metadata: authors: 0: author: Li, Ying
1: author: Rowe,Robert Francis
count: Tanzania
docna: 0: docna: Aid inflows and the real effective exchange
            rate in Tanzania
docty: Policy Research Working Paper
subtopic: Debt Relief and HIPC,External Debt,International Trade and Trade Rules,Inflation,Macroeconomic Management,Debt Markets,Commodity Risk Management
teratopic: Macroeconomics and Economic Growth,Finance and Financial Sector Development,Private Sector Development
abstracts: cdata!: Tanzania is well placed to receive a
            significant increase in aid inflows in coming years. Despite
            the potential for the additional aid inflows to raise income
            levels in the country, increasing them may bring about
            structural changes in the economy that may be unwelcome. One
            such change is an appreciation of the real exchange rate
            that leads to a contraction of traditional export sectors
            and a loss of export competitiveness. This paper employs a
            reduced-form equilibrium real exchange rate approach to
            explain movements in Tanzania's real effective exchange
            in recent decades. Particular attention is paid to the
            relationship between aid inflows and the real effective
            exchange rate. The authors find that the long-run behavior
            of the real effective exchange rate is influenced by terms
            of trade movements, the government's trade
            liberalization efforts, and aid inflows. Positive
            terms-of-trade movements are associated with an
            appreciation, periods of improving trade liberalization are
            associated with a depreciation, and increases in aid inflows
            are associated with a depreciation in the real effective
            exchange rate. Although the last result is non-standard, it
            is not empirically unique and does have theoretical
            underpinnings. A detailed analysis of this relationship over
            the last decade shows that the Bank of Tanzania's
            response to aid inflows is likely the main reason for the finding.
geo_reg_key: 517191
repnme: repnme: Aid inflows and the real effective exchange
            rate in Tanzania
display_title: Aid inflows and the real effective
            exchange rate in Tanzania
listing_relative_url: /research/2007/12/8894922/aid-inflows-real-effective-exchange-rate-tanzania
topicv3: Debt Relief m1326505 452,Inflation m1326709 0870F4727ACED1CF8525815C00471347,Trade m1326924 698,Balance of Payments m1326965 441,Commodity and Resource Prices m1503849 3034
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Macroeconomics and Economic Growth,Finance and Financial Sector Development,Private Sector Development
no_of_pages: 48
author_keys: 0: author_key: 674570
model_extractions: WPS4456 Policy ReseaRch WoRking PaPeR 4456 Aid Inflows and the Real Effective Exchange Rate in Tanzania _Ying Li Francis Rowe_ The World Bank Poverty Reduction and Economic Management Network Economic Policy and Debt Department December 2007
Policy ReseaRch WoRking PaPeR 4456

# **Abstract**

Tanzania is well placed to receive a significant increase in aid inflows in coming years. Despite the potential for the additional aid inflows to raise income levels in the country, increasing them may bring about structural changes in the economy that may be unwelcome. One such change is an appreciation of the real exchange rate that leads to a contraction of traditional export sectors and a loss of export competitiveness. This paper employs a reduced-form equilibrium real exchange rate approach to explain movements in Tanzania’s real effective exchange in recent decades. Particular attention is paid to the relationship between aid inflows and the real effective exchange rate. The authors find that the long-run behavior of the real effective exchange rate is influenced by terms of trade movements, the government’s trade liberalization efforts, and aid inflows. Positive terms-oftrade movements are associated with an appreciation, periods of improving trade liberalization are associated with a depreciation, and increases in aid inflows are associated with a depreciation in the real effective exchange rate. Although the last result is non-standard, it is not empirically unique and does have theoretical underpinnings. A detailed analysis of this relationship over the last decade shows that the Bank of Tanzania’s response to aid inflows is likely the main reason for the finding.

This paper—a product of the Economic Policy and Debt Department, Poverty Reduction and Economic Management Network—is part of a larger effort in the network to strengthen the Bank's capacity to analyze the implications of scaledup aid inflows. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The author may be contacted at frowe@worldbank.org.

_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 views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
**Aid Inflows and the Real Effective Exchange Rate in Tanzania**

**Ying Li and Francis Rowe**<sup>**1**</sup>

# **Economic Policy and Debt Department, World Bank September 2007**

> 1 We are grateful for the comments received from Kathie Krumm, Robert Utz, Paolo Zacchia, Emmanuel Mungunasi, Vikram Nehru, Jean-Francois Perrault, Niko Hobdari, Eduardo Ley, Mark Thomas, Santiago Herrera, and seminar participants at the University of Dar Es Salaam. Special thanks go to Brian Pinto for his insights and comments on various drafts. Staff at the Bank of Tanzania provided valuable feedback during the early stages of the work, helped clarify many data issues and provided important comments during the later stages of the work.  Corresponding author: <u>frowe@worldbank.org.</u>
# **Introduction**

The international donor community is being encouraged to deliver on its commitments to scale up its official development assistance (ODA) in low income countries (LICs). The G-8 Summit in Gleneagles agreed that the G-8 group of countries and other donors would increase ODA to Africa by US$25 billion per year by 2010, which would represent a doubling of aid to Africa compared to 2004 levels. While aid to Sub-Saharan Africa has risen, the rate of increase is well short of that needed to achieve the Gleneagles commitments (World Bank 2007). Within Sub-Saharan Africa, aid inflows have and are expected to continue to be channeled to relatively well governed, good performing countries. With recent average annual real GDP growth of 6.0 percent (2000-06) and governance indicators that are improving relative to its neighbors, Tanzania has received a large fraction of aid inflows to Africa and may well receive a significant increase in coming years.

Despite the potential for additional aid inflows to raise income levels in Tanzania, increasing aid inflows may bring about structural changes in the economy that may be unwelcome. One such change is an appreciation of the real exchange rate that leads to a contraction of traditional export sectors and a loss of export competitiveness. A real effective exchange rate (REER) index is often monitored to detect possible changes in international competitiveness and is used to inform monetary and exchange rate policy, especially in times of aid surges. Unless the underlying causes for movements in an REER index are satisfactorily understood conclusions regarding changes in competitiveness based simply on appreciations or depreciations of the REER are incomplete.

This paper will examine how the REER has responded to internal and external macroeconomic developments over recent decades and pay particular attention to the relationship between aid inflows and the REER. We find that the long-run behavior of the REER is influenced by terms of trade movements, the government’s trade liberalization efforts and aid inflows. Positive terms-of-trade movements are associated with an appreciation of the REER, periods of improving trade liberalization are associated with a depreciation of the REER, while increases in aid inflows are associated with a depreciation in the REER. While the last result is non-standard, it is not empirically unique and does have theoretical underpinnings. A detailed analysis of this relationship over the last decade shows that the Bank of Tanzania’s response to aid inflows is likely the main reason for the finding.

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# **I. Measuring the Real Effective Exchange Rate (REER)**

In a small-open economy the real exchange rate may be its most important relative price measure and can be used as a key indicator of the economy’s external competitiveness. There are numerous ways to measure the real exchange rate and the choice of measure depends on the analytic question under investigation and data availability to empirically measure it. The analytic framework used to derive the real exchange rate in this paper is the two-sector dependent economy framework developed by Salter (1959) and Swan (1960). In this framework the relative domestic price of nontraded to traded goods _within_ the country is the real exchange rate. It is the relative price that achieves internal balance in the domestic supply and demand of nontraded and traded goods and captures the _internal_ relative price incentives in an economy for producing or consuming tradable or nontradable goods (Hinkle and Nsengiyumva 1999). This measure has particular appeal in the low-income country (LIC) context and has been widely used in empirical real exchange rate studies (e.g. Van Wijnbergen (1985), Edwards (1989) and Elbadawi and Soto (2005)).

In principle, the domestic price indices of tradables and nontradables should be used to construct the _internal_ RER, but these series are typically not available in LICs. In practice, the _internal_ real exchange rate is measured using the foreign WPI and the domestic CPI. The foreign WPI multiplied by the nominal exchange rate proxies the home country’s tradable goods price, while the domestic CPI is a proxy for nontradable prices in the home economy.<sup>2</sup> A key drawback in using the CPI as a proxy for nontradables prices is that the greater the weight of traded goods in the CPI implies a greater divergence in the proxy to nontraded goods prices. An important drawback in using foreign WPI is that it is unlikely to track fluctuations in a LIC’s exports prices, especially commodity prices. It may, however, do better tracking import prices and nontraditional exports. One alternative is to calculate a domestic tradables price index by taking a weighted average of the foreign price of importables ( _PMd_ ) and exportables 3 ( _PXd_ ) multiplied by the nominal exchange rate as in equation one.

> 2 One direct measure includes using expenditure data from nation accounts to measure the ratio of domestic prices of goods actually exported and imported and the price of domestically produced and consumed goods (Devarajan, Lewis and Robinson 1993). Another direct measure attempts to split sectors of production into tradable and nontradable categories and then calculate implicit price deflators.

