foreign currency while most of the expenditures (with the wage bill absorbing half of the budget) are largely denominated in domestic currency. Thus, a nominal exchange rate devaluation could generate short-term fiscal savings that could be reallocated for poverty reduction purposes.

**_However, a currency devaluation could have a considerable negative impact on poverty._** In Djibouti, unlike many developing countries, tradable goods make up a significant share of poor household’s consumption baskets (over 60 percent). Tradable goods and services include food staples, qhat, medicines, clothing, housing, water, electricity gas and other fuels, furnishing, domestic equipment, health, transportation, hotels, cafes and restaurants. Food staples and qhat alone account for over 80 percent of the share of tradables in total household expenditure. In rural areas, poor households’ consumption baskets are even more biased towards tradable goods, reflecting the larger share of food staples in consumption. Furthermore, the degree of import substitution is limited owing to the country’s weak domestic productive capacity and the poor natural conditions for the development of agriculture. On the other hand, poor household’s labor income is mostly derived from non tradable services. The proportion of labor earnings from the tradable sector is low and rises slightly as household consumption increases. The lack of formal safety nets and the strong reliance of poor households on informal transfers from family members employed in the public sector calls for a careful assessment of the potential social costs associated with a nominal exchange rate devaluation.

# **_This paper seeks to answer three main questions_** :

- _(i) What would be the short-term fiscal gain of a nominal exchange rate devaluation?_

- _(ii) What would be the social cost associated with a devaluation of the Djibouti franc?_

- _(iii)   What would be the net fiscal gain of a nominal exchange rate devaluation (after accounting for the social transfers needed to compensate the poor for their real income loss)?_

Holding other things constant, the answers to these questions will be dependent on the magnitude of the devaluation, the degree of exchange-rate pass-through to domestic prices and the degree of public sector wage indexation. To answer these questions the paper proceeds in sequential steps. First, it estimates the exchange rate pass-through to domestic prices. Second, it moves on to quantify the potential short-term fiscal impact of a nominal exchange rate devaluation drawing on a static, partial equilibrium model. Third, it proceeds to quantify the potential short-term social impact (in terms of average real income loss per household; impact on incidence and depth of poverty and on overall income distribution) using available household survey data<sup>4</sup> . Fourth, it estimates the total amount of social transfers that would be needed to compensate the poor (including poor households that become poorer after the devaluation; and those who are not poor but fall below the poverty line after the devaluation).

# **_The paper’s main findings are as follows:_**

> 4 The two most recent household surveys in Djibouti were conducted in 1996 and 2002. This paper draws on the 1996 household survey (EDAM-I) because its design was better suited for the analysis. While the composition of household expenditure and sectoral labor participation patterns are similar in both surveys, the 2002 survey point to a deterioration in overall poverty and unemployment levels. Therefore, the preliminary estimates reported in the paper may underestimate the social impact of a currency devaluation in Djibouti.

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