metadata: authors: 0: author: Matin,Kazi Mahbub-Al
count: Bangladesh
docna: 0: docna: Fiscal adjustment and the real exchange rate
            : the case of Bangladesh
docty: Policy Research Working Paper
subtopic: Macro-Fiscal Policy,Economic Adjustment and Lending,Public Sector Economics,Trade Policy,International Trade and Trade Rules,Rules of Origin,Inflation,Public Finance Decentralization and
            Poverty Reduction,Trade and Multilateral Issues
teratopic: Environment
abstracts: cdata!: The author examines the effect of fiscal
            adjustment on the real exchange rate. The argument is made
            that the direction and extent of that effect depends on the
            way fiscal adjustment is carried out. If a fiscal deficit is
            reduced mainly by reducing total government spending, the
            effect on the real exchange rate depends on whether the
            adjustment is achieved through proportionate cuts in both
            capital and current spending or through disproportionately
            greater cuts in capital spending. A disproportionately high
            cut in capital spending affects the composition of
            government spending between tradables and nontradables.
            Econometric estimates of the model for Bangladesh show that
            the propensity to spend on nontradables is greater for
            government spending than for private, and greater for the
            government's current spending than for its capital
            spending. The author emphasizes two important implications
            of fiscal adjustment for developing countries like
            Bangladesh : a) when fiscal adjustment involves
            unsustainably heavy cuts in capital spending, appreciation
            of the real exchange rate misaligns that rate, causing
            misallocation of resources and b) when disproportionate cuts
            in capital spending occur at the same time as trade
            liberalization, appreciation of the real exchange rate
            undermines the effectiveness of trade.
geo_reg_key: 517198,517212,517191
repnme: repnme: Fiscal adjustment and the real exchange
            rate : the case of Bangladesh
display_title: Fiscal adjustment and the real
            exchange rate : the case of Bangladesh
listing_relative_url: /research/1992/02/699749/fiscal-adjustment-real-exchange-rate-case-bangladesh
topicv3: Government Expenditure m1326649 1112,Inflation m1326709 0870F4727ACED1CF8525815C00471347,Trade m1326924 698,Trade Policy and Integration m1327407 775,Trade Policy m1327640 776
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Environment
origu: Policy Research Department
no_of_pages: 47
author_keys: 0: author_key: 93628
model_extractions: **Policy Research**

<!-- Start of picture text --> Trade Policy E<br>I-<br>WPS 850<br><!-- End of picture text --> T'his paper -a product of thc Tradc Policy Division, Country Economics Departmentis part of a larger research project on the sustainability of trade rcform in structural adjustment loans (RPO 675-32). Thc paper was presentcd at Bank seminars held in August and October 1991. Copies of the paper are available rree from the World Bark, 1818 H Strect NW, Washington, DC 20433. Please contact Dawn Ballantyne, room N I0-007, extension 38004 (42 pages). February 1992.

Malin examines the effect of fiscal adjustment on the real exchange rate. He argucs that thle direction and extent of that effect depend on the way fiscal adjustment is carried out. If a fiscal delicit is reduced mainly by reducing total govemment spending, the effect on the real exchangc rate depends on whether the adjustment is achieved through proportionate cuts in both capital and current spending or through disproportionately greater cuts in capital spending. A disproportionately high cut in catpital spending affects the composition of government spending between tradables and nontradables.

nontradables is greater for government spending than for private spcnding and greater lor the governmcnt's current spending than for its capital spending. This result is highly robust across different measures of the real exchange rate and across different methods of estimation. Thus as Bangladesh's fiscal adjustment shifted government spending toward nontradables, the real cxchangc rate tended to appreciate.

Matin emphasizes two important i7molications of such fiscal adjustment for developing countries like Bangladesh: Matin extends the dependent-economy model of the rcal exchange rate, incorporating both the level and composition of government spending. He then estimates the model for Bangladesh, a country that reduced total govcrnmcnt spending in the face of growing current expenditures. Bangladesh's fiscal adjustment involved an unsustainably large decline in capital spending as a share ol total spending.

Econometric estimates of the model for Bangladesh sihow that the propensity to spend on

* When fiscal adjustment involves unsustainably heavy cuts in capital spending (a trend that is now being reversed in Bangladesh), appreciation of the real exchange rate misaligns that rate, causing a misallocation of resources.

***** When disproportionate cuts in capital spending occur at the same timc as trade liberalization, appreciation of the real exchange rate undermines the effectiveness of trade liberalization.

Thc Policy Research Working PapcrSeriesdisseminates the findingsofwork under way in the Bank. Anobjectivcof hc scries i is to get thesc findings out quickly, even if presentations are less than fully polished. The findings, interpretations, and I conclusions in these papers do not necessarily represent official bank policy.

Produced by the Policy Research Dissemination Center
Table of Contents

|I.|Introduction<br>.......................<br>,|
|---|---|
|II.|<br>Bangladesh's Fiscal Adjustment in the 1980s<br>.5<br>Overview.<br>5<br>Adjustment.<br>7|
|III.|Dependent Economy Model of R.eal Exchange Rate With Government<br>Expenditure<br>.10<br>The Model<br>.10<br>Fundamentals Affecting RER .13<br>Basic Model for RER .14|
|IV.|Econometric Estimation of the RER Model .18<br>Estimation Results of Basic Model<br>.<br>.18<br>Simultaneity Bias<br>..<br>19<br>Estimation Results of Reduced Form Model<br>.<br>.21<br>i) Government Expenditure<br>.22<br>ii) Terms of Trade<br>.23<br>Elasticity Estimates<br>..<br>24|
|VI.|Implications of Fiscal Adjustment<br>.25<br>Alternative Fiscal Adjustment<br>.25|
||Trade Liberalization<br>.27|
||Misaligned RER .28<br>Conclusions...................<br>.....<br>30|
||Data Annex .....<br>32|
||Tables and Figures<br>.....<br>34<br>References<br>.........................<br>41|

This work is part of the research project on Sustainability of Trade Reforms in SALs (RPO 675-32). The author would like to thank Jaime de Melo, Pradeep Mitra, Ichiro Otani, Arvind Panagariya, Ram Agarwala, Jim Sackey, Jim Tybout and participants at Trade Policy Division Seminar for comments and Partha Mukhopadhyay for excellent research assistance.
# I. INTRODUCTION

The success of fiscal adjustment depends not only on the size of deficit reduction but also on the way it is reduced. The same reduction in fiscal deficit can have different macroeconomic and microeconomic implications (Tanzi 1989) if different combinations of tax and expenditure cuts are used to achieve it. Similarly, the same cut in total expenditure can have different effects depending on the way it is cut and how that alters the composi-<sup>4</sup> on of government expenditure. For example fiscal adjustment that falls predominantly on government's capital expenditure has been found to have an adverse effect on private investment and thus on overall growth (Chhibber & Dailami, 1990 , Faini and de Melo 1991).