> 3 This measure of the internal real exchange rate implicitly assumes that import prices and export prices move together so that they can be aggregated into one tradable goods price. If the price of imports and export diverge then the measure will be less likely to appropriately capture the price incentives of producing or consuming tradables. In this case, it may be more appropriate to consider separate internal RER indices, one using exports prices and the other using import prices. In this way, the incentives in the exportable or the import-substituting sectors are better represented by the separate indices.

3
(1) _RER_ = _Edc_ ⋅ [ _PMd_ ]α ⋅ [ _PXd_ ] (1 −α ) / _PNd_ where _Edc_ is units of domestic currency per unit of foreign currency, _PMd_ and _PXd_ are price indices of importables and exportables respectively, _PNd_ is domestic nontradables price index, and α is the share of importables in total tradables.

In the sections that follow the internal real exchange rate is measured using foreign wholesale price indices to proxy tradable prices and Tanzanian CPI index to proxy nontradables. We choose this measure for two reasons. The first is data availability and the second is that a careful analysis of the various measures of the REER showed that all suitable candidates were very strongly correlated over the sample and the empirical results that follow are not sensitive to various measures (Figure1 and Annex 1). We did, however, augment our preferred measure to allow for the parallel nominal exchange rate.

**Figure 1. Tanzania: Real Effective Exchange Rate Measures**

<!-- Start of picture text --> Real Effective Exchange Rate for Tanzania (2000=100) Real Effective Exchange Rate for Tanzania (2000=100)<br>Full Sample 130 Recent History<br>320<br>120<br>280 110<br>240 100<br>200 90<br>80<br>160<br>70<br>120<br>60<br>80 50<br>40 40<br>1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 1990 1992 1994 1996 1998 2000 2002 2004<br>REER (WPI-based) REER(WPI+ Comm. Price) REER (WPI-based) REER (WPI+Comm. Price) REER (Exp+Imp)<br>REER (2000=100) REER (2000=100)<br><!-- End of picture text --> <!-- Start of picture text --> Many LICs either Figure 2. Tanzania Parallel Market Premium<br>have had or still have 800<br>parallel markets for 700<br>600<br>foreign exchange,<br>where an exchange rate 500<br>determined by the 400<br>market (either legally 300200<br>or illegally) coexists 100<br>with a pegged or 0<br>managed exchange 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003<br>rate. Using the USD/TZA Shilling Parallel Market Rate Parallel Premium<br>officially managed<br>nominal exchange rate Source: IFS and Pick’s currency yearbook<br>only in the calculation<br>premium (%)<br>US $/TZA Shilling<br><!-- End of picture text --> of an REER could be a misleading indicator of economy-wide price incentives in the LIC as the official rate is most times overvalued. Tanzania has had a parallel exchange rate for much of it post-independence history, with the parallel exchange premium peaking at 4
over 700 percent in 1986. The parallel premium gradually declined to less than 10 percent 1993 and the exchange rates were unified in 1994 (see Figure 2). In the next section, empirical results using an REER using a weighted average of the parallel and official nominal exchange rates are presented.<sup>4</sup> A final consideration in the construction of an REER index is the choice of a weighting scheme. Moving beyond a two-country framework necessitates consideration of the range of trading partners to include in the real exchange rate index and how they should be weighted. There are two key issues that must be addressed when choosing a weighting scheme. The first is choosing the appropriate weights, either export weights, import weights, or both. We use export and imports or total trade flows as weights given that external competitiveness consists of both export and import competitiveness. The second issue concerns the choice between fixed or flexible weights over time. As trading patterns change over time, a real exchange rate index using fixed weights may provide a misleading picture of the net effect of movements in particular bilateral exchange rates, and thereby competitiveness. We use flexible weights as Tanzania’s trading partners have changed quite significantly over time (Annex 1). However, using either fixed or flexible weights does not materially alter any of the results that follow.<sup>5</sup>

# **II. Explaining the Behavior of Tanzania’s Long-Run Equilibrium REER**

# **i) The long-run equilibrium REER**

Tanzania’s REER has been characterized by dramatic swings in recent decades. The 40 percent appreciation over the 1990s and subsequent sharp depreciation since 2000, are relatively modest movements compared to fluctuations in the 1980s. Even large movements in the REER provide only limited guidance on changes in Tanzania’s competitiveness. Understanding the underlying factors that explain the movements in the REER is necessary before conclusions on external competitiveness can be drawn. A depreciation of the REER may result from a decline in the terms-of-trade which would not signal a gain in competitiveness, but a restoration of it. Alternatively, an appreciation of the REER may be justified by productivity improvements in the tradables sector, which would not imply a loss of competitiveness. To understand if Tanzania’s competitiveness has improved or worsened relative to any point in time it first must be understood if its REER is overvalued or undervalued. To make statements about the degree of misalignment of the REER it is necessary to have an understanding of an equilibrium value of the REER. It is appreciations and depreciations of the REER relative to an equilibrium value that signal a loss or gain in Tanzanian competitiveness.

A standard definition of the equilibrium value of the REER is the relative price of tradables to nontradables that is consistent with the dual objectives of internal and

> 4 Jorgensen and Paldam (1986) justify the use of an average of the two rates on the basis that misalignments in the parallel and official rates tend to be in opposite directions (the parallel rate being undervalued while the official rate is overvalued) and policy shocks such as large devaluations often move the rates in opposite directions.

> 5 More detail on the weighting schemes can be found in Annex 1.

5
external balance, given specific values of relevant macroeconomic variables that influence internal and external balance (Montiel 1999, Edwards 1989). Internal balance is when the nontradables market clears in the current and futures periods. External equilibrium is attained when the current account balance is compatible with long-run sustainable capital flows. Concretely, an equilibrium REER is an unobservable variable that would prevail from real macroeconomic factors acting upon foreign exchange markets without interruption. Because an equilibrium REER is unobservable it must estimated by identifying fundamental macroeconomic factors that are theoretically expected to act upon foreign exchange markets.

Estimating the equilibrium REER as a function of macroeconomic variables that vary over time implies that the equilibrium REER changes <u>over time. But, the function</u> between the REER and the **Figure 3. Tanzania Real Effective Exchange Rate** fundamentals is fixed over the **Long-term Trend** time period of analysis. This approach is well supported 360 320 theoretically (Edwards (1989), Montiel (1997) and 280 Elbadawi (1990), (1994)) and 240 is particularly relevant in a 200 case where the REER is 160 found to be nonstationary. 120 Figure 3 displays the long-run 80 component of Tanzania’s 40 REER, which shows 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 significant changes over the REER (WPI-based) long-term trend (HP filtered) sample period. The aim of the ’ Calculations <u>Source: Authors’ Calculations Calculations</u> next section is to identify the <!-- Start of picture text --> Figure 3. Tanzania Real Effective Exchange Rate<br>Long-term Trend<br>360<br>320<br>280<br>240<br>200<br>160<br>120<br>80<br>40<br>1969 1973 1977 1981 1985 1989 1993 1997 2001 2005<br>REER (WPI-based) long-term trend (HP filtered)<br>Source: Authors’ Calculations<br>REER (2000=100)<br><!-- End of picture text --> macroeconomic variables that explain these long-term movements. This reduced-form equilibrium real exchange rate approach is one of a number of complementary approaches that can be used to assess real exchange rates. Others include the macroeconomic balance approach, the external sustainability approach and in the LIC context, the PPP approach.<sup>6</sup> IMF (2006) and Hinkle and Nsengiyumva (1999) compare and contrast the various methods for real exchange rate assessments.

# **ii) Recent macroeconomic developments**

The recent macroeconomic history of Tanzania can be broadly grouped into three periods – 1970-1986, 1987-1995 and 1996-2005. The first period was marked by an increasing role of the state in the domestic economy and the pursuit of an importsubstituting strategy aimed at creating a new brand of African socialism. Donors were

> 6 This approach is common in LICs when data availability is an issue. It involves identifying a base year for which the economy under consideration is judged to be in both external and internal balance and choosing the REER that prevailed in that year as the estimate of the equilibrium REER. This approach implies that the equilibrium REER does not change over time and assumes that the values of fundamental macroeconomic variables that influence internal and external balance do not change over time.

6
initially quite supportive of the inward looking reform program and aid flows reached almost 15 percent of GDP in 1979. During the early 1980s and leading to the 1986 balance of payments crisis, macroeconomic conditions deteriorated sharply as a result of the unsustainable economic program and commodity price shocks. Prices for Tanzania main commodity exports – cotton, coffee and cloves – which made up about 57 percent of export revenues at the time, declined by almost 15 percent over the period 1979-87. Consequently, real GDP growth declined sharply, while consumer price inflation took off averaging over 30 percent annually. Large imbalances in the country’s fiscal and external accounts emerged. Responding to a balance of payments crises in 1986, the shilling was devalued by more than 50 percent. During the pre-crisis period aid inflows declined to just under 10 percent of GDP by 1985.

