The External Balance Assessment Methodology: 2018 Update

The Level REER model in the External Balance Assessment (EBA) Methodology

“…Our approach combines insights from existing empirical work related to the time-series of REERs and to the cross-sectional variation of relative prices. The benchmark regression for the level REER is as close as possible to the one adopted for the earlier CPI index-based REER in the IMF EBA methodology (Phillips et al, 2013, andCubeddu et al, 2019). In addition, the framework builds on the theories of the drivers of relative price-level differences across countries, such as those underlying the Penn effect (GDP per capita and capital labor ratios).…”

“…A conceptual framework, explaining the channels through which each regressor affects the REER, is presented below, often indicating the consistency with the results of the same variables in the current account regressions. Indeed, the choice of the determinants is based on the key variables that have been essential in explaining the index-REER in the EBA methodology (see Phillips et al, 2013, andCubeddu et al, 2019) coupled with the variables that others (see Mano, 2017) find important understanding the cross-sectional variation of price levels (e.g. proxies for the Balassa-Samuelson effect and the Bhagwati-Kravis-Lipsey effect, and the level of VAT).…”

Japan’s Foreign Assets and Liabilities

“…When income credit flows are significantly larger than income debit flows, the income credit channel will dominate (as per the formula linking income credit and debit elasticities to the income balance semi-elasticity; see Annex 5). For Japan, applying income credit and debit ratios to GDP to the elasticities from Table 3 leads to an income balance semi-elasticity of -0.03 (versus trade balance semi-elasticities of -0.12 to -0.14 in Cubeddu et al, 2019). 21 The current account response to changes in REER in Japan would thus be only marginally larger when taking into account the income balance response, in addition to the usual trade balance response.…”

“…This method originally relied on panel regressions to estimate separately the elasticities of exports and imports, before combining them by using trade openness ratios (see e.g. Cubeddu et al, 2019). We extend the methodology in this paper to the income account, by decomposing income balance semi-elasticities into (i) the responsiveness of income flows to exchange rate; and (ii) the size of income flows.…”

“…Normative questions of whether Japan's external position is in line with fundamentals and desirable policies are outside the scope of this paper; see IMF (2020) for the latest assessment of Japan's external position.3 More recent estimates of trade elasticities using varying methodologies are presented inCubeddu et al (2019),Leigh et al (2017), and Colacelli (2010), among others.©International Monetary Fund. Not for Redistribution…”