This paper explores another effect of fiscal adjustment: the effect of changing composition of government expenditure on the real exchange rate. Typically rising fiscal d-eficits and its inflationary financing appreciate the real exchange rate, when such financing is inconsistert with the pegged nominal exchange -ate (Edwards 1989). Fiscal adjustment seeks to restore macro-stability and competitiveness by reducing fiscal deficits to a level that can be financed in a non-inflationary manner (Tanzi 1990). This paper shows that if reductions in fiscal deficit is accompanied by a substantial shift in the composition of
2 government expenditure towards consumption, fiscal adjustment tends to appreciate the real exchange rate (RER).

This incipient real appreciation generated by fiscal adjustment is of concern for at least two reasons. First, though this RER movement is in response to a shift in a "fundamental" (e.g. in the composition of government expenditure arising from fiscal adjustment) it may not be an eguilibrium movement of the RER if the shift in "fundamental" is not sustainable and thus temporary (Lizondo 1989). Ideally, the RER should not appreciate because wholly temporary shifts in fundamentals do not alter the long-run equilibrium real exchange rate. However, if the private sector either does not perceive the unsustainability of a shift in expenditure composition, or it perceives the unsustainability but is constrained from responding appropriately to it (e.g. is liquidity constrained), the RER appreciation will inevitably be larger than is warranted by long-run equilibrium. In the presence of imperfections in domestic capital market, adjustment costs and other externalities, this appreciation can result in substantial misallocation of resources. (Neary and Van Wijnbergen 1986). Second, if trade 1<sup>4</sup> beralization and fiscal adjustment are implemented simultaneously as is often the case,<sup>1</sup> any RER appreciation (whether 'equilibrium' or not) gives confusing "signals" to producers and thus undermines the credibility of trade liberalization (Corbo and De Melo 1987, Rodrik 1989).

Surprisingly however, the effect of such fiscal. adjustment on the real exchange rate (RER) has not been well appreciated in the literature. Most of the 1In most of the forty countries receiving "trade" adjustment loans between 1979 and 1987, trade policy reform and fiscal adjustment were carried out simultaneously (Thomas, Matin and Nash, 1990, p. 2, 8).
3 theoretical studies on fiscal policy and the real exchange rate (see Penati 1983 -or a survey) have focused on the real exchange rate effect of changes in the level of total government expenditure.

Only recently, a few papers have examined the theoretical link between the changes in the composition of government exDenditure and real exchange rate (Monteil 1986, Khan and Lizondo 1987). Khan and Lizondo (1987) show that for a small open economy, the reduction in government expenditure that falls wholly on tradables has no effect on the real exchange rate because prices of non tradables are not altered by this reduction. However, when the same reduction in expenditure falls entirely on non-tradables, it depreciates the real exchange -ate. Similarly, increases in government's propensity to spend on non-tradables with no change in expenditure levels, appreciates the real exchange rate (Monteil 1986).

Most empirical work on real exchange rate models for developing countries (Edwards 1989, Cottani et al 1991, Easterly 1991, Rodriguez, 1991) have also ignored the effect of changes in the composition of government expenditure on RER. Barring one exception (Ramangkura and Nidhiprabha 1991), the comoosition of government expenditure do not feature in their econometric models.

This paper develops a dependent economy model of 'equilibrium' real exchange rate that incorporates not only the level but also the composition of government expenditure. The distinctive feature of this model is that it allows for differences between current and capital expenditure in terms of their propensities to spend on non-tradables. This means changes in the share of
4 capital expenditure in total expenditure can alter tne composition of total expenditure between tradables and non tradables. However the direct,on of the real exchange rate effect of changes in level and composition of expenditure are a priori ambiguous and must be ascertained empirically.

This =del of real exchange rate is estimated with data from Bangladesh. Though many developing countries have experienced changes in the composition of government expenditure2, Bangladesh presents an interesting case for several reasons. First unlike other countries that reduced total expenditure by reducing capital expenditure more than current expenditure (Hicks 1991), Bangladesh reduced total expenditure in the face of rising current expenditure. This implied a much larger shift in the composition of government expenditure towards consumption or current expenditure than in most other countries. Second, given the higher propensity of government's current outlays to spend on non tradables, this large shift in composition towards current expenditure implied an equally large shift in composition towards non-tradables. Third, since fiscal adjustment and trade liberalization is being implemented simultaneously in Bangladesh, the effect of fiscal adjustment on RER is of considerable interest.

The paper is orgauiized as follows: Section II describes the nature of Bangladesh's fiscal adjustment over the 1980s. Section III develops the dependent-economy model of equilibrium real exchange rate and Section IV undertakes econometric estimation of the model. Section V concludes by highlighting the implications of the results.

2A recent review of adjustment experience in the IMF shows that in nearly a dozen countries fiscal adjustment was accompanied by a rise in current expenditure and a large decline in capital expenditure.
5

# II. B^GAISH'S FISCAL ADJUSTMENT IN THE 1980s

Bat.gladesh's fiscal adjustment since fiscal year (FY) 1983 (i.e. 1982/83) succeeded in reducing deficits sufficiently to eliminate inflationary financing of deficits. The raduction in fiscal deficit was made possible by cuts in total government expenditure.3 However, since such cuts in total expenditure were accompanied by growth in current expenditure, capital expenditure fell by one and half times the fall in total expenditure, as a share of GDP. This led to a substantial change in the composition of government expenditure towards cutrent expenditure and consumption. As the propensity to spend on non-tradables was greater for current than for capital expenditure, fiscal adjustment over the 1980s raised the expenditure-share of non tradables in total government expenditure substantially.

## Overview

Bangladesh's fiscal deficit has averaged around 8 percent of GDP over the last two decades. In six of those years, it averaged around 10 percent of GDP, four of which were in the early 1980s. Fiscal deficit has fluctuated from a low of 2.5 percent in FY 1975 to a high of 11 percent in FY 1983. As in so many other developing countries, the fiscal deficit has remained high largely because of political and administrative inability to mobilize additional revenue.

> 3The level of Bangladesh's total government expenditures relative to GDP is not high by developing country standards. The average for India, Indonesia, Pakistan, Sri Lanka and Thailand is 27.4% (World Bank 1989 p.4). At its peak in FY 1983 Bangladesh's expenditure was 19.3% of GDP; the average is around 17%.
6 Bangladesh's government revenue averaged about 9% of GDP over nearly two decades, which is a Iittle more than half that for tha . w-income countries as a group.4 Though the fiscal deficit has been high, inflation has been lower than in most developing countrles with deficits of comparable magnitude.5 Only in four years has inflationary financing of the fiscal deficit been substantial: the first two years after independence, and in FY 1980 and 1981. Sharp increases in capital or (the Annual Development Program, ADP) expenditure6 and a rise in government food imports caused by a severe drought expanded both the fiscal deficit and its inflationary financing in FY 1980. Stabilization efforts in the form of increased tax revenue and reduced capital or ADP expenditure lowered the fiscal deficit slightly in FY 1981. However an unanticipated shortfall in aid inflow led to larger instead of smaller inflationary financing in that year (Matin 1990).