The immediate post-crisis period was characterized by government attempts to open up the economy, liberalize the foreign exchange market and reduce the role of the state in the domestic economy. The reform program was supported by an IMF ESAF and a structural adjustment program with the Bank. These programs and other donor inflows drove aid inflows to a peak of 25 percent of GDP in 1992. From 1987 to 1991, real GDP growth averaged 4.6 percent and fiscal policy improved markedly despite falling commodity prices ( mainly coffee prices) and inflation remaining close to 30 percent. The foreign exchange market was liberalized and the premium on the shilling in the parallel market all but disappeared by 1993. However, structural reforms waned and commitment to macroeconomic stability diminished over the years 1992-1995. Lack of fiscal control and large scale tax exemptions implied that the earlier fiscal gains were rolled back. The emerging fiscal imbalances led authorities to increase customs duties to compensate for shortfalls in domestic tax revenues. In response, the IMF, the Bank and other donors cut back on flows, which once again declined to about 10 percent of GDP.

The decade spanning 1996-2005 was marked by steady progress in implementing macroeconomic reforms, resulting in robust growth rates and a significant decline in inflation. The authorities signaled their renewed commitment to reform with the signing of another ESAF with the IMF in 1996. A premium was placed on macroeconomic stabilization, while a key component of the structural reform program was trade liberalization, especially in the agriculture sector (World Bank 2007, IMF 2005). The first half of this period was characterized by average annual real GDP growth of 4 percent, while consumer price inflation fell from 27.4 percent to 6.0 percent. Prices for Tanzania’ key commodity exports rebounded and remained strong during this period as well. The second half of the decade was even more impressive, with annual average real GDP growth of 6.5 percent and inflation falling to 5 percent by 2005. Since 2000, the government’s commitment to macroeconomic and structural reform emphasizing the importance of restricting the role of the state in the economy has coincided with another surge in aid flows, with the aid-to-GDP ratio over 12 percent in recent years Tanzania’ recent economic history has been shaped in large part by donors’ response to its successive economic reform programs, each of which placed an emphasis on trade reforms. As a primary commodity exporter, exogenous changes in the prices of its key commodity exports have also played an important role in its economic evolution.

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Given these broad features of Tanzania’s economic history we focus on aid, trade and the terms-of-trade as the key explanations of the long-run behavior of real effective exchange rate. These three factors are standard among the macroeconomic economic fundamentals cited in the literature as determinants of REERs in LICs. The next section explains the relationship between each of these factors, among others, and Tanzania’s real effective exchange rate.

# **iii) Possible factors affecting the long –run equilibrium REER**

# _Terms of trade_

Tanzania’s export revenues are heavily dependant on international commodity prices. On average, well over half of its export earnings over the last thirty years have been comprised of primary commodities – coffee, tobacco and cotton being the most important. While the principal commodity exports have changed over time, it remains a primary commodity exporter. Revenues from Tanzania’s top three commodity exports – fish, coffee, and cashew nuts, - accounted for 31% of non-gold exports in 2005. International commodity prices are volatile and when they change relative to Tanzanian import prices the equilibrium path of the REER will be affected. An increase in the international price for Tanzania’s commodity exports will increase real incomes in the export sector, resulting in an increase in the demand for nontraded goods. An appreciation of the REER will follow unless there is a substitution effect from domestic goods to foreign goods, in which case the REER may depreciate.

Following Cashin et al (2002) we use a measure of Tanzania’s real commodity prices as a proxy for its terms of **Figure 4. Term of Trade and Real Effective** trade. The index is a geometric **Exchange rate** weighted average of Tanzania’s nine largest commodity export 300 300 prices deflated by the World 250 250 Bank’s index of manufactured 200 200 exports (MUV).<sup>7</sup> In principal, 150 150 the price of all exports rather than simply commodity exports, 100 100 over the price of all imports, 50 50 rather than a generic industrial 0 0 1970 1975 1980 1985 1990 1995 2000 2005 country export deflator, should be used to measure terms of WPI-based REER Real Commodity Price (2000=100) trade. However, concerns about <u>Source: Authors’ calculation rce: Authors’ calculation ce: Authors’ calculation Authors’ calculation uthors’ calculation hors’ calculation ors’ calculation rs’ calculation s’ calculation ’ calculation calculation lculation culation lation ation ion on n</u> the data quality and the <!-- Start of picture text --> Figure 4. Term of Trade and Real Effective<br>Exchange rate<br>300 300<br>250 250<br>200 200<br>150 150<br>100 100<br>50 50<br>0 0<br>1970 1975 1980 1985 1990 1995 2000 2005<br>WPI-based REER Real Commodity Price (2000=100)<br>Source: Authors’ calculation rce: Authors’ calculation ce: Authors’ calculation Authors’ calculation uthors’ calculation hors’ calculation ors’ calculation rs’ calculation s’ calculation ’ calculation calculation lculation culation lation ation ion on n<br>REER (2000=100)<br>Real Commodity Price (2000=100)<br><!-- End of picture text --> 7 The index is a weighted average of export prices of manufactured goods for the G-5 economies (the United States, Japan, Germany, France, and the United Kingdom), which is generally accepted as proxy of price index of developing country manufacture imports.We augment the measure to incorporate oil prices in the measure, as oil imports make up about 17% of Tanzanian imports in 2000s on average.

8
availability of Tanzania’s export and import prices make the real commodity price index our preferred measure of Tanzania’s ToT.<sup>8</sup> Like many other African countries, Tanzania has experienced a secular decline in their terms of trade over the sample period, which broadly corresponds to the long-term trend decline in the REER (Figure 4).

# _Aid flows_

Tanzania has received large and sustained aid flows for much of the last thirty years. Even when aid inflows decreased in the early 1980s, Tanzania received higher aid inlfows than most SSA countries (Ndulu and Mwase 2005). Following the reformist government’s move to market-base economy in 1985, aid flows surged to over 25 percent of GDP by 1992. When commitment to further economic reform weakened in the early to mid-1990s, aid flows again declined, but remained higher than most other SSA countries at almost 10 percent of GDP (Muganda 2004). Since 2000, the government’s commitment to macroeconomic and structural reform emphasizing the importance of restricting the role of the state in the economy has coincided with another surge in aid flows, with the aid-to-GDP ratio over 12 percent in recent years (IMF 2005).

Aid inflows that are spent in the local economy will contribute to an increase in the demand for both tradables and nontradables.<sup>9</sup> When **Figure 5. Aid Inflow and Real Effective Exchange Rate** tradable goods’ prices are fixed by international prices it is 300 35 nontradables prices that would 250 30 tend to increase. The pressure 25 of expanded liquidity on 200 20 domestic demand and prices of 150 nontraded goods would lead to 100 15 a real exchange rate 10 appreciation. Figure 5 indicates 50 5 that no such relationship 0 0 appears to be present in 1970 1975 1980 1985 1990 1995 2000 2005 Tanzania. In fact, the series are Aid (% of GDP) WPI-based REER highly negatively correlated, Source: OECD DAC and authors’ calculations i.e. a depreciation (appreciation) of the REER is associated with an increase (decline) in aid flows.

The ‘equilibrium’ relationship described could be muted or nonexistent for a number of reasons. There may be no change in the REER if aid is spent entirely on imports, implying no impact on money supply or aggregate demand in the local

> 8 The correlation coefficient between the real commodity price index and the ratio of Tanzania’s export and import prices taken from the IMF’s World Economic Outlook (WEO) database is 0.84 over the period 1980 to 2004.

> 9 To make local purchases, foreign exchange would need to be converted into local currency that would expand the money base, fuelling the increase in demand.

9
economy. Alternatively, if the economy receiving the inflow is characterized by unemployed resources then the increase in demand generated by the aid inflow may not lead to an increase in nontradable prices. Import purchases and unemployed resources can explain why there may be a muted or no response in the REER to an aid surge, but they do not explain the observed negative relationship in Tanzania. There are numerous theoretical explanations for this relationship, but a proper multivariate framework that accounts for the nonstationarity of these series and controls for other factors is necessary before this relationship can be taken seriously. The empirical section that follows will do this.

# _Trade liberalization_

Economic reforms introduced by the Tanzanian authorities from 1986 included a move away from the policies of import substitution undertaken in the 1970s. During 1980-86, nontariff barriers covered more than 50 percent of imports, and the average simple tariff rate was about 40 percent. By 1999, nontariff barriers were largely confined to restrictions on imports of petroleum products and the simple tariff rate was between 15 and 20 percent (Kanaan 2000). During the 1990s, the marketing and export of traditional export crops was decontrolled and the commercial role of the parastatal crop authorities was scaled back, resulting in the increase in the producer prices of food. The system of export and import licensing was abolished and the requirement of registration of exporting companies eliminate by 1994. The maximum tariff rate has been lowered and the number of tariffs has been reduced from six to three. Moreover, import surcharges imposed in 2001 on imports from other East African countries were gradually reduced or eliminated (IMF 2005).

