• **_A currency devaluation could generate fiscal savings in the short-term_** _. A 30 percent nominal exchange rate devaluation could generate short-term fiscal savings amounting between 3 and 7 percent of GDP ( depending on the degree of exchange rate pass-through)._ • **_However, a devaluation of the Djibouti franc will have a significant negative short-term impact on poverty_** _. Assuming a nominal exchange rate devaluation of 30 percent and exchange pass-through of 60 percent, the number of households below the national poverty line could rise by 5 to 6 percentage points. Over 17 percent of households in the lowest consumption quartile could fall below the subsistence or extreme poverty line. About 20 percent of middle-income households (in the third quartile of the income distribution) could fall below the national poverty line._ • **_A currency devaluation could still generate fiscal savings even after accounting for the social transfers that would be needed to compensate the poor for their real income loss_** _. A nominal exchange rate devaluation of 30 percent could still generate fiscal savings between 1 and 3 percent of GDP (depending on the degree of exchange rate pass-through) even after accounting for the social transfers that would be needed to compensate the poor for their real income loss._ • **_Yet, the lack of formal safety nets limits the government’s readiness to provide welltargeted and timely social transfers to compensate the poor for their real income loss caused by a currency devaluation._** _Irrespective of the policy option chosen to address the high factor cost problem and the high public sector wage bill, setting up an effective system of social safety nets should be a short-term priority. Adequate safety nets will help the government address the needs of the poor in good economic times and be adaptable to combat the adverse effect of eventual shocks._

**_The remainder of the paper is organized as follows._** Section 2 provides the country background, sketching the main features of Djibouti’s economy and describes recent exchange rate and fiscal developments. Section 3 estimates the exchange pass-through drawing on available household survey data. Section 4 develops an empirical model of the real exchange rate and the fiscal sector to quantify the real fiscal savings of nominal exchange rate devaluation. Section 5 estimates the impact on poverty and income distribution of the devaluation drawing on available household survey data. Section 6 estimates the amount of social transfers that would be needed to compensate the poor for their real income loss and computes the fiscal savings generated by a currency devaluation after accounting for social transfers. Section 7 concludes with some policy implications.

# **2. Country Background**

## **2.1. Economic Structure**

**_Djibouti has a limited domestic productive capacity and the tertiary sector dominates the economy._** Djibouti is poorly endowed with natural resources (limited arable land, rainfall, and underground water). Domestic production remains limited, owing to the harsh climate, high production costs, and the paucity of skilled workers. The country’s small internal market and high factor costs limit its manufacturing potential. Agriculture and manufacturing accounted together for only 6 percent of GDP in 2004. The tertiary sector dominates the economy, contributing about 80 percent to gross domestic product (GDP) in 2004. With the exception of port-related services, military logistics services and tourism, most services are classified as non-tradables. These

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