4For a sample of 25 low income countries (World Bank 1988 p 46.) revenue was 15.4% of GDP in 1985. The average revenue for the five countries of the region (India, Indonesia, Pakistan, Sri Lanka and Thailand) is 21.1% of GDP (World Bank 1989 p. 4).

5Bangladesh's annual average inflation rate of around 12 percent is substantially below the average for non-oil developing countries as a group. In only three years out of eighteen, did inflation exceed 20 percent. The loose link between fiscal deficit and inflation is owed mainly to its external financing.

6Annual Development Program (ADP) expenditure consists predominantly of projects that is the main source of public capital formation.
7 Adfiustmen The fiscal deficit was reduced afte- FY 19837 mainly through expenditure compression, as the governmen'. failed to generate the needed increases in revenue. More than four-fifth of the reduction in fiscal deficit between FY 1983 and 1990 was accomplished through expenditure compression (Table 1). As fiscal deficit fell from 11 percent of GDP to 8.1 percent over that period, total government expenditure fell from 19.7% to 17.4% of GDP.

This fall in total government expenditure was not as significant as the change in the composition of total expenditure that accompanied fiscal adjustment. Capital (ADP) expenditure fell by 3.4 percent of GDP which was oneand-half times the fall in total expenditure. On the other hand, current expenditure instead of falling, rose by 2.1 percent of GDP.<sup>8</sup> Figure 1 highlights the fact that these trend changes were sustained for most of the 1980s.

This opposite movemert in current and ADP expenditure led to a large shift in the composition of government expenditure. The share of capital expenditure in Zotal expenditure fell from 52% to 39% over the same period. In addition within capital expenditure, the components of capital expenditure on 7The average fiscal deficit stood at around 10% of GDP over tb..) period FY 1980-1984, peak4ng at 11% in FY 1983.

8They do not add up to the decline in total expenditure i.e. 2.3% of GDP, because "other capital expenditure" and "Food Account" expenditures are not included in ADP and current expenditure cited in Table L.
8 infrastructur3 and on provision of economic<sup>services experienced the largest</sup> decline.9 Thus the nature of Bangladesh's fiscal<sup>adjustment tended to alter the</sup> composition of government's total<sup>expenditure in favor of non-tradables in two</sup> ways. As the prop^nsity to spend<sup>on non tradables was greater for current than</sup> for capital expenditure, a rising<sup>share of current expendit-re</sup> 10 in total government expenditure increased<sup>the expenditure share of non tradables. In</sup> addition greater declines in capital<sup>expenditure on infrastructure</sup> raised the share of non-tradables in capital<sup>expeziditure</sup> relative to FY 1983.

The decline in the share of capital<sup>expenditure tended to appreciate the</sup> real exchange rate (RER). F_gure<sup>2 shows the movements in three different</sup> measures of the RER<sup>1</sup> l in the top panel,<sup>and changes in the composition of total</sup> expenditure in the bottom panel. Though<sup>composition of government expenditure</sup> 9The share of ADP expenditure on both economic services and infrastructure as a whole fell from<sup>53.1% in 1982/83 to 70.8% in 1989/90. In</sup> view of the relatively lower intensity<sup>of tradables in the capital (ADP)</sup> expenditure on social sector, the<sup>above implies a clear increase in the non-</sup> tradable-component of development expenditure as<sup>well.</sup> 10The coe.P icient of the government expenditure composition variable obtained from an estimated import demand<sup>function confirms that in Bangladesh,</sup> capital or ADP expenditure is more intensive<sup>in tradables (i.e. in imports)</sup> than current expenditure (see Matin<sup>1991).</sup> 11This is the ratio of non-tradable price to the price of traded goods. Non-tradable price is proxied by<sup>CPI for one measure (RPT) and by adjusted CPI</sup> (i.e. CPI purged of import prices in<sup>another (RPTI). See Annex on Data for</sup> details.
**_V_**

9 is only one of several 'fundamentals' affecting the RER, it is interesting to find a strongly negative relationship between RER movements on the one hand and changes in the share of capital expenditure on the other hand especially after
10

# III. pLEPNDENT-ECONOMY MODEL OF REAL EXCHANGE RATE WITH GOVERNMENT EXPENDITURE

We derive an equilibrium real exchange rate (RER) model for econometric estimation, by extending the model in Rodriguez (1989) to incorporate both the. size of total government expenditure and the coL,osition of that expenditure. For this purpose we distinguish between private and government demand for nontradables and between government's current and capital expenditure so as to accommodate different propensities to spend on non-tradables.

# The Model

The model is based on three goods: non tradables (N), import competing (M) and exportables (X) whose prices in domestic currency are PN IP. and Px. The supply of non-tradables (YN) can be represented as a function of three nominal prices and nominal output. Deflating nominal prices and output by **PN** and assuming that the share of nontradables in GDP is only a function of relative prices only we get: where Y (. ) is the share of N in GDP and Y is real GDP expressed in nontradables. Equation (1) can be expressed in terms of the real exchange rate (e - PN/PT) and the terms of trade (T - P./P,)12 as follows:

> 1 2 If PT is a price index of the two tradables prices PT - F (PX, PM) homogenous of degree one, then PT - f (PX/Pm) P".
11 The supply of non-tradables is a positive function of the real exchange rate and a negative or positive function of the terms of trade.

On the demand side we extend Rodriguez (1989) by distinguishing between various types of expenditure. ThiL extension can accommodate (a) differences in the propensity of private and government sector to spend on non tradables, and (b) differences in the propensity of government's current and capital outlays to spend on non tradebles.

Private demand for non tradables (Dpn) is shown as a function of the real exchange rate(e) terms of trade (T) and total private spending (DP) Private demand for non-tradabLes is thus a negative function of the real exchange rate and a positive or negative function of the terms of trade.