Trade liberalization can have an important impact on the long-run ‘equilibrium’ REER. The lowering of **Figure 6. Trade Liberalization and Real Effective** import tariffs, for example, **Exchange rate** will decrease the domestic 300 60 price of imported goods increasing the demand for 250 50 imports and the volume for 200 40 imports. At the same time 150 30 (assuming perfect substitutability) a decrease in 100 20 demand for nontradables will 50 10 result. In equilibrium, the 0 0 price of nontradables will 1970 1975 1980 1985 1990 1995 2000 2005 decrease resulting in a Trade (% of GDP) WPI-based REER depreciation of the real <u>Source: IFS and authors’ calculations</u> exchange rate. The ratio of total trade to GDP is a commonly used measure of trade liberalization as it captures the assumption that a more liberal trade regime means higher trade volumes. Figure 6 presents this measure of trade liberalization and Tanzania’s REER. As expected, there appears to be a strong inverse relationship between the series for the entire sample, 10
implying that trade liberalizing reforms have contributed to periods of REER depreciation.

# _Relative productivity differentials_

Perhaps the best known explanation for the behavior of long-run ‘equilibrium’ exchange rates is relative productivity differentials, the so-called Balassa-Samuelson effect. The Balassa-Samuelson effect rests on the assumption that productivity gains in the tradables goods sector are greater than productivity gains in the nontradables sector. The effect can be understood to work both within and across countries, with the same resulting impact on the real exchange rate. Within a country, an increase in productivity in the traded goods sector will lead to an increase in wages in both the tradable and nontradable sectors. Consequently, there is an increase in nontradables prices and an appreciation of the real exchange rate. If PPP in tradable goods holds across countries, stronger productivity gains in the tradables sector in one country relative to another implies a stronger increase in the relative price of nontradables. The result is an appreciating real exchange rate for the country with the higher relative productivity gain.

A striking feature of the Tanzania growth experience over the last thirty years is that it appears to be uncorrelated with the **Figure 7: Relative Productivity and Real Effective** investment rate (World **Exchange Rate** Bank 2002). Indeed, 300 300 several periods were characterized by high 250 250 investment rates and low 200 200 growth, implying declining productivity of 150 150 investment. Devarajan, 100 100 Easterly and Pack 1999, note that value added per 50 50 worker in the 0 0 manufacturing 1970 1975 1980 1985 1990 1995 2000 2005 experienced a sustained WPI-based REER Relative Productivity decline between 1975 and 1990. Poor productivity <u>Source: Authors’ calculations</u> performance relative to its key trading partners is consistent with the observed long-term trend decline in Tanzania’s REER (Figure 7). However, recent reforms aimed at increasing efficiency and investment appear to be bearing fruit as relative productivity in Tanzania appears to have halted its long-term decline.10

> 10 There are a number of measures that proxy relative productivity, but due to data limitations we use the ratio of real GDP per capita in the seven largest trading partners to real GDP per capita in Tanzania. An area for further work would be to develop some measures for productivity in different sectors of the economy to proxy the relative productivity growth differentials between tradables and nontradables within Tanzania.

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# _Government expenditures_

The final factor that we consider to explain movements in the long-run equilibrium REER is a change in the level of government expenditures. An increase in spending on traded goods generates an increase in demand for imports that results in a trade deficit, requiring a real exchange rate depreciation to maintain external balance. In the LIC context, an increase in government investment is likely to capture spending on tradables. Alternatively, an increase in government spending on nontradables is likely captured by consumption expenditures, which is expected to generate an increase in the relative price of nontradables. If the increase in government spending is financed by government borrowing that require subsequent tax increases to finance, aggregate demand may be muted relative to the initial increase. It is the allocation of government expenditure across sectors in the economy is a fundamental determinant of the long-run equilibrium real exchange rate, not unsustainable fiscal policy financed by excessive credit creation. The latter can cause a short-run deviation from the long-run equilibrium real exchange rate, i.e. a misalignment, but it is not considered a driver of the long-run equilibrium exchange rate.

Public expenditures in Tanzania have increased significantly in recent years, contributing to rapid GDP growth (World Bank **Figure 8. Public Investment and Real Effective** 2006). Importantly, the **Exchange Rate** composition of those expenditures has been 300 18 16 increasingly toward 250 public investment. Given 14 the high import content of 200 12 10 public investment, a rise 150 in the share of investment 8 in aggregate spending is a 100 6 4 good proxy for a shift in 50 public spending to 2 0 0 tradable goods. This 1970 1975 1980 1985 1990 1995 2000 2005 compositional shift is consistent with the recent Public Investment (% of GDP) WPI-based REER depreciation of the REER <u>Source: World Bank WDI and reports</u> (Figure 8). Tanzania’s budget is heavily financed by aid inflows for much of the sample under consideration (e.g. 40 percent in 2004) which makes it particularly difficult to disentangle the individual contribution of both aid inflows and government expenditures to movements in the REER in the same empirical specification. The issue of multicollinearity, which is not only limited to the aid and government expenditure variables, is addressed in the next section.

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# **III. An Empirical Specification of Tanzania’s Long-Run Equilibrium REER**

This section presents the results of an estimated model of Tanzania’s long-run equilibrium REER (EREER). It is the first step in a two-step procedure that aims to distinguish between movements in the REER that are consistent with persistent movements in economic variables that affect the REER and temporary movements in the REER that may be explained by short-lived events like monetary policy. This approach will allow the estimation of the long-run equilibrium exchange rate, the degree of misalignment of the actual REER relative to the estimated equilibrium value, and the estimated speed of the actual REER’s adjustment to equilibrium. An error-correction model is employed to achieve these results. We use a modified version of Engle and Granger’s (1987) two-stage error-correction procedure to estimate the long-run relationship between the EREER and its fundamentals and the short-term dynamics affecting the REER.

The first stage of Engle and Granger (1987) involves estimating a cointegrating relationship by OLS. We modify this stage by estimating the cointegrating relationship using Phillips and Hansen’s (1990) Fully Modified (FM) method. Although the OLS estimators are consistent and highly efficient, they are biased in small samples making inference based on parameter estimates unreliable. The Phillips and Hansen (1990) FM estimator applies a semi-parametric modification to the standard OLS procedure that corrects for autocorrelation of the OLS residuals as well as endogeneity of the regressors. The result is parameter estimates that are asymptotically optimal, making inference more reliable. There are alternative approaches to achieving reliable parameters estimates, such as Johansen’s (1995) maximum likelihood estimator using a vector error-correction mechanism specification, but it requires more data observations than are available in the present analysis to be effectively implemented. We present the results of both OLS and FM-OLS methods below.

The first step in the first stage of Engle and Granger (1987) is to determine the order of integration of the variables, which identifies if the chosen variables are nonstationary. Annex 3 Table 1 presents the results of Augmented Dickey-Fuller (ADF) tests for unit roots and the Phillips- Perron test, which shows that all variables are nonstationary in levels and stationary in first differences, i.e. integrated of the first order I(1), over the entire sample period 1970-2005. The results support the notion that the series are integrated processes that can be exploited to uncover a long-run equilibrium relationship.

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# **i) Cointegration results**

The following model is estimated by OLS and Phillips and Hansen’s (1990) FMOLS over the period 1970-2005: REER is the real effective exchange rate as measured as the nominal effective exchange rate multiplied by the ratio of foreign wholesale prices to Tanzanian CPI. A variety of measures of the REER (see Section II) including a measure that incorporates the parallel exchange rate will be used to test the robustness of the results. TOT is the terms of trade measured as Tanzania’s real commodity price index. AID is net aid inflows taken from the OECD’s DAC database.<sup>11</sup> We also include net private capital flows in the measure to capture total public and private capital inflows. Trade is a measure of trade liberalization and is proxied by the ratio of exports plus imports to GDP. PROD is a relative productivity measure aiming to capture Balassa-Samuelson effects and is measured as the ratio of real GDP per capita in Tanzania relative to its major trading partners. INV is government investment expressed as a percentage of GDP.

