling equity prices).
  - Broad money: represents capital flight risk from the stock of liquid domestic assets that could be sold and transferred into foreign assets during a crisis.
- Construction of relative risk weights:
  - Based on observed outflows from emerging markets during periods of exchange market pressure.
  - Potential outflows computed from the distribution of the annual percentage loss of export income, short-term debt, other longer-term liabilities, and liquid domestic assets observed during such events.
  - Separate distributions for fixed and floating exchange rate regimes; final weights based on observed outflows at the tenth percentile.
  - Due to large uncertainty, “round-number” weights were ultimately used.
- Composite metric formulas:
  - Fixed: 30% of STD + 15% of OPL + 10% of M2 + 10% of X
  - Floating: 30% of STD + 10% of OPL + 5% of M2 + 5% of X
  - Where STD = short-term debt, OPL = other portfolio liabilities, M2 = broad money, and X = exports of goods and services.
- Reserve adequacy interpretation:
  - Reserves in the range of 100–150 percent of the composite metric are considered adequate for precautionary purposes.
  - Countries with reserves much below 100 percent of the metric generally suffered larger consumption falls during the post-Lehman crisis.
  - Estimates suggest reserve levels above 150 percent of the composite metric result in minimal reductions in the probability of an emerging market facing exchange market pressure.

*Source: External Sector Report (excerpt).*

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