Total government expenditure (D.) which is a share 'g' of total output 'Y' (i.e. gY) is equal to the sum of current expenditure C. and capital expenditure Ig. Government expenditure on non-tradables (Don) is a weighted average of current and capital expenditures, with the shares of non-tradables (dc and dl) in each type of government expenditure as weights. Thus: Dividing both sides by Dg we get
12 (5) dc(l-tl) + dl -1 - d where t, us the share of capital expenditure in total expenditure<sup>and 'd' is the</sup> fraction of total government expenditure spent on<sup>non-tradables. This fraction</sup> 'd' is a function of c1 and the relative propensity of the two types of government expenditure to spend on non tradables<sup>(i.e. dc and d,. Thus:</sup> Equilibrium in the non tradables market yields the equilibrium<sup>real exchange</sup> rate (e*). For such equilibrium, supply of non tradables<sup>must equal its demand.</sup> Thus: (7) a (e, T) Y - b (e, T) (E-gY) + d(Tr) gY where E is the total aggregate expenditure<sup>in the economy and private</sup> expenditure, Dp - E - gY. By definition we have (8) E - (1-cas) Y where cas is the ratio of current account surplus to Y.<sup>Thus substituting (8)</sup> in (7) and rearranging we get: (9) b (e, T) (l-cas-g) + d(T1) g - a (e, T) Solving (9) for e* or the equilibrium real exchange<sup>rate we get:</sup>
13

- (10) e* e (cas, T, g, TI)

Equation (10) is the derived real exchange rate (RER) model.

# Fundamentals Affecting RER

The above model of equilibrium real exchange rate (RER) determination suggest that there are four fundamentals that affect the RER. However, with the exception of "cas", the a priori direction of their effects are ambiguous.

Increases in the excess of aggregate expenditure over aggregate income, or in the current account deficit (i.e. -cas) appreciates the RER. Assuming both tradables and non-tradables to be normal goods, increases in capital inflow (i.e. increases in aggregate expenditure over income) appreciates the RER because the demand for non-tradables is likely to rise relative to supply.<sup>13</sup> The extent of this real appreciation depends on the income elasticity of demand and the price elasticities of both demand and supply of non-tradables.

The larger the income elasticity the greater the real appreciation and the higher the supply price elasticity the lower the real appreciation; If aid flows relaxes certain import constraints and this increases the supply of non13Though most types of capital inflows including aid have such an effect, some types of aid may not. It is conceivable however that some capital inflow like aid in the form of goods or aid used to import an aircraft or a ship has little or no effect on the RER because it has no spending effect on nontradables. But even in this case a spending effect on non-tradables is ruled out only if this import of aircraft or ship is a net addition to the economy's supply of imports. Otherwise if the aircraft or ship would be imported anyway with domestic resources, even this aid frees resources that can be spent on non-tradables.
14 tradables, the resulting RER appreciation may be small, notwithstanditig a large income elasticity of demand.<sup>14</sup> For a given capital inflow or a given current account deficit fiscal adjustment affects the RER. Sustainable changes in the level of government expenditure (e.g. its share in GDP) and in its composition will alter the equilibrium RER. The direction of the effect is ambiguous in both cases. If the government as a whole has higher propensity to spend on non-tradables than the private sector, then an increase in the GDP share of government expenditure ('g') will result in a real appreciation. Conversely, if government has a relatively lower propensity, increases in the GDP share of government expenditure will lead to a real depreciation. Thus the impact of increases in size of government expenditure ('g') on the RER could go either way.<sup>15</sup> If government's propensity to spend on non-tradables differ between current and capital expenditure then changes in composition (e.g. in the share of capital expenditure in total government expenditure) will have a separate impact on the RER (Lizondo & Khan 1987, Monteil 1986). Again the direction of its impact is an empirical issue.

14For examuple, if aid relaxes the constraints on imports of intermediate inputs used in constructing buildings/housing, it would raise supply of non tradables.

15Empirical estimates of RER equations have reported both positive and negative signs for the coefficient on the size of government expenditure (Easterly 1991, Rodriguez 1991, Edwards 1989).
15 The effect of changes in terms of trade<sup>16</sup> (T) depends on the relative strength of income and substitution effects. Adverse shifts in the external terms of trade will affect Bangladesh's aggregate budget constraint and thus exert a negative income effect on demand for non-tradables irrespective of whether import prices rise or export prices fall. The substitution eff'ct will also lower demand for non-tradables if there is a decrease in export prices but this is not likely to be large in Bangladesh. If however import prices rise, then the magnitude of the net effect depends on substitutability between imports and non-tradables. So long as the income effect is stronger than the substitution effect, RER will depreciate when terms of trade deteriorate.

# Basic Model for RER

We augment the RER model derived in equation (10) by adding two other variables discussed in the literature: a proxy for relative growth in productiv:ty of tradable sector and a nominal variable like exchange rate or domestic credit.

The first relates to the RER effect of productivity growth in the tradable sector. It has been argued that major differences in productivity among countries arise from productivity differences in the countries' tradable sector rather than in the non-tradable sector (Balassa 1964, p. 586). If productivity growth in a country's tradable sector is greater than that in another country, 16The terms of trade variable could be augmented by the effect of domestic controls, taxes and subsidies on import and export prices, or an additional variable could be added to capture the effect of trade reform. For that, a good proxy for changes in controls, taxes and subsidies on imports is necessary.
16 then its wage will rise and its real exchange rate will appreciate (Balassa p. 586). Thus if Bangladesh's productivity in tradable sector grows faster (slower) than other countries, Bangladesh's RER will appreciate (depreciate).

While nominal variables have no effect on the long-run RER, they do affect the RER in the short run. A nominal depreciation leads to an immediate RER depreciation, but it is eroded over the medium term if the fundamentals do not warrant such RER depreciation (Edwards 1989). The same is true of dolnestic cre.Lt whose growth alters the RER, until price level increases reduce real domestic credit (money balances) to its original level.

The basic model we estimate in the next section is shown in equation (11) below: 7

- (11) LN (RER) - a. + a, COMP + a2 GEXP + a3 LN (TOT) + a4 PRODIFF + a5 CADEFG + a6 NOMVAR

where we use the following notation:

- ADPSHR Composition of government expenditure proxied by share of capital (ADP) expenditure in total Government expenditure (i.e. T, in equation 10).18

GEXPG Total government expenditure as a share of CDP (i.e. 'g'). RER Real Exchange Rate Index (seven different indices) where a rise in the index is an appreciation.

CADEFG Current account deficit as a share of GDP (i.e. -cas).

17Since five of the six explanatory variables of the basic model are in ratios or rates of change, we use natural logs of terms of trade and the real exchange rate index.

18Some have proxied composition by the ratio of capital to current expenditure. The measure is equivalent to ours as they differ by a constant.
17 TOT The terms of trade defined as the ratio of the dollar export price index to import price index (i.e. 'T'). PRODIFF Measure of Productivity Difference proxied by difference between Bangladesh's export growth rate and that of to a set of six comparable countries.<sup>19</sup> NOMVAR1 Nominal variable like devaluation where the nominal exchange rate is expressed as local currency per US dollar. NOMVAR2 Nominal Variable like domestic credit growth rate.