ADF tests indicate that the error term in our OLS regressions is stationary, indicating that there is a long-run cointegrating relationship between the REER and the fundamental macroeconomic variables chosen (Table 1). The preliminary results suggest that the terms of trade, aid and trade liberalization are strongly significant determinants of Tanzania’s long-run equilibrium exchange rate (Table 1, column (1)). The sign of the parameter estimate on the government investment variable is not as expected, although it is insignificant at conventional levels. The coefficient on the relative productivity measure is also insignificant, but this is likely the result of measurement error. It is also the case that the relative productivity measure is highly correlated with the terms of trade measure. We ran the specification alternately excluding the relative productively measure and the terms of trade measure and found that by excluding the ToT measure the relative productivity measure remained insignificant. On the basis of this result we dropped the relative productivity measure from the specification.<sup>12</sup> Dropping both the investment and the relative productivity measures from the original specification does not significantly alter the parameter estimates on the remaining variables or the overall goodness of fit of the model. Column 2 reports the results of the more parsimonious specification. This specification was re-run using the parallel nominal exchange rate in the REER index.<sup>13</sup> The signs and the significance of

> 11 The debt relief component of this measure is adjusted to better reflect the annual cash flow of HIPC debt relief which purges the DAC’s measure of the possible over recording of debt relief in a single year due to the practice of some DAC reporting creditors to record debt relief as stock of debt reduction operation rather than a flow of debt service reduction.

> 12 Better proxies for relative productivity differentials in the tradable and nontradables sectors are required before further testing on this variable can be undertaken.

> 13 The parallel nominal exchange rate is incorporated into the REER by taking a weighted average of the official and parallel rates by assuming that the share of transactions in the parallel market is 80 percent when parallel premium is highest and the share of parallel market trade decline proportionally with (square

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each of the variables remain unchanged. The parameter estimates on the terms-of-trade and the trade liberalization variables decline, while the estimate on the aid inflows variable increases somewhat. A similar pattern is observed with the FM-OLS estimators.

**-** **<u>Table 1. Tanzania: Long Run Cointegration Estimation Results</u>**

|Variable|OLS<br>(1)|OLS<br>(2)|OLS-<br>Parallel<br>Rate<sup>1/</sup><br>(3)|FMOLS-<br>(4)|FMOLS-<br>Structural<br>Break<br>(5)|FMOLS-<br>Parallel<br>Rate<sup>1/</sup><br>(6)|
|---|---|---|---|---|---|---|
|Log (ToT)|0.68***<br>(0.23)|0.73***<br>(0.13)|0.30***<br>(0.09)|0.80***<br>(0.17)|0.84***<br>(0.15)|0.31***<br>(0.08)|
|Log (Open)|-0.80***<br>(0.17)|-0.73***<br>(0.12)|-0.44***<br>(0.08)|-1.08***<br>(0.16)|-0.95***<br>(0.15)|-0.57***<br>(0.07)|
|Log (Invest)|0.11<br>(0.15)||||||
|Log (PROD)|-0.00<br>(0.48)||||||
|Log (Aid)|-0.29**|-0.30***|-0.43***|-0.26**|-0.31**|-0.46***|
|_Cons|(0.14)<br>4.71***|(0.09)<br>4.41***|(0.06)<br>5.77***|(0.13)<br>5.18***|(0.15)<br>4.69***|(0.06)<br>6.24***|
||(1.46)|(0.90)|(0.62)|(1.17)|(1.23)|(0.53)|
|No. of obs<br>|36|36|36|36|31|36|
|Adjusted R<sup>2</sup>|0.77|0.77|0.80||||
|D-W Stat.|1.23|1.22|1.97||||
|Residual ADF|-3.92|-3.89|-5.74||||
|test|||||||
|LC ( P-value)||||0.09|>=0.20|0.11|
|MeanF (P-<br>value)||||<=0.01|0.09|<=0.01|
|SupF (P-<br>value)||||<=0.01|<=0.01|<=0.01|

Notes: Standard errors are in parentheses. * indicates significance at the 10% level, ** indicates significance at the 5% level and *** indicates significance at the 1% level.

1/ REER is calculated incorporating parallel exchange rate. The share of parallel varies with the size of parallel market premium.

A key result is that the inverse relationship between aid inflows and the REER observed in the bivariate context holds in the multivariate specification. The statistically significant inverse relationship between aid inflows and the equilibrium REER is somewhat unexpected, but the finding is not unique (Nyoni 1997: Tanzania, Ogun 1995: Nigeria, Sackey 2001: Ghana, Ouattara and Strobl: CFA Franc Zone). Nevertheless, we think this relationship deserves careful consideration before any policy conclusions are drawn. We consider three possible avenues that may be leading to a spurious relationship between aid inflows and Tanzania’s REER. The first is multicollinearity between aid flows and our measure of trade liberalization. The second is that the specification may not be adequately capturing the possibility that the aid inflows generate positive supply side responses in the economy that may overwhelm the expected demand side effects.

root of) parallel premium. While somewhat arbitrary, this definition does reflect discussions with Bank of Tanzania officials.

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The third is that our results may be unduly influenced by the period in the run-up to and including the balance of payments crisis in 1986. We address each in turn below.

# **ii) Robustness checks**

The openness proxy used to capture trade liberalization and the aid inflows variable are highly correlated over the 1980-2004 period (correlation coefficient 0.79), possibly suggesting that trade liberalization efforts in Tanzania have been rewarded with higher aid inflows. Mwase and Ndulu (2005) state that, “Tanzania’s evolving relationship with donors illustrates the endogeneity of the perceived state of the policy environment to the prevailing global development paradigm.” For much of our sample, the prevailing global development paradigm had trade liberalization as a key component. To see if our results were being affected by this relationship we ran a separate bivariate regression of trade liberalization on aid inflows and put the residuals from this regression in the general specification. This instrumental variable represents an aid inflows measure purged of any trade liberalization influence.<sup>14</sup> The parameter estimates on both the aid inflows and the trade liberalization variables are virtually unchanged.<sup>15</sup> The inclusion of the government investment spending directly in the specification is one way of capturing the notion that aid flows could be generating positive supply-side responses in the economy that are deflationary. Including the investment spending measure should reduce the amount of variation in the REER that is explained by the aid inflows variable and attribute it to the investment spending variable.<sup>16</sup> However, the results above indicate that public investment spending is not a significant determinant of the REER. Alternatively, we test if the negative relationship between aid inflows and the REER may be working through indirect channels. We include a measure in the general specification that interacts aid inflows with an estimate of Tanzania’s output gap. An equilibrium real exchange rate appreciation would only be expected when the economy is running close to, at or above capacity in the presence of high and rising aid inflows.<sup>17</sup> The results of including the interaction term (not shown) indicate that its parameter estimate is not significant at conventional levels and its inclusion in the baseline specification does not affect the parameter estimates of either the aid inflows variable or the others in the specification.

We re-ran the parsimonious specification with a structural break to be confident that the results are not being influenced by the balance of payments crisis in 1986 when the devaluation of the shilling coincided with a surge in aid inflows. Chow test results indicate that a structural difference exists in the parameter estimates between the periods 1986-90 and the rest of the sample. Column 5 in Table 1 shows the parameter estimates when the data points over the period 1986-90 are excluded from the sample. The results

> 14 Ganger-causality tests show that trade liberalization Granger-causes aid inflows and not vis versa. 15  Simply adding more data can also rid the specification of this multicollinearity, which is confirmed by the results of expanding the dataset back to 1970.

> 16 Also, investment spending is a strong proxy for government spending on tradables, which could result in a decrease in the relative price of nontradables and therefore REER depreciation.

> 17 See Mwanza 2004 for an analytic framework that relaxes some standard assumptions of the core “Dutch Disease” model to illustrate this point.

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are virtually unchanged, giving some assurance that the relationship between aid inflows and the REER is not being driven by the 1986 crisis.<sup>18</sup> Lastly, we estimated the specification incorporating the parallel exchange rate into the REER measure. The signs of the coefficients do not change and all three variables remain highly significant. However, the coefficients on the terms of trade and the trade liberalization variables decline somewhat.

# **iii) Elasticity estimates**

The results from the FM-OLS (with a structural break) estimation are preferred when interpreting the elasticities given by the long-run parameter estimates (Column 5). Given the uncertainty surrounding the correct incorporation of the parallel nominal exchange rate in the REER measure we present the elasticities as ranges. On the basis of these results, the long-run relationship between Tanzania’s REER and its terms of trade, net aid inflows and trade liberalization can be identified as follows:

- The terms of trade parameter estimates suggests that a 1 percent increase in Tanzania’s terms of trade leads to an approximately 0.3 to 0.8 percent increase in the REER. This positive relationship suggests that the income effect of terms of trade increase dominates the substitution effect.

- The parameter estimate on the aid variable indicates that 1 percent increase in aid inflows (as a share of GDP) is associated with a 0.3 to 0.5 percent depreciation of the equilibrium REER.

- The parameter estimate on the openness proxy capturing trade liberalization suggests that an improvement in trade liberalization captured by a 1 percent increase in Tanzania’s trade to GDP ratio will result in a 0.6 to 1.0 percent depreciation of the equilibrium REER.

To be confident in the interpretation of the long-run elasticities it is important that the parameter estimates are stable over the sample period. We test for parameter stability using the _Lc_ and _MeanF_ tests proposed by Hansen (1992). Both tests have the same null hypothesis of parameter stability. The results indicate that we can not reject the null hypothesis of parameter stability over the sample period at all conventional significance levels.

