1. Introduction to Financial Programming First Part
Macro - I
Introduction to Financial Programming
First Part

2. Outline of the session - Financial programming - Overview
- Real – Production Sector
- External Sector

3. Overview of financial programming
A financial programming framework combines what is happening (or likely to happen) in each sector of the economy (real/production, government, monetary and external) over one period of time (usually a year).
I allows to check for overall consistency.
It is mainly based on accounting identities (not much economic theory there) that hold for any economy.
e.g. Y = C + I + G + (X – M) ; CA = I – S
It also incorporates economic relationships that are not identities and depend on the behavior of individuals:
e.g. Impact of an appreciation of the currency on imports and exports ; impact of an interest rate increase on investment and saving ; …..

4. Overview of financial programming
A comprehensive financial programming framework is forward looking:
The emphasis is on the current and the few next years.
It may have longer horizon (up to 20 – 30 years when interested in medium-long term sustainability).
However, looking at the past is also important to understand economic behavior of individuals:
e.g. Impact of an appreciation of the currency on imports and exports ; impact of an interest rate increase on investment and saving ; …..

5. Overview of financial programming
Distinction between the four economic sectors:
What happens in one given sector has real and financial implications on the 3 others.
Policies (fiscal, monetary, structural) and shocks (internal or external) in a given sector have implications on the others.
Sector
« Table »
Real Sector
National Account
External Sector
Balance of Payments
Governement Sector
Government Financial Operation
Monetary Sector
Monetary Survey
Ajouter une slide avec 2 ou 3 exemples

6. Circular Flow of the Economy
Daraban, Bogdan. "Introducing the Circular Flow Diagram to Business Students." Journal of Education for Business 85.5 (2010):

7. Overview of financial programming
Main linkages between sectors
(not exhaustive)
Ajouter « general government

8. Overview of financial programming
How and for what is this framework used in practice?
1 - Create baseline / forecast for the next years, that is "consistent" in the sense that the economic activity can be “financed”:
In case of a budget deficit: is domestic and/or external financing (debt or grants) likely to be available?
In case of a current account deficit in the BoP, is external financing (debt or grants or FDI …) or domestic financing (FX reserves) likely to be available?
Are government revenue forecasts consistent with the projected economic growth?
Is private investment forecast consistent with funding by the banking sector …..
This is an important reality check …..as both the baseline and/or forecast should be realistic!

9. Overview of financial programming
2 – Evaluating the likely impact of various economic policies on the economy. The baseline must be prepared under the hypothesis that economic policy will remain the same for the next few years.
Policy scenario can then be performed in order to evaluate the impact on the economy of various policies:
Fiscal policy (e.g. change in government expenditure)
Budget financing (e.g. domestic borrowing vs external borrowing)
Monetary policy (e.g. an increase in short term interest rate to tame inflation)
…….

10. Overview of financial programming
3 - Detect short term vulnerabilities
- The framework helps assessing whether the economy is approaching a dangerous zone (low FX reserves, risk of “dollarization”, heavy reliance on short term and volatile external capital flows, level of investment too low or too high, high budget deficit ….).
- By performing scenario analyses: “What if ….”
Investors are losing confidence in the economy: FDI and portfolio flows are lower than expected, prompting a depreciation in the currency that could lead to inflation ….
There is an Ebola epidemic in the country requiring higher government expenditures and a partial shutdown of the economy thus reducing economic activity, including private income and government revenues ….
Ajouter un policy factor

11. Overview of financial programming
4 - Detect long term vulnerabilities (imbalances and unsustainable paths)
Typical examples:
Government debt sustainability
External debt sustainability

12. Overview of financial programming
4 sectors:
(i) Real – Production Sector ; (ii) External Sector ;
(iii) Government Sector ; (iv) Banking Sector
Examples are taken from IMF article IV reports (or equivalent) for two countries
- Ghana
- Cambodia
IMF tables follow the same structure across countries, whereas figures – graphs are country specific (so as to emphasize the important issues for the country).

13. Standard content of IMF Article IV report
Overview of financial programming
Standard content of IMF Article IV report

14. Other Country specific documents: - Debt Sustainability Analysis (DSA)
Overview of financial programming
Other Country specific documents:
- Debt Sustainability Analysis (DSA)
For public debt
For external debt
- Financial Sector Assessment Program (FSAP)
Other publications:
WEO (2/year)
Fiscal Monitor (2/year)
GFSR (2/year) +
Early Warning Exercise (not public)

15. Outline of the session - Overview of financial programming
- Real – Production Sector
- External Sector

16. Real – Production sector
Y = C + I + G + (X – M)
This accounting identity holds in value (current nominal currency) and in “volume” (real terms)
Y: GDP (Value added in the economy during one year)
C: Private Consumption of goods and services
I: Private Investment (of goods and services)
(not necessarily by residents)
G: Government Consumption + Government Investment (of good and services)
X: Export of goods and services
M: Import of goods and services
(X – M): “net exports”

17. In the Financing Programming Framework, emphasis is on:
Real – Production sector
In the Financing Programming Framework, emphasis is on:
- real economic growth
- nominal GDP
- Investment / GDP
- Inflation (CPI, and GDP deflator)
- Exports and Imports (nominal values and contribution to growth).