19A simple average of export growth rates of India, China, Indonesia, Thailand, Pakistan and Singapore is used.
18

# IV. ECONOMETRIC ESTIMATION OF THE RER MODEL

Norwithstanding the well-known problems of estimating a single-equation model instead of a simultaneous equation macro-model, we estimate the basic model directly. In view of the small size of our sample (i.e. annual observations for 16 years), our choice of estimation technique was limited to ordinary least squares (OLS), which is in line with the practice o' v hers (Edwards 1989, Cottani et al 1990, Rodriguez 1991, Easterly 1991).20 However, to overcome the problem of 'simultaneity bias' arising from the fact that the current account is an explanatory variable, we estimate a reduced form RER model by replacing the current account variable with its determinants. While the explanatory power of the model rises, the estimated coefficients of the reduced form are not significantly different from those of the basic model.

# Estimation Results of Basic Model

The basic model is estimated for seven different measures of the real exchange rate (RER). Table 2 provides the estimation results. The reported results of the basic model excludes those wth NOMVAR1 or NOMVAR2 because they had insignificant coefficients for all the RER measures. Dropping them improves both the fit of the RER equation and the precision of the coefficient estimates.

20This has been the estimation technique of choice even when there was a larger sample of pooled cross section data (Edwards 1989, Cottani et al 1990).
19 The coefficients for both the level and composition of government expenditure are significant in virtually all of the estimated equations.21 They are not significantly different across the equations. The results<sup>show that</sup> increases in the level of total government expenditure (GEXPG) and in the share of capital expenditure in total expenditure i.e. composition (ADPSHR) deRreciates the real exchange rate. The coefficients on the other variables<sup>are also</sup> significant and of the right sign for most of the RER measures.

# Simultaneity Bias

However, the fact that changes in the current account may be simultaneously affected by RER raises the possibility of simultaneity bias in the estimated coefficients of the basic model in Table 2. Though we could overlook this by arguing that the extent of simultaneity bias is likely to be small for several reasons,< we seek to address the problem in the best possible way instead.

21The only exception is the coefficient estimate for expenditure compositions in the RERT measure.

22First, in the context of low income countries like Bangladesh where "aid" finances most of the current account deficit, such deficits can be viewed as more exogenous than in most countries. It is more likely to affect RER char.ges, instead of being affected by it. Second since the current account is mainly a function of aggregate expenditure-income balance over the medium term, changes in the real exchange rate with no change in aggregate expenditure-income balance is unlikely to have a marginal effect on the current account. Third many empirical studies have been unable to detect<sup>a</sup> significant effect of RER on the trade balance (Pritchett 1991, Rose 1991). Some of these arguments are implicit or explicit in studies reporting singleequation RER models the current account/capital inflow variable on the right hand side (Cottani et al 1989, Rodriguez 1991, Easterly 1991). Notwithstanding the above, it is difficult to rule out all effects of RER<sup>on</sup> the current account
20 The small size of our sample<sup>severely limits our options on alternative</sup> estimation techniques. One way<sup>to avoid the simultaneity bias in the estimated</sup> coefficients is to estimate a reduced form RER<sup>model. We obtain the reduced form</sup> equation by replacing the current<sup>account variable in the basic model with its</sup> determinants. For example our structural<sup>model obtained in Section III is:</sup>

# (12) LN(RER) - aO + a1 ADPSHR + a2<sup>GEXPG+a</sup> 3<sup>LN(TOT)</sup>

## +a4 XGRDIIFF + aS CADEFG

Current account deficit as a share<sup>of GDP (CADEFG) is assumed to be a function</sup> of real exchange rate, real aid<sup>disbursements (RAID) and output or real GDP</sup> (RGDP). Thus: (13) CADEFG - bo + b1 LN(RER) + b2<sup>LN(RAID)+b</sup> 3<sup>LN(RGDP).</sup> Substituting (13) into (12) se get<sup>the reduced form as follows:</sup> (14) LN(RER) - CO + C1 ADPSHR + C2<sup>GEXPG+C</sup> 3<sup>LN(TOT)+C</sup> 4<sup>PRODIFF</sup>

- + C5 LN(RAID) + C6 LN(RGDP)

## where C. _ aO*b

~1- 1~b 1 a5, C2 a2 _1-a5b1_
21 <!-- Start of picture text --> a3<br>1-asb5<br>C 1-a a 4 5b1<br>Ca1-a5 .t) 1<br><!-- End of picture text --> None of the structural coefficients (i.e. 'a' of equation 12) can be recovered from the estimates of the reduced form equation (14). Nevertheless, the estimated coefficients gives us 'true' overall response of the real exchange rate to fiscal adjustment.

# Estimation Results of Reduced Form Model

The estimated coefficients of the reduced form in Table 3 are similar to those of the basic model in Table 2 in terms of both sign and significance. The estimates are reassuringly robust to alternative RER measurps and alternative determinants of current account deficit.23 The overall fit of the reduced form equations are better than those of the basic model.

2Alternative reduced form equations arising from alternative sets of explanatory variables determining the current account (i.e. in equation 13) do not change the coefficient estimates for expenditure variables significantly.
22

# _(1) Governmen: expenditure_

The coefficients for composition of government expenditure and for total government expenditure are the most robust both in sign, and significance. They are significant (at less than 10% level)24 and have the expected sign in six out of seven equations. The coefficients on both the level and composition of government expenditure are n significantly different across the equations and between the two models estimated. For expenditure composition the estimated coefficient from reduced form in Table 3 is lower and less precisely estimated than those in Table 2, but boch the estimates are not significantly different from unity.<sup>25</sup> As for total government expenditure (GEXPG), again their reduced form estimates are not significantly different from those estimated in the basic model and the precision level is the same.

Increases in the level of total government expenditure and in the share of capital (ADP' expenditure in total expenditure depreciates the real exchange rate. For any given total public expenditure, a shift in its composition away from capital or ADP expenditure apgreciates the real exchange rate. Thus the effect of a given reduction in total expenditure on RER will be different if it is accompanied by a change in composition of such expenditure, than if it is not. This suggests that specifications of RER models for Bangladesh that ignore 24Even in the RERT equation (column 1, table 4 and 6) the coefficient for total goverrnment expenditure is significant 3nd of the right sign; that for composition is not significant.

25T-tests confirm that they are not significantly different from one.
23 public-expenditure-composition are likely to produce real exchange rate elasticities with respect to total public expenditure that are unstable.26

# _(11) Terms of trade_

The coefficient of the terms of trade is significant ia five and four out of seven RER equations in Tables 2 and 3 respectively. Though their signs differ across RER measures in each Table, the same sign is obtained for the same RER measure in both cases. Terms of trade improvement leads to RER appreciation for all measures except the export price based RER; it leads to a depreciation in the latter measure (i.e. RPX and RPX1).