# **iv) Possible explanations for the Aid-REER relationship**

There is a growing body of theoretical research that shows an REER depreciation in the presence of increasing aid inflows. A number of models focus on supply-side impacts of aid inflows. They suggest that aid inflows may induce a rapid supply-side

> 18 As an additional check, we re-ran a similar parsimonious specification on a quarterly dataset beginning in the first quarter of 1998 and the aid inflows REER relationship remained unchanged. Although, the aid inflow variable and the trade liberalization variable are defined differently than in the annual dataset, so the results are not directly comparable.

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response in the economy that more than offsets the demand responses. Similarly, aid that is targeted at easing supply bottlenecks in the economy could have a deflationary impact that could dominate the upward pressure on the price of nontradables due to the initial aid inflow (Hjertholm, Laursen and White 1999).<sup>19</sup> Such a situation may well describe circumstances in Tanzania, particularly in the years following 1986 when the underground economy resurfaced generating a large supply response to the increased availability of goods (Mwase and Ndulu 2005).

Adam and Bevan (2003) develop a computable general equilibrium (CGE) model that simulates the impacts of a permanent increase in aid-financed public infrastructure investment. Under a scenario where the increase in investment spending induces a productivity gain that is concentrated in the nontradables sectors and there is a high subsistence element in food consumption a depreciation of the real exchange rate results. Adam (2003) also presents evidence from a simulation exercise that shows a real exchange rate depreciation over the medium-term in response to aid inflows. It is less clear that productivity gains are at work to create the inverse relationship in Tanzania, given the secular decline in productivity over the last 30 years.

Devarajan et. al. (2007) present a CGE model that introduces explicitly the implications of intertemporal choices that attempt to smooth aid flows. Their model also includes the evolution of trade shares and elasticities to explore the impact of trade liberalization and globalization in the macroeconomic dynamics of scaled up aid. The authors simulate an increase in foreign official grants by 2 percent of output permanently and find that dynamically optimal decisions in investment and consumption will result in a real exchange rate depreciation. For investment to increase in the face of aid inflows, the returns to the firm must improve. A real exchange rate depreciation is required to cause the forward depreciation of the real exchange rate and in turn increase the market discount rate affecting supply behavior. A depreciation also increases the demand-side discount-rate, postponing consumption immediately, but causing an increasing growth rate in consumption over time. Like standard CGE models, consumption, investment and output increase with aid inflows, but optimal intertemporal behavior on the part of consumers and producers requires real exchange rate depreciation in this model. Attempts to smooth aid inflows hold perhaps the most convincing argument for the inverse relationship between aid inflows and the REER found in Tanzania, especially in recent years. The final two sections of the paper explore this possibility in detail.

Other possible explanations for the relationship include ‘tied’ aid and exchange rate regime changes. If a donor provides aid that is conditional upon the recipient country to import from that donor and the value of the imports is greater than the original aid inflow then the real exchange rate could depreciate.<sup>20</sup> Lastly, donors may provide aid to support the change in an exchange rate regime, which in many cases would mean a strong

> 19 In this case, output would grow faster than money supply growth.

> 20 This explanation is put forward by Nyoni 1998 when he finds a negative and significant relationship between aid flows and Tanzania’s REER. While this explanation may describe aid flows in the 1970s and 1980s it is not clear that the same explanation is relevant for recent history.

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devaluation of the nominal exchange rate.<sup>21</sup> The empirical results suggest that this last explanation is not driving the relationship in Tanzania, but the tie aid story holds some promise. In general, it is likely that a number of these factors are working together – tie aid, the easing of supply bottlenecks and aid inflow smoothing, - to produce the observed inverse relationship over the entire sample.

# **v) The estimated equilibrium REER and misalignment**

The long-run equilibrium relationship estimated above allows for the calculation of an annual estimate of Tanzania’s equilibrium REER (EREER). The estimated EREER is a function of the long-term or permanent components of the explanatory variables and the parameter estimates from the preferred specification in table 1 above. To get the permanent components of the explanatory variable we apply an HP filter to each series. It is also necessary to make a constant term adjustment to ensure that the sample period means of the estimated EREER and the actual REER are equal. Figure 9 shows the actual REER and the estimated EREER over the period 1970-2005. The EREER shows significant variations over the sample period, reflecting the changes in the structural conditions in Tanzania as well as significant changes in external factors like its terms of trade. Both the EREER and the actual REER move together quite closely over the period, but there are periods of significant and sustained deviations.

**Figure 9. Tanzania: Indices of Actual and Estimated Equilibrium REER and Misalignment (1970-2005)**

<!-- Start of picture text --> Tanzania: Indices of Actual and Estimated Equilibrium REERs Tanzania: REER Misalignment Index<br>300 60<br>250 50<br>40<br>200<br>30<br>150 20<br>100 10<br>0<br>50<br>-10<br>0 -20<br>1970 1974 1978 1982 1986 1990 1994 1998 2002 -30<br>1970 1974 1978 1982 1986 1990 1994 1998 2002<br>Estimated EREER Actual REER<br><!-- End of picture text --> The second panel in Figure 9 depicts the estimated degree of misalignment between the estimate EREER and the actual REER. Temporary changes in the explanatory variables in our long-run specification and other short-term factors like monetary policy explain divergences between the estimated EREER and the actual REER. The misalignment index coincides quite closely with what are generally considered periods of overvaluation and undervaluation of Tanzania’s real exchange rate. The REER was undervalued for much of the 1970s. A series of devaluations and price controls implemented by the National Price Commission meant that the REER 21 Devaluation policy should not affect the equilibrium real exchange rate over the long term, but it can exert an influence that can last for a significant period of time.

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depreciated by almost 30 percent over the decade. From 1980 the actual REER appreciated sharply in the run-up to the 1986 balance of payments crisis and was overvalued for much of this time, reaching a high of 55 percent in 1985. In the post-crises years 1988-1990 the index illustrates the typical over-shooting of the nominal exchange rate that occurs after crises episodes with the REER being undervalued for this period. From the mid- 1990s the REER has largely been close to equilibrium.

# **IV. Short-term Dynamics of the REER: An Error Correction Model**

# **i) Short-term dynamics**

Tanzania’s REER has exhibited significant fluctuations and some sustained deviations around the estimated equilibrium REER (Figure 9). The purpose of this section is to specify a model of the REER that captures short-term dynamics that explain movements around the long-term equilibrium REER, the second step in the Engle and Granger two-stage procedure. The existence of a long-term equilibrium value of the REER does not mean that the observed REER has to be permanently equal to the equilibrium value. The observed REER can display short-term, even medium-term deviations from equilibrium and may be driven by short-term changes in fundamentals or policy variables.

Monetary and other policy variables may play a particularly import role in explaining REER movements in the case of a fixed exchange rate regime, where such policies must be consistent with the fixed rate regime. For example, excess domestic credit expansion will put pressure on domestic prices, resulting in a temporary real appreciation of the REER, or an REER misalignment. However, in the absence of a change in fundamentals to support excessive credit expansion there will be pressure to devalue the nominal exchange rate. Policy variables will also impact the REER under a flexible exchange rate regime if domestic prices and nominal exchange rates adjust to shocks at different speeds. The short-run specification below will attempt to isolate the short-term factors influences deviations around the long run EREER.

Given Tanzania’s aid dependency over the sample we also consider more closely the policy reaction to aid inflows in the short-run specification. The central bank’s policy response to aid inflows that are spent domestically by the government may mitigate a real exchange rate appreciation in the short-run. The central bank may respond to aid inflows by selling foreign exchange to remove from circulation the increase in the money base spent by the government.<sup>22</sup> . Another possibility is for the central bank to curtail inflation and real exchange rate appreciation by selling Treasury bills.<sup>23</sup> In this case, rising interest

> 22 Although, there would still be real exchange rate appreciation in this case due to the initial overall rising aggregate demand and an appreciation of the nominal exchange rate associated with the sale of foreign exchange.

> 23 The sale of T-bills would reduce the money supply and raise domestic interest rates.

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rates and the reduction in the money supply mitigates rising inflation and aggregate demand, thereby muting REER appreciation.<sup>24</sup> Alternatively, the government may decide to build up reserves in the central bank. The government may do this because it is concerned about potential loss of competitiveness or as form of insurance against future shortfalls in aid inflows. While the level of aid inflows to Tanzania has been relatively high over the entire sample period they have been subject to wide fluctuations. The average annual level of net aid inflows jumped from 10 percent of GDP over the 1970-86 period to 24 percent over the 1987-94 period before falling to 15 percent over the 1995-2004 period. Moreover, annual aid disbursements have been unpredictable as donor commitments differ significantly from actual disbursements. One possible response to the volatility of aid inflows is for the central bank to build reserves during aid surges and draw down reserves when aid flows decline.<sup>25</sup> Such a strategy would tend to depreciate (appreciate) the nominal and, in the short run, the real exchange rate in the presence of on aid surge (decline), all else equal.

