devaluation and a 60 percent pass-through, a 30 percent indexation of public wages will cause real public sector wages to rise by 1.6 percent.

# **6.  Estimating Fiscal Savings Net of Social Transfers**

## **6.1. Costing out Social Transfers**

As the foregoing analysis shows, a nominal exchange rate devaluation will adversely affect households, particularly the poor since most of their expenditure is on tradable goods (food and qhat)<sup>33</sup> . This section aims to estimate the value of fiscal transfers needed to compensate the poor (including those households that would fall below the national poverty line after the devaluation and those poor households that experienced a real income loss as a result of the devaluation).

### **_6.1.1. Methodology and Main Assumptions_**

First, the results regarding the average real income loss to the Djibouti population presented in the previous section (based on sample data from the EDAM 1996 household survey) are extrapolated to the total population. To arrive at the total cost for the (sedentary) population, it is first assumed that for each location sampled, the same proportion of (sedentary) households that are poor in the sample also holds true for the population. This implicitly means that the income distribution in the household survey sample is the same for the population. The survey design provides the number of households in the population for each location in 1996 (for example, see Table A.3a). Sample weights, which vary by location, can be determined from the ratio of households in the population to the 1996 sample.

A growth rate of 3 percent per year is used to estimate the number of households in the population in 2005. The resulting new sample weights are broadly, 25.7 for Djibouti-ville, 15.3 for other urban areas and 8.5 for rural areas. These weights are multiplied with the real income loss for the sample of poor households for each respective location to derive the cost to poor households in the population under various scenarios of wage indexation<sup>34</sup> and degrees of nominal exchange rate devaluation. The total real income loss of a nominal exchange rate devaluation is estimated by summing across locations. This is assumed to be the value of social transfers that the government can anticipate to compensate the affected population for their welfare loss.

### **_6.1.2. Costing out the social transfers needed to compensate the poor for their real income loss_**

**_Assuming a pass-through elasticity of 60% and no wage indexation, a 30%, 60% and 100% nominal devaluation will result in a cost of DF 2.44 billion, 6.29 billion and 14.54 billion respectively in social transfers needed to compensate the poor. This is equivalent to 2%, 5.14% and 11.88% of GDP respectively._** As expected, the cost of social transfers increases with higher degrees of devaluation and pass-through elasticity. The results are presented in Tables A.3 to A.5 of the appendix. Figure 10 graphically displays what appears to be a convex relationship between

> 33 Some of the loss may be mitigated by higher nominal wages for households with members working in the public sector if the government decides to index wages. Naturally, not all households will benefit from the indexation of public wages.  For our purpose, only households where the share of annual income earned from the public sector exceeding 90% of total income are assumed to have their wages indexed. These households represent 65% of the total households in the sample.

> 34 Only households where the share of annual labor income from the public sector exceeding  0.9 have wages indexed.

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