This difference in sign is perhaps not as surprising as it first seems. While the income effect of a terms of trade improvement on the price of nontradables (e.g. CPI and CPI<sup>1</sup> ) is similar irrespective of whether export or import price changes cause the terms of trade improvement, the effect on relative prices (i.e. on RER indices) need not be. This is because the proxy for tradable prices in the RER index (the denominator in our indices) may move differently depending on which price index proxy tradable prices and on which price change, import or export price change causes the terms of trade improvement. Since RPX and RPX1 measures use export prices and export price increases have dominated Bangladesh's terms of trade improvements, the difference in sign is not surprising.27 26 This raises questions about the stability of expenditure coefficients in RER models estimated recently for other countries (Edwards 1989, Cottani et al 1990, Rodriguez 1991, Easterly 1991), because they ignore expenditure composition.

27 Simple regressions of CPI, CPIl and PX on terms of trade confirm this association. If the rise in dollar export price rise causing the terms of trade improvement is larger than the rise in non-tradable prices caused by the income effect of export price increases, which is not unlikely given that the
24

# Elasticity Estimates

The elasticity of RER for expenditure<sup>level is larger than for expenditure</sup> composition. A 10% increase in<sup>the level of total government expenditure</sup> relative to its mean, depreciates the<sup>RER by anywhere between 5.5% and 9.7% while</sup> similar percentage rise in the share<sup>of capital in total expenditure depreciates</sup> the RER by between 3.8% and 4.8%. They<sup>are shown in Table 4.</sup> Yet, over the 1980s changes in composition<sup>had a greater appreciation</sup> effect than decreases in expenditure level.<sup>The actual fall in total expenditure from</sup> 19.7% of GDP in FY 1983 to 17.4% in<sup>FY 1990 tended to appreciate the RER by</sup> between 6% and 8%, whereas actual fall<sup>in the share of capital expenditure in</sup> total expenditure over the same period<sup>tended to appreciate the RER by anywhere</sup> between 10% and 14%. Thus changes in composition of total government expenditure contributed around two-thirds of the<sup>total RER appreciation effect of fiscal</sup> adjustment.

income effect will take some time to work<sup>itself out, the sign can be</sup> negative.
25

# VI. IMPLICATIONS OF FISCAL ADJUSTMENT

The nature of fisc. L adjustment implemented by Bangladesh28 has important policy implications. Whether it is sustainable or not the RER effect of fiscal adjustment depends critically on the way fiscal deficit and/or total expenditure is reduced. When fiscal adjustment is sustainable, the resulting change in real exchange rate is an equilibrium change that is consistent with the maintenance of long-run external balance. Nevertheless, even sustainable fiscal adjustment that involves a large shift in expenditure composition towards non tradables should not be carried out simultaneously with trade liberalization because the resulting RER appreciation, will undermine liberalization. When such fiscal adjustment is unsustainable and temporary as is the case in Bangladesh, the problems are compounded because the magnitude of RER appreciation is not an equilibrium one. The RER becomes misaligned in a long run sense (Lizondo 1989), and resources get misallocated. We discuss each of these implications in turn.

# Alternative Fiscal Adjustment Policies

Alternative fiscal adjustment policies aimed at reducing the same fiscal deficit have different RER effects. Fiscal deficit can be reduced either through some combination of lower expenditure and higher revenue or through expenditure reductions only. Even if deficit reduction is undertaken mainly through expenditure reductions, as was the case in Bangladesh, different ways of reducing 28A 10 percent reduction in total public expenditure/GDP was accompeanied by a 26% decline in the share of capital expenditure in total expenditure, between FY 1983 and FY 1990.
26 total expenditure have different effects on composition of total expenditure, which in turn has different effect on the RER.

The same actual reduction in Bangladesh's total expenditure between FY 1983 and FY 1990 could have been undertaken in at least two other ways that would have implied less RER appreciation and would have been less adverse for Bangladesh's external sector competitiveness." The first would involve equivalent reductions in both current and capital expenditure, such that the composition of Bangladesh's total expenditure would not change. The resulting RER appreciation would have been only around a third of the actual appreciation effect over that period. Similarly, the second way would require that the entire change in total expenditure was borne only by current expenditure. In that event there would be little or no appreciation effect resulting from fiscal adjustment.

We carry out a simulation to show how the RER would have moved if the actual reductions in total expenditure were carried out in the two hypothetical ways described above. Figure 3 shows three graphs of Bangladesh's RER predicted by the equation for RPT in Table 3 on three basis: (a) RER predicted using actual changes in &il variables, (b) RER predicted using actual changes in all variables except expenditure composition (ADPSHR) which is held unchanged at FY 1981 level, (c) RER predicted using actual changes in all variables exceRt expenditure 29Equivalent reductions in current and capital expenditure would have ensured a constant ADP share.
27 composition, but in this case ADPSHR rises30, because total expenditure is reduced by reducing current expenditure only.

Figure 3 is self explanatory. Both ways of reducing total expenditure implies a less appreciated real exchange rate in every year after FY 1983. The difference is most pronounced after FY 1987. Actual movement of other fundamentals would have led to substantial RER depreciation since FY 1987, if Bangladesh's fiscal adjustment had reduced total expenditure in any of the above described two ways rather than the way it actually did.

# Trade Liberalization

This means that Bangladesh's fiscal adjustment could have avoided undermining competitiveness and thus the potential supply response to the ongoing trade liberalization. If fiscal adjustment contributes to actual RER appreciation during liberalization, it provides confusing signals and undermines producers' incentives to move resources to the export sectors which trade liberalization seeks to encourage. The 'wait-and-see' strategy of potential exporters in the face of import liberalization, undermines the credibility and sustdinability of liberalization (Rodrik 1991, Corbo and de Melo 1987).

Even when such fiscal adjustment does not lead to an actual RER appreciation but instead reduces the extent of RER depreciation that accompany the trade 30Current expenditure as a share of GDP changes by exactly the same direction and magnitude each year after FY 1983, as total expenditure as a share of GDP. Since ADP expenditure as a share of GDP is constant, share of capital expenditure (ADPSHR) rises.
28 liberalization, it can increase transitional unemployment from the liberalization.

This is because for a given reduction in implicit or explicit tariffs, a lower depreciation implies a larger immediate fall in the price and profitability of import substitutes. The consequent profit squeeze leads to greater immediate unemployment in the import-substitute sector.31 On the export side with no real depreciation (or a lower real depreciation) the relative profitability of export sector improves only vis-a-vis import substitutes after liberalization but does not improve (or improves less) vis-a-vis non tradables. Thus the lower the real depreciation accompanying liberalization, the more likely it is that the 32 expansion of the export sector is less pronounced . This sector is therefore less effective in absorbing the labor shed by import-substituting sectors. In short, fiscal adjustment of the type Bangladesh undertook should preferably not be implemented simultaneously with trade liberalization.

# Misaligned RER

Even if there is no trade liberalization and the magnitude of RER appreciation is in line with changes in current fundamentals including government expenditure, unsustainable fiscal adjustment can overvalue the RER in a long-term sense (Lizondo 1989). Though given the small sample size, it was not possible 31The extent of employment loss in this sector depends on the flexibility of nominal wages and the rate of inflation. If inflation is low and nominal wages inflexible downwards, the transitional employment loss effect will be larger.