Figure 10 shows the relationship between net aid inflows and reserve accumulation in Tanzania over our sample. There appears to be no relationship between the series until 1990, at which point changes in BoT reserves become highly correlated with net aid inflows (correlation coefficient 0.73). Since 1995, reserve accumulation has been dramatic, increasing from

**Figure 10. Aid Inflow and Change in Reserves**

<!-- Start of picture text --> 600 2000<br>500 1800<br>400 1600<br>1400<br>300<br>1200<br>200<br>1000<br>100<br>800<br>0<br>600<br>-100 400<br>-200 200<br>-300 0<br>1976 1980 1984 1988 1992 1996 2000 2004<br>Change in Reserves Aid (US$)<br>Source: OECD DAC and IFS<br>Aid Inflow (mil US$)<br>Change in Reserve (mil US$)<br><!-- End of picture text -->

1.5 months of imports to 6.5 months of imports in 2004. The reserve accumulation combined with significant unemployed resources in the economy may be explaining part of the negative relationship between aid inflows and the REER, especially in recent years. The short-run specification below will include changes in BoT reserves to capture this possible influence on the REER over the short-run.

# **ii) Tanzania’s REER: An error correction model**

Stage two of Engle and Granger (1987) consists of running a short-run specification of the REER which includes changes in the key explanatory variables

> 24 If capital market is free from controls, rising domestic interest rates may actually attract international capital flows and appreciate the currency (IMF 2005).

> 25 Improving tax revenues is also an option, but the ratio of tax revenues to GDP has been virtually constant over the last thirty years at less than 14 percent.

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identified in the long-run cointegrating relationship and other policy variables that are considered to influence the short-run dynamics of the REER. The key policy variables included in the model are excess credit (defined as the growth of base money in excess of nominal GDP growth) and the change in Bank of Tanzania reserves. It also includes the lagged residuals from the preferred long-run specification to capture the speed of adjustment of the REER to its equilibrium value (i.e. the error correction term). Table 2 presents the results of the ECM, a number of which are worth highlighting: • The growth rate of aid inflows has a negative and significant short-run impact on the REER, echoing the result obtained in the long-run relationship.

• The short-run impact of the trade liberalization proxy on the REER is also similar to the results obtained in the long-run specification. However, it appears that the short-run effects of changes in the TOT are insignificant.

• Including changes in the Bank of Tanzania (BoT) reserves in the specification renders the aid variable insignificant, implying that BoT reserve policy in reaction to aid inflows may be an explanation for the inverse relationship between aid inflows and the REER in the short-run.

The key parameter in the ECM is the error-correction term measuring the speed of adjustment of the actual REER to its equilibrium value. When a gap between the real exchange rate and its equilibrium value arises, the real exchange rate will tend to converge to its equilibrium value. Depending on the cause of the gap, the adjustment requires that the real exchange rate either moves progressively to a new equilibrium level, or returns from its temporary deviation to the original equilibrium value. The parameter estimate on the error-correction term suggests that it takes less than two years for a deviation in the REER to return halfway to its equilibrium level. This result is similar to the speed of adjustment estimates found in Edwards (1989), but is longer than the Baffes et al (1998) estimates found for Burkina Faso and the Ivory Coast. The rather long halflife of the return to equilibrium is likely influenced significantly by the apparent extended period of undervaluation during the 1970s.

The ECM was re-run using the REER that incorporates the parallel nominal exchange rate. The results (Column 3 and 5) are generally similar to those found using the REER based on the official nominal exchange rate. An important difference is the estimated speed of adjustment to equilibrium. Incorporating the extra market information associated with the transactions in the parallel market indicates that the REER moves more quickly to equilibrium than the REER based only on the official nominal exchange rate. The estimated parameter on the error correction term implies that it takes roughly less than a year for the REER to return halfway to its equilibrium value.

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**<u>Table 2: Error-Correction Model Results: 1970-2005</u>**

|Variable|(1)|(2)|(3)<sup>1/</sup>|(4)|(5)<sup>1/</sup>|
|---|---|---|---|---|---|
|Error Correction Term|-0.37**|-0.30***|-0.78***|-0.29**|-0.69***|
||(0.17)|(0.147)|(0.21)|(0.14)|(0.17)|
|Δ Log (Open)|-0.42**|-0.36**|-0.53***|-0.36**|-0.51***|
||(0.19)|(0.16)|(0.16)|(0.16)|(0.12)|
|Δ Log (TOT)|0.12|0.08|0.14|0.23|-0.03|
||(0.21)|(0.17)|(0.18)|(0.19)|(0.14)|
|Δ Log (Aid)|-0.20|-0.22*|-0.26*|0.15|-0.13|
||(0.14)|(0.13)|(0.17)|(0.13)|(0.12)|
|Δ Log (Invest.)|0.03<br>(0.12)|||||
|Δ Log (Prod)|-0.76<br>(0.63)|||||
|Δ Log (Reserves)||||-0.08*|-0.14***|
|||||(0.04)|(0.03)|
|_Cons|-0.03|-0.01|-0.02|-0.01|-0.01*|
||(0.03)|(0.02)|(0.02)|(0.02)|(0.02)|
|No. of obs|35|35|35|35|35|
|Adjusted R<sup>2</sup>|0.35|0.37|0.52|0.42|0.70|

1/Independent variable incorporates parallel exchange rate.

# **V. The Policy Response to Aid Inflows**

This section builds the ECM results in the previous section to focus specifically on the policy response to aid inflows over the period 1995-2005. We undertake an accounting exercise in the spirit of the IMF (2004) to look for additional evidence that the policy response to aid inflows helps explain the negative and significant relationship between the REER and net aid inflows over this period. When aid flows into Tanzania the authorities must decide whether it is <u>to be used to finance expenditures or a tax</u> reduction. Following the **Figure 11. Fiscal Response to Aid (% of GDP)** IMF (2004) the spending of 4 aid is defined as the 3 widening in the 2 government’s fiscal deficit 1 0 before aid that accompanies -1 the increase in aid. The first -2 thing to note about these -3 series is that there has been a -4 94/95 95/96 96/97 97/98 98/99 99/00 00/01 01/02 02/03 03/04 04/05 steady increase in the amount of net aid financing Change in total expenditure Change in development expenditure that is recorded in the budget Change in net aid (Annex 3 Table A4). This has the effect of showing up <u>Source: IMF reports and authors’ calculations</u> as a steady increase in net aid inflows in the fiscal accounts over the entire period 199523
2005. It is clear, however, that increases in net aid inflows are largely being spent in the economy as increases in net aid inflows are accompanied by a widening of the before aid fiscal deficit (Annex Table 2). A strong correlation between net aid inflows and fiscal expenditures is also apparent (Figure 11). This result is consistent with IMF (2004) which found that over 90 percent of incremental aid flowing into Tanzania was spent over the period 2000-05.

It is the interaction between monetary policy and fiscal policy in response to aid inflows that determines the macroeconomic impact of aid, including the potential impact on the real exchange rate. Monetary policy can react to the spending of an increase in aid inflows in three ways. The Bank of Tanzania can allow the money supply to increase, aggregate demand to increase and the price of nontradables to increase, resulting in a real exchange rate appreciation. Alternatively, the BoT could sterilize the increase in the money supply by selling foreign exchange, again resulting in an appreciation of the real exchange rate.<sup>26</sup> Lastly, the BoT could opt to curtail inflation and real appreciation of the real exchange rate by selling treasury bills.

The accounting evidence suggests that rather than selling foreign exchange to permit the increase in net imports that an aid increase allows, the BoT choose instead to build reserves in the face of increasing aid inflows. At the same time, it issued T-bills to sterilize the aid flows that were spent in the economy. The stock of liquidity paper (Tbills) increased from 56 billion Tza shilling (less than one percent of GDP) in 1999 to 454 billion Tza shillings (3.7 percent of GDP) by end-2004. The annual average nominal T-bill rate declined from 10 percent in 1999 to 3.5 percent in 2002 before climbing to 8.3 percent in 2004. In this way, inflation was kept in check, while the policy of building reserves supported a nominal depreciation of the shilling over the entire period 19952005.

Table 3 is a summarized balance of payments presentation for Tanzania over the period 1995-2005. It isolates how much of the non-aid current account balance is covered by net aid inflows and how the change in gross reserves responds to net aid’s over- or under-coverage of the CA deficit. For example, in 2000 net aid inflows were $60 million greater than the recorded CA deficit, while the accumulation of reserves was $197 million. This accounting suggests that the Bank of Tanzania did not sell the additional foreign exchange to finance additional net imports, but rather built up reserves in an amount that was greater than the excess aid inflow. Subsequent years over the period 2000-2004 show a similar response. In 2001, net aid inflows actually fell short of covering the non-aid CA by $53 million, yet reserves were accumulated by an additional $186 million. Other thing being equal, this reaction would create pressure for a nominal depreciation, and in the short run, a real depreciation. The bottom panel of Table 3 shows

> 26 This response describes what the IMF (2004) calls the absorption of aid inflows. Absorption is defined as the extent to which the non-aid current account deficit widens in response to an increase in aid inflows. It aims to measure the quantity of net imports financed by an increase in aid, which represents the real resource transfer of resources enabled by aid (IMF 2004). Aid that is spent and not absorbed is similar to increasing government expenditures in the absence of aid. The difference is that international reserves are higher.

