Large Current Account Deficits and Currency Boards

A new working paper from IMF on Bosnia and Herzegovina’s trade balance and discusses the trade-offs between monetary and fiscal policy needed to improve current account deficit; the country’s external position has deteriorated even with strong fiscal tightening. The country has a currency board enshrined in the constitution. The policy implications of the model are noted below;

“The estimated model raises a number of policy issues. First, the impact of a given flow of total credit to the private sector on the trade balance depends strongly on the composition of that credit. The flow of credit to enterprises has a markedly smaller negative impact on the trade balance than that of credit to households. Thus, to the extent that credit flows are led by credit to households, the adverse impact on the external deficit will be larger. This result implies that (if it can be devised) a policy measure targeted primarily at restraining credit to households would be more effective in achieving a desired correction in the external deficit.

The estimated model also indicates that the policy variable with the most immediate impact on the trade balance is fiscal expenditure, followed by credit flows and then fiscal revenue. This suggests that when an immediate correction to the trade balance is needed, the preferred policy option should be fiscal expenditure restraint.

Regarding the relative power of fiscal or credit policy to reduce the trade balance, empirical projections were made using the model, where plausible quarterly paths of the regressors were generated for 2006, and the impact on the trade balance assessed. Given the already heavy burden of taxation, the assessment of fiscal policy focused on a fiscal tightening generated solely through expenditure restraint, while, for credit tightening, the impact of changes in the overall flow of credit to the private sector was considered, keeping the breakdown between credit to households and enterprises the same as observed in 2005. These experiments indicate that a fiscal tightening through a 1 percent of GDP reduction in expenditure over a one-year horizon generates a 0.45 percent of GDP reduction in the trade deficit, whereas a reduction in the flow of credit of 1 percent of GDP over the same horizon generates a 0.44 percent of GDP reduction in the trade deficit. Thus, fiscal expenditure and credit tightening appear to be roughly equally effective in achieving reductions in the trade deficit over a one-year horizon.

However, the currency board and open capital account in Bosnia and Herzegovina imply that it is very difficult to target a particular credit growth rate. Generally, to restrain credit one could either tighten the required reserves regime or tighten prudential regulations. But with the domestic banking system dominated by subsidiaries of foreign banks with access to ample liquidity from their parents, these instruments are typically ineffective. This leaves fiscal policy as the only instrument that can be precisely calibrated to affect the trade balance.

Thus, in practice most of the efforts to restrain demand over the near term should focus on fiscal policy. Over the long term, however, deep structural reforms would be needed to bring the trade deficit down to sustainable levels.”

The country has a complicated federal system with a constitution largely dictated by the US which further makes things difficult for the authorities.

Related;
Bosnia and Herzegovina - Addressing fiscal challenges and enhancing growth prospects:a public expenditure and institutional review