32This is because the relative price of exports to nontradables rises less with a lower depreciation.
29 to decompose the time series into 'permanent' and 'temporary' components to test for the differential effects of each, it is not difficult to argue<sup>that the</sup> 33 . changes in Bangladesh's expenditure composition. is unsustainable. Nevertheless it is more than likely that private sector decisions affecting the RER were not influenced by that unsustainability.

Ideally the RER response to unsustainable shifts in composition should reflect private sector demand and supply decisions based on that "unsustainability." In that event, the RER appreciation in response to a given unsustainable shift in composition would be negligible. If a part of the change is temporary, the appreciation would be much smaller than if the same shift was wholly sustainable or permanent. However, if this unsustainability is not perceived by Bangladesh's private sector and their demand and supply responses are thus based only on the current not on the long-run values of public expenditure, the RER appreciation in response to a change in current composition of expenditure, would be larger than the equilibrium level. The same is true, if the private sector perceives the unsustainability but is unable to incorporate this information into its ictual demand and supply decisions because it is constrained by controls or by liquidity constraints.

In both situations the appreciated RER is misaligned or departs<sup>from long-</sup> run equilibrium but resources continue to be allocated on the basis of<sup>that</sup> misaligned RER if producers do not perceive the misalignment.<sup>Even if they</sup> perceive the misalignment and expect a future depreciation,domestic<sup>capital</sup> 33The FY 1991 budget of Bangladesh government and the country projections of donors confirm a reversal in the trend of the share of capital (ADP) expenditure over the next three years.
30 market imperfections may prevent them from investing in tradables today to take advantage of that depreciation tomorrow. If there are significant "externalities" in the tradable sector (e.g. learning-by-doing externality or export marketing externality), then the lower allocation of resources to the tradables sector today arising from a more appreciated RER imply significantly greater costs over the long-run.

# Conclusion

Bangladesh presents a case of fiscal adjustment with little restraint on growth of current expenditure. As a result, there was a large shift in the composition of total government expenditure towards current expenditure which is more intensive in non-tradables. This tended to appreciate the real exchange rate. The appreciation effect was greater than would be the case, if fiscal deficit had been reduced without altering the composition of government expenditure. While simultaneous movements in other fundamentals like terms of trade deterioration and trade liberalization averted actual real appreciation of such magnitude Bangladesh's RER remained less depreciated than it would without such fiscal adjustment.

The effect of fiscal adjustment on RER, especially when it involves a shift in the composition of total government expenditure, is of importance to a large number of developing countries. Fiscal adjustment should thus focus not only on the size of the deficit that has to be bridged and the level of expenditure that has to be reduced, but also on the composition of expenditure that such adjustment generates. Large shifts in composition of expenditure towards non
31 tradables can cause 'difficulties' both when they are sustainable and when they are not. When they are not sustainable, the real exchange rate becomes misaligned and resources are likely to get misallocated in the presence of domestic capital market imperfections. When they are sustainable there is no problem, unless such fiscal adjustment is carried out simultaneously with trade liberalization. In that situation the incipient real exchange rate appreciation arising from fiscal adjustment undermines trade liberalization.
32 DAT NNEX The data series used in the econometric<sup>estimatior,</sup> cf the basic model are given in the Annex, and are<sup>all taken from World Bank sources. The GDP series</sup> used is the n series with the base of 1984/85.

Bangladesh's Annual Development<sup>Program (ADP) expenditure reported in the</sup> budget, proxies capital<sup>expenditure. This expenditure category consists</sup> predominantly of projects involving<sup>fixed investment. Budget data on current</sup> expenditure proxy goverrnent<sup>consumption. Data on Bangladesh's "actual"</sup> government expenditure is not<sup>available prior to 1980/81. Only "revised budget"</sup> figures are available for the<sup>entire period of 1972/73 to 1989/90. Revised</sup> budget figures are government's<sup>estimates of "actual" revenue and expenditure</sup> made provisionally after eleven<sup>months of the relevant fiscal year has elapsed.</sup> It is announced at the time<sup>of each budget for the previous fiscal year. This</sup> is thus the only consistent series<sup>for the period available for our exercise that</sup> is closest to "actual" public<sup>expenditures.</sup> The measures of real exchange<sup>rates were computed specifizally for this</sup> paper. The available estimates<sup>are those that are most commonly used by monetary</sup> authorities, but are far from ideal in terms<sup>of both concept and coverage as an</sup> indicator of relative price<sup>of tradables facing Bangladeshi producers. Though</sup> the available data on price indices<sup>makes it difficult to compute or estimate the</sup> "correct" empirical equivalent<sup>of the real exchange rate concept, it is possible</sup> to improve on the available measure<sup>of real exchange rate by using a better proxy</sup> for tradable prices. In any<sup>case, given the problems of measurement, a number</sup>
33 of different RER measures is preferable to a single measure.> Table A-2 provides a set of seven RER measures used for estimation.

The current account deficit as a share of GDP is computed by deflating the dollar value of the deficit by Bangladesh's import price index dnd expressing it as a share of constant dollar value of Bangladesh's GDP. Similarly the dollar value of total aid disbursement is deflated by the import price index to obtain real aid levels. The productivity growth variable is proxied by the difference between Bangladesh's annual export growth rate and the average annual export growth rate of a set of comparable countries.

Table A-1 provides the lata taker from World b6ak sources, Table A-2, the computed real exchange rates and Table A-3, the variables used in the regressions.

34Surprisingly few studies use several RER measures. One exception is Corbo (1985).
34 Table I

|G|overn|ment Re|venue|and Ex|Egndit|ure||||
|---|---|---|---|---|---|---|---|---|---|
|Fiscal Years|1981|1983|1984|1985<br>(Pe|1986<br>rcenta|1987<br>ge of G|1988<br>DP)|1989|1990|
|Total Revenue<br>Total Expenditure|9.3.<br>**ILA4**|8.7<br>1ii.|8.1<br>IL.2|__.A_<br> 16.2|9.1<br>Ifif|<br>8.9<br>1**1** 2..|<br>8.9<br> 1i|_.S_<br>L6.|9<br>1_1LA_|
|Current Expenditure|5.6|<br>6.5|<br>6.5|<br>6.5|<br>7.5|<br>7.7|<br>8.1|<br>8.5|<br>8.4|
|Food Account Deficit|2.0|<br>2.2|<br>1.2|<br>1.1|<br>0.4|<br>C.1|<br>0.9|<br>0.6|<br>1.5|
|Development (ADP) Expenditur|e 10.1|10.2|<br>8.5|<br>7.5|<br>7.8|<br>8.6|<br>6.4|<br>6.7|<br>6.8|
|Other Capital Expenditure|0.7|<br>0.8|<br>1.0|<br>1.1|0.9|<br>0.9|<br>0.7|<br>0.9|<br>0.7|
|Overall Fiscal Deficit|9.0|11.0|<br>9.1|<br>7.4|<br>7.5|<br>8.4|<br>7.1|<br>7.2|<br>8.1|