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the cumulative increase in each component over the entire period. The cumulative change in net aid inflows marginally exceeded the cumulative increase in the non aid current account ($91 million), while gross reserves were accumulated by over $1 billion.

The accumulation of reserves in this amount over the period 2000-05 is consistent with a real exchange rate depreciation. However, the BoT’s reserve policy over the 19951999 period is not consistent with the REER appreciation observed. Despite a period of accumulation of reserves ($ 0.4 billion) the REER appreciated sharply. The reserve policy is consistent, however, with the observed depreciation of the nominal exchange rate over this period. There are a number of reasons why the BoT may have wanted to increase reserves over this period. Over the period 2000-05, it could have been done as a response to a surge in aid inflows resulting from a concern about a potential loss of competitiveness or as form of insurance against future shortfalls in aid inflows. It is equally plausible that BoT aimed to build up reserves for prudential reasons and was a continuation of a trend that started in the mid-1990s. Gross reserves covered only 1.5 months of imports in 1995 and were built up to 6.5 months of imports by end-2004. Regardless of the BoT’s motive for building reserves the effect was the same: it supported a nominal depreciation of the shilling, and over the period 2000-05 a real depreciation.

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**Table 3. Balance of Payments 1994-2005**

||**1995**|**1996**|**1997**|**1998**|**1999**|**2000**|**2001**|**2002**<sup>**2/**</sup>|**2003**<sup>**2/**</sup>|**2004**<sup>**2/**</sup>|**2005**<sup>**2/**</sup>|
|---|---|---|---|---|---|---|---|---|---|---|---|
|||Years of|REER Apprecia|tion||||Years of REER De|preciation|||
|**Levels**_(millions US$)_||||||||||||
|Net aid flow|727.53|698.42|967.74|627.65|795.92|937.31|754.64|667.10|876.29|1140.26|1405.16|
|Non-aid current account balance|-1008.64|-578.20|-784.88|-1230.33|-1194.69|-877.30|-808.26|-818.8|-795.1|-984.7|-1324.30|
|Change in Reserves (- = increase)|57.25|-209.45|-182.14|20.91|-175.41|-197.41|-186.38|-333.44|-348.16|-218.62|-128.49|
|_Potenial REER Impact (-=expected_<br>_depreciation)_|-223.86|-89.23|0.72|-581.77|-574.18|**-137.41**|**-240.00**|**-485.12**|**-267.00**|**-63.10**|**-47.63**|
|Non-aid capital account balance 1/|223.86|89.23|-0.72|581.77|574.18|137.41|240.00|485.12|267.00|63.10|47.63|
|**Percent of GDP**||||||||||||
|Net aid flow|13.84|10.75|12.59|7.49|9.21|10.32|7.99|6.83|8.52|10.08|11.60|
|Non-aid current account balance|-19.19|-8.90|-10.21|-14.68|-13.83|-9.66|-8.56|-8.38|-7.73|-8.71|-10.93|
|Change in Reserves (- = increase)|1.09|-3.22|-2.37|0.25|-2.03|-2.17|-1.97|-3.41|-3.38|-1.93|-1.06|
|_Potenial REER Impact (-=expected_<br>_depreciation)_|-4.26|-1.37|**0.01**|-6.94|-6.65|**-1.51**|**-2.54**|**-4.96**|**-2.59**|**-0.56**|**-0.39**|
|Non-aid capitalaccount balance1/|4.26|1.37|-0.01|6.94|6.65|1.51|2.54|4.96|2.59|0.56|-0.39|
|**Cummulative Changes **_(millions US$)_|||_1995-1999_|||||_2000-2005_||||
|Net aid flow|||3817.26|||||5780.75||||
|Non-aid current account balance|||-4796.74|||||-5608.50||||
|Change in Reserves (- = increase)|||-488.84|||||-1412.50||||
|_Potenial REER Impact (-=expected_<br>_depreciation)_|||-1468.32|||||-1240.25||||
|Non-aid capitalaccount balance1/|||1468.32|||||1240.25||||
|**Changes **_(millions US$)_||||||||||||
|∆Net aid flow||-29.11|269.32|-340.09|168.27|141.38|754.64|-270.21|121.65|473.16|528.87|
|∆ Non-aid current account balance||430.44|-206.68|-445.45|35.64|317.39|-808.26|58.52|13.13|-165.97|-529.17|
|∆ Change in Reserves (- = increase)||-266.70|27.31|203.05|-196.33|-22.00|-186.38|-136.03|-161.78|114.82|219.67|
|_Potenial REER Impact (-=expected_<br>_depreciation)_||134.63|89.95|-582.49|7.59|436.77|-240.00|-347.71|-27.00|422.02|219.37|
|∆ Non-aid capital account balance 1/||-134.63|-89.95|582.49|-7.59|-436.77|240.00|347.71|27.00|-422.02|-219.37|
|<br>**Changes **_(% of GDP)_|||_1995-1999_|||||_2000-200_|_5_|||
|∆Net aid flow||-3.09|1.84|-5.11|1.73|1.11|7.99|-3.50|0.52|3.25|3.09|
|∆ Non-aid current account balance||10.29|-1.31|-4.46|0.85|4.17|-8.56|1.28|0.83|-0.33|-3.21|
|∆ Change in Reserves (- = increase)||-4.31|0.85|2.62|-2.28|-0.14|-1.97|-1.24|-1.41|1.48|2.32|
|_Potenial REER Impact (-=expected_||||||||||||
|_depreciation)_||2.89|1.38|-6.95|0.29|5.13|-2.54|-3.45|-0.05|4.41|2.20|
|∆Non-aid capitalaccount balance1/||-2.89|-1.38|6.95|-0.29|-5.13|2.54|3.45|0.05|-4.41|-2.99|

Source: IMF Staff Reports.

1/ Includes errors and omissions.

- 2/ Original data available in fiscal year, converted to calendar year by taking average
# **Conclusions**

This paper examined how Tanzania’s REER has responded to internal and external macroeconomic developments since 1970. A long-run cointegrating relationship was developed to explain the long-run relationship between the REER and fundamental macroeconomic variables. An error-correction specification was employed to better understand the short-run dynamics of Tanzania’s REER. As Tanzania appears to be a likely candidate to receive an increase in its already significant aid inflows, a special emphasis was placed on the relationship between the REER and aid inflows. **A key conclusion of this work is that we can find no evidence that net aid inflows to Tanzania have led to an appreciation of the REER.** Indeed, the evidence suggests that aid surges are associated with depreciations in the REER both in the short-run and the long-term. This result, while somewhat counterintuitive, is not unique. Moreover, there are plausible explanations for such a result and in the case of Tanzania it appears that:

- Before full import liberalization in Tanzania, aid was used to finance imported inputs to ease constraints to domestic production, helping to raise output through increased levels of capacity utilization (Nyoni 1998). This description is particularly relevant in the years following 1986 when the underground economy resurfaced generating a large supply response to the increased availability of goods (Mwase and Ndulu 2005).These factors are likely at work in the early years of the sample.

- As borne out in the ECM results and supported by the accounting exercise, it appears that the BoT, whether a result of fears of loss of competitiveness, as insurance against future aid inflow shortfalls, or a desire to target a specific prudential level of reserves is building gross reserves that is consistent with a depreciation of the real exchange rate. This policy response to aid inflows seems particularly strong in recent years.

Other important conclusions reached along the way to producing the results on the relationship between aid inflows and the REER are:

- The long-run cointegrating relationship indicates that, in addition to aid inflows, the terms of trade and trade liberalization exert a significant influence on the level of the REER. The REER appreciates (depreciates) with an improvement (decline) in the TOT and depreciates (appreciates) with a more open (closed) trade regime.

- Incorporating the parallel nominal exchange rate in the measure of Tanzanina’s REER is important when considering the historical evolution of the REER. Incorporating the parallel rate into the econometric analysis did not fundamentally change the results obtained with the official rate.
- Relative to our estimates of the equilibrium REER, Tanzania’s actual REER was undervalued for much of the 1970s, sharply overvalued in the run-up to the balance of payments crises in 1986 and has recently been near equilibrium.

- Using an error correction model to capture the short-run dynamics of the REER indicates that it takes slightly less than 2 years for the REER to return halfway to its equilibrium value.

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