RDP 9705: The Response of the Current Account to Terms of Trade Shocks: A Panel-data Study 3. Counting Episodes

This section of the paper determines the relative frequency of episodes of positive and negative correlations between the current account and the terms of trade at frequencies of one and two years. The episodic methodology used here is useful because it does not presume that changes in the terms of trade within a country were always either entirely temporary or entirely permanent. Because of this, the results can be regarded as complementary to the regression analysis of Section 4.

3.1 Data Description

The data are from various sources – full details are provided in Appendix B. Series are annual from 1960 to 1994, although many countries have a much shorter sample period. I have included 128 countries in my sample. The countries are listed in Table A1 in Appendix A. The two variables introduced in this section are the current account balance (as a proportion of GDP) and the terms of trade. The terms of trade were constructed from the ratio of export to import price indices where possible, otherwise they were based on export and import unit value indices or on estimates provided by the World Bank. Despite the less than ideal data for some countries there was no reason to expect any systematic bias in the terms of trade series.

I leave a discussion of the important issue of stationarity until the estimation of the econometric model. At this stage, it is sufficient to point out that many countries in the sample appeared to have non-stationary terms of trade. This was dealt with in this section of the paper by transforming the data to ensure that variables are integrated of the same order (that is, stationary or I(0) variables). The terms of trade index for each country was transformed by demeaning the annual growth rate of the series. The current account (as a per cent to GDP) was transformed by demeaning the first difference of the series.

3.2 Episodic Approach

The average contemporaneous correlation between the current account and the terms of trade across all countries was 0.21. The average correlation with the terms of trade lagged by one year was −0.15. (The lagged correlation allows for a delayed or slow response of the current account balance to changes in the terms of trade.^[11]) For countries that had negative correlations (both contemporaneous and lagged), it was most often the lagged correlation that was larger in absolute value (Table A1 in Appendix A for country results). These simple correlations suggest that there were countries for which terms of trade shocks were very persistent and hence, the investment should have dominated the consumption-smoothing effect. However, many countries were likely to have had episodes of both very transitory and very persistent terms of trade shocks. This section of the paper addressed this problem by counting episodes of correlations within each country.

There are 3,043 observations (that is, country years) in the full sample. For each country, I calculated the sample standard deviations of the transformed current account balance and the terms of trade and then asked the following question:

What happened to the current account balance in years when the terms of trade changed by more than one standard deviation?

Within this set of observations I considered six possibilities. These are shown in Table 1. Large positive and negative changes in the terms of trade are split into columns 1 and 2 respectively. The response of the current account is divided into one of three rows in Table 1; that is, large positive, large negative or small changes in the current account (large being greater than one standard deviation). The two shaded boxes in the table represent negative correlations between the terms of trade and the current account balance.

Almost 30 per cent of large changes in the terms of trade were associated with large changes in the current account. Almost one third of these episodes were negative correlations.

Table 1 only captures high-frequency changes. The following extension allowed the current account a longer time to respond to changes in the terms of trade. First, two-year episodes of either consecutive rises or consecutive falls in the terms of trade were identified. This set of observations was further reduced by keeping only those observations for which the change in the terms of trade over the two years was larger in absolute value than one standard deviation. The response of the current account balance during each two-year period was then recorded. These results are displayed in Table 2 – in order to be comparable to Table 1, in Table 2 each year of each two-year episode was counted separately.

The point estimates from Table 2 show that 11 per cent of large changes in the terms of trade were associated with a large movement of the current account in the opposite direction (over a two-year window). These episodes of negative correlation were almost half as frequent as episodes of positive correlation between large terms of trade changes and large current account changes.^[12]

Many of the observations in Table 1 do not appear in Table 2. Therefore, it makes sense to combine the results of the two tables (making sure to not double count the same country year observation).^[13] The results from this aggregation were similar to results for the tables shown above and are not reported in the paper. However, the individual country results for one- and two-year windows combined are provided in Table A1 (in Appendix A), which gives the breakdown according to the total number of years of positive, negative and zero correlation episodes. Countries tended to have episodes of both negative and positive correlations, although there were countries with either no positive or no negative correlation episodes. The interesting question is whether these episodes reflect the terms of trade persistence of different countries in the way that theory would suggest. This is taken up in the next section of the paper.

Footnotes

If the net real trade balance does not react contemporaneously to a rise in the terms of trade, the current account will automatically rise; that is, a positive contemporaneous correlation will occur if there is no instantaneous response of trade volumes. [11]

It was not possible to test a null hypothesis of perfect consumption smoothing (that is, no investment effect). This would be equivalent to testing if the frequency of negative correlations is significantly greater than zero which would always be rejected in the case where the point estimate is non-zero. [12]

There is a problem of double counting for some years. That is, under Table 1, a given year might be classified as a negative correlation, whereas over the two-year window the same year is classified as a positive correlation. This problem was avoided by classifying such years as a zero correlation (this occurrence was very rare). [13]