18. Useful tool: decomposing real growth
Real – Production sector
Useful tool: decomposing real growth
- Demand side: based on Y = C + I + G + (X-M).
What is the contribution of net exports, of private consumption … to economic growth?
- Supply side: based on industry activities
What is the contribution of the oil industry, of the construction sector … to economic growth?
- Production function approach:
What is the contribution of inputs (equipment, labor) and total factor productivity (TFP) to economic growth?

19. Sectorial Accounts and Macroeconomic Interdependences
Real Sector (4/4)
Usually, not much information on the real sector in IMF article IV reports (see World Bank).
Basic information is available at the top and the bottom of the “Selected Economic Indicators”.
(Does not mean that real sector is not looked at carefully)
Usually, growth forecast comes from industry-by-industry forecasts (supply side) with some impact of government expenditure, and FDI on economic activity (demand side).

20. Ghana, real sector Real – Production sector
Source: IMF, 2016, Program Review, Ghana

21. Cambodia, real sector Real – Production sector
Source: IMF, 2016, Article IV report, Cambodia

22. Overview of financial programming
Main linkages between sectors
(not exhaustive)
Ajouter « general government

23. Outline of the session - Overview of financial programming
- Real – Production Sector
- External Sector

24. Very important sector in the financial programming approach.
External Sector
Very important sector in the financial programming approach.
The initial mandate (in 1944) of the IMF was to monitor Balance of Payment (BoP) imbalances, lend money to and design adjustment program for, countries facing BoP crisis. At that time, exchange rates were fixed (the so-called “Bretton Woods System”) and international capital flows very limited.
BoP crisis at the time happened when a country became unable to pay for its imports because of (near-)exhaustion of its foreign exchange reserves (often due to years of BoP deficits).
The usual IMF recommendation was to “finance” (i.e. borrow) a temporary problem, but to “adjust” to a permanent problrm (through a mix a devaluation and structural reforms) so as to reach long-term sustainability.
Possible discussions with the class:
1 - Examples of permanent / temporary problems ?
2 - Is it always easy to know in real time wether the BoP difficulties are permanent or transitory ?
Adjustment is always difficult: country prefer to pretend that their problems are transitory / cyclical rather than permanent
3 – Why would a devaluation of the currency help with BoP?
4 – What kind of « structural » reforms might help with BoP ?

25. External Sector
What is a BOP ?
A statistical statement that systematically summarizes, for a specific time period (usually a year), the economic transactions of an economy with the rest of the world
The accounts are based on the residency of the agents ;
Transactions are valued at market prices ;
Unit of account : the national currency or a stable foreign currency.

26. Balance of Payments: Analytical Presentation
External Sector
Balance of Payments: Analytical Presentation
Current Account Balance (CAB)
Trade Balance good and services (X – M)
Investment income
Transfers
Private (including remittances)
Official (including EU grants)
Capital and Financial Account Balance (CFAB)
Direct investment (net)
Portfolio investment (net)
Medium and long term loans
Short-term capital
Errors and Omissions
Overall balance = CAB + CFAB + Errors and Omissions
Lot of time on this slide, explaining line by line what is in there, taking examples in the 3 example countries (Tunisia, Fiji and Ghana)
FDI and portfolio investment
Acquisition of equities  no contractual obligations  FDI does not add to external debt.
FDI involves not only a transfer of resources but also the acquisition of partial or full control.
Debt (loans and short term capital)
Contractual obligations  they add to gross external debt.

27. Foreign Aid in the BoP
Official Grants are registered as “Official Transfers” in the Current Account
Loans are registered as “Official Long-term Borrowing” in the Financial Account

28. A current account surplus is reflected in
External Sector
CAB is always matched by a change in net claims on the rest of the world.
CAB + CFAB = Change in FX reserves
A current account surplus is reflected in
an increase in claims on the rest of the World
and/or an increase in FX reserves
A current account deficit is reflected in
an increase in country’s net liabilities with the rest of the world
and/or a decline in FX reserves
Have the students check for the 3 example countries that this is indeed the case

29. Ghana, external sector External Sector
Source: IMF, 2016, Program Review, Ghana

30. Ghana, external sector External Sector
Source: IMF, 2016, Program Review, Ghana

31. Ghana, external sector External Sector
Source: IMF, 2016, Program Review, Ghana

32. Cambodia, external sector
Source: IMF, 2016, Country report, Cambodia

33. Cambodia, external sector
Source: IMF, 2016, Country report, Cambodia

34. Cambodia, external sector
Source: IMF, 2016, Country report, Cambodia

35. Investment, Saving and the Current Account
External Sector
Current Account and the Real Sector
Investment, Saving and the Current Account
Gross Domestic Product
GDP = C + I + GC + GI + (X-M)
Gross National Domestic Income
GNDI = C + I + GC + GI + (X-M) + YF + TRF
YF : Factor income (net)
TRF : Official and private transfers (net)
GNDI – (C +GC) – ( I+ GI) = (X-M) + YF + TRF
S – I = CAB
Have the class check in the selected indicator table of the 3 example countries that the identity holds.
Discussion with the class :
Examples of countries with positive current account
Examples of countries with negative current account
Is it good or bad to run a negative current account ? (of course …it depends !)

