# WPS4028

## **Fiscal and Social Impact of a Nominal Exchange Rate Devaluation in Djibouti** by Paloma Anós Casero and Ganesh Seshan<sup>1</sup>

### **Abstract**

Limited fiscal space limits Djibouti’s ability to meet the Millennium Development Goals and improve the living conditions of its population. Djibouti’s fiscal structure is unique in that almost 70 percent of government revenue is denominated in foreign currency (import taxes, foreign aid grants and military revenue) while over 50 percent of government expenditure is denominated in local currency (wages, salaries and social transfers). Djibouti’s economic structure is also unusual in that merchandise exports of local origin are insignificant, and the country relies heavily on imported goods (food, medicines, consumer and capital goods). A currency devaluation, by reducing real wages, could potentially generate additional fiscal space that would help meet Djibouti’s fundamental development goals. Using macro and household level data, this paper quantifies the impact of a devaluation of the nominal exchange rate on fiscal savings, real public sector wages, real income and poverty, under various hypothetical scenarios of exchange-rate pass-through and magnitude of devaluation. We find that a currency devaluation could indeed generate fiscal savings in the short-term, but it would have an adverse effect on poverty and income distribution. A 30 percent nominal exchange rate devaluation could generate fiscal savings amounting between 3 and 7 percent of GDP. At the same time, a 30 percent nominal devaluation could cause nearly a fifth of the poorest households to fall below the extreme poverty line and pull the same fraction of upper middle-income households below the national poverty line. We also find that currency devaluation could generate net fiscal savings even after accounting for the additional social transfers needed to compensate the poor for their real income loss. However, the absence of formal social safety nets limits the government’s readiness to provide well-targeted and timely social transfers to the poor.

This paper aims at providing some empirical evidence of the potential fiscal and social impact of currency devaluation in Djibouti drawing on household survey data. In this regard, the paper does not aim to provide economic policy recommendations on exchange rate management nor does it represent the views of the World Bank or the government of Djibouti.

#### World Bank Policy Research Working Paper 4028, October 2006

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent. Policy Research Working Papers are available online at http://econ.worldbank.org._

> 1 Paloma Anós Casero is a Senior Economist at the Middle East and North Africa Region, Social and Economic Development Group (MNSED). Ganesh Kumar Seshan is a consultant (ETC) at the Middle East and North Africa, Social and Economic Development Unit, World Bank, Washington D.C. For queries, email: panoscasero@worldbank.org

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