36. External debt accumulation:
External Sector
External debt
External debt accumulation:
Dt = (1+Rt-1) Dt-1 + Bt  At
D : stock of debt
R : interest rate on debt
B : new loans
A : amortization of debt
Inter-temporal Constraint:
If a country is net debtor, it will have to run a current account surplus in the future.
A country is solvent when the present discounted value of future CA balances is not less than current external debt. An analysis of solvency requires
Forecasting future CA balances
Assumptions about future policies
The current stance of policies is sustainable if they do not lead to insolvency.

37. External debt sustainability
External Sector
External debt
External debt sustainability
The external debt is sustainable if future debt service obligations can be met without rescheduling debt or seeking debt relief.
In their debt sustainability analysis, the IMF and the WB use various indicators / threshold to assess external debt sustainability
(More on debt sustainability in lecture 2)
Indicator
Threshold
Present value of debt / GDP
40%
Present value of debt / Exports
50%
Present value of debt / government revenue
250%
Debt service / exports
20%
Debt service / government revenue
Indicators of external debt burden:
Concept: Ratio of Net Present Value (NPV) of all future debt service obligations to NPV of all future export receipts
Practice:
(i) (scheduled) debt service / exports
(ii) interest payments / exports
(iii) outstanding debt / GDP

38. External (public) debt, Cambodia
External Sector
External (public) debt, Cambodia
Indicators of external debt burden:
Concept: Ratio of Net Present Value (NPV) of all future debt service obligations to NPV of all future export receipts
Practice:
(i) (scheduled) debt service / exports
(ii) interest payments / exports
(iii) outstanding debt / GDP

39. Foreign Exchange Reserves and the exchange rate regime:
External Sector
Foreign Exchange Reserves
Foreign Exchange Reserves and the exchange rate regime:
Under fixed exchange rate, RES is determined by the net demand or supply of foreign exchange.
Under pure float, RES = 0  CAB = – CFAB
Role of FX Reserves
Financing (temporary) BOP deficits
Supporting an exchange rate peg
Sustaining confidence in the domestic currency and the economy

40. Usefulness of FX reserves
External Sector
Foreign Exchange Reserves
FX Reserve Adequacy
Usefulness of FX reserves
Reserves act as an insurance cover to smooth (i.e. finance) temporary fluctuations in capital flows (rather than having disruptive changes in domestic absorption).
A high level of reserves gives confidence and reduces incentives for speculation.
FX reserves: return and cost
FX reserves have a financial return (depending on the global interest rate)
FX reserves have an opportunity cost (investing in the economy)
… can complicate Monetary Policy (more on that when discussing the monetary sector)

41. External Sector
Foreign Exchange Reserves
FX Reserve Adequacy Traditional indicator : Reserves in months of imports = Gross international reserve at end-period / average monthly import bill  ( 3) Large and volatile international capital flows have reduced the relevance of the traditional indicator. The capital account crises of the late 90s made clear that the appropriate level of reserves cannot be assessed without reference to the capital account.

42. Exchange rate regime and the credibility of authorities’ policies
External Sector
Foreign Exchange Reserves
FX Reserve Adequacy
Additional indicators for reserve adequacy focus on ‘financial vulnerability’ include
Exchange rate regime and the credibility of authorities’ policies
Openness of the economy (to trade and capital flows)
Variability and volume of foreign exchange transactions
Country’s access to short-term borrowing facilities
Maturity structure of liabilities (ability to cover short term debt (less than one year))

43. Role of short-term debt and capital flight
External Sector
Foreign Exchange Reserves
Role of short-term debt and capital flight
From: IMF, Assessing Reserve Adequacy (2011).

44. External Sector
Foreign Exchange Reserves

45. External Reserve adequacy, Cambodia
External Sector
External Reserve adequacy, Cambodia
Source: IMF, 2016,Country report, Cambodia

46. External Reserve adequacy, Ghana
External Sector
External Reserve adequacy, Ghana
A standardized approach assesses Ghana’s gross reserves to be below adequate levels. Following Dabla-Norris et al. (2011), the net benefit of holding reserves is calculated based on the expected cost of a crisis given the stock of reserves, fundamentals (exchange rate regime, fiscal balance, institutions), exposure to shocks (external demand, FDI, aid), and the opportunity cost of holding reserves, quantified as the “normal” range of the interest differential over 10-year U.S. bonds (300 to 400 bps).
The approach suggests that Ghana’s international reserves should have covered months of imports in 2013, under the 50 percent default probability of a shock. Reserves should be higher ( months of imports) for a shock probability of 60 percent. In the medium term, with a stronger fiscal position, reserves are expected to exceed benchmark levels.
Source: IMF, 2014, Article IV report, Ghana

47. Main linkages between sectors (not exhaustive)
Ajouter « general government

48. Thank you