(Percentage of Total ExRenditure) Development Expenditure

|55.1 51.6 49.7 46.1 47.1 49.8 39.6 40.1 39.1|
|---|

Source: Table 1.5 in World Bank (1991) p. 14 Note: 1981 refers to fiscal year July 1980 to June 1981
35 Table 2: Estimation Results of Basic Model

|Depend|able Variabl|e is the Log|(FY1975-<br>of the Rea|FY 1990)<br>l Exchange R|ate (RER) I|ndex||
|---|---|---|---|---|---|---|---|
||(1)|(2)|(3)|(4)|(5)|(6)|t7)|
|Measure of|RERT|RPT|RPX|RPM|RPT1|RPX1|RPM1|
|Constant|0.95|1.10|1.13|1.12|1.68|1.71|1.72|
|Capital<br>Exp./Total<br>Govt. Exp.|0.02<br>(0.05)|-1.01***<br>(-4.02)|<br>-1.02***<br>(-3.75)|-1.02***<br>(-4.03)|<br>-1.47*<br>(-2.04)|-1.41*<br>(-1.82)|-1.46*<br>(-2.04)|
|Total Govt.<br>Exp/GDP|-7.01***<br>(-.5.89)|<br>-3.97***<br>(-5.35)|<br>-4.05***<br>(-4.99)|-4.00***<br>(-5.34)|<br>-4.87***<br>(3.51)|-5.16***<br>(-3.63)|-5.07***<br>(3.69)|
|Log Terms of<br>Trade (Price<br>of Exports<br>to imports)|<br>-0.04<br>(0.29)<br>_______|0.16*<br>(1.95)<br>____|-0.60***<br>(-6.64)|<br>0.39***<br>(4.73)|<br>0.05<br>(0.38)|-0.71***<br>(-4.88)|<br>0.28*<br>(1.97)|
|Productivity<br>Growth<br>(export<br>differences)|<br>0.25<br>(1.67)<br>|0.22**<br>(2.41)|0.21*<br>(2.10)|0.21*<br>(2.27)|0.42***<br>(3.18)|<br>0.40**<br>(2.95)|0.40***<br>(3.09)|
|Current<br>Account Def.<br>GDP|2.37**<br> <br>(2.39)|1.57**<br>(2.53)|1.46**<br>(2.17)|1.54**<br>(2.46)|0.43<br>(0.49)|0.35<br>(0.39)|0.39<br>(0.46)<br>I|
|AR (1)||..<br>_|..<br>_________<br>________|..|0.73**<br>(2.47)|0.75**<br>(2.50)|0.75**<br>(2.60)|
|R2|-0.88|O.91|0.93|**O.9-1**|**.86**|**..28**|0.87|
|FStatistic|23.1|31.4|42.5|33.0|15.8|19.2|17.3|
|D. W.<br>Statistic|2.32|2.02|1.85|1.96<br>I|2.22<br> <br>_I|2.25|2.26<br>_<br>_|
|No. of<br>Observations|16|16|16|16|16|16|16|

lotes: Data in parenthes.s are t-sta tistis. *** Significant at 1% or

****** Significant at between 1 and 5%. * Significant at between 5 and 10%.
36 Table 3: Reduced Form Fstimate of RER Model (FY 1975-FY 1990) Dependent Variable is the log of the Real Exchange Rate (RER) Index

||(1)|(2)|(3)|(4)|(5)|(6)|(7)|
|---|---|---|---|---|---|---|---|
|i<br>Megsgre of|RERT|RPT|RPX|RPM|RPT1|RPXl|RPM1|
|Constant|4.34|1.73|1.51|1.60|-3.35|-3.57|-3.97|
|Capital<br>Exp./Total<br>Govt. Exp.|-0.04<br>(-0.07)|-0.70**<br>(-2.53)|<br>-0.70**<br>(-2.63)|-0.69**<br>(-2.61)|-0.88*<br>(-2.15)|-0.87*<br>(-2.13)|-0.87**<br>(-2.28)|
|Total Govt.<br>Exp/GDP|-7.30***<br>(-3.85)|<br>-3.51***<br>(-3.73)|-3.52***<br>(-3.93)|<br>-3.56***<br>(-3.94)|<br>-6.10***<br>(-4.38)|-6.10***<br>(-4.39)|-6.14***<br>(-4.35)|
|Log Terms of<br>Trade (Price<br>of Exports<br>to imports)|<br>-0.04<br> <br>(0.21)<br> <br>_|-0.03<br>(-0.23)<br>_|-0.80***<br>(-8.82)<br>_|<br>0.20**<br>(2.29)|-0.03<br>(-0.21)|-0.81***<br>(-5.75)|0.19*<br>(1.40)|
|Productivity<br>|rowth|<br>0.12<br>(0.55)|0.39***<br>(3.58)|<br>0.41***<br>(3.92)|<br>0.39***<br>(3.74)|<br>0.44***<br>(2.72)|<br>0.46**<br>(2.82)|0.44***<br>(2.80)|
|Log GDP<br>l_____________|-0.23<br>(0.55)|-0.31**<br>(-2.26)|<br>-0.31**<br>(-2.92)|-0.31**<br>(-2.36)|0.32<br>(1.59)|0.32<br>(1.57)|0.32<br>(1.64)|
|Log real<br>aid|-0.03<br>(-0.11)|0.43***<br>(3.11)|<br>0.47***<br>(3.57)|<br>0.45***<br>(3.36)|<br>0.13<br>(0.64)|0.17<br>(0.83)|0.15<br>(0.74)|
|R<sup>2</sup>|_.84|0.92|_.96|0.93|0.91|0.93L|0_.9_2|
|F Statistic|<br>13.8|30.5|54.8|35.9|25.2|32.3|28.6|
|D. W.<br>Statistic|2.12|2.17|2.19|2.14|2.25|2.21|2.25|
|No. of<br>Observations|16<br> I<br>I<br>_|16<br>|16|16|16|16|16|

Notes: 1. Where the GDP share of current account deficit is assumed to be a function of real exchange rate, real aid disbursement and real GDP.
37 Table 4: RER Elasticitv with Resvect to Fiscal Variabl.e

|||(P|ercentage C|hange in RER|)|||
|---|---|---|---|---|---|---|---|
||(1)|(2)|(3)|(4)|(5)|(6)|(7)|
|10% Rise in:|RPT|RPX|RPM|RPTJ|RPXl|RPM.1|<br>RERT|
|Capital<br>Exp./Total<br>Govt. Exp.|-3.81|-3.81|-3.76|-4.79|-4.71A|<br>4.74|n.s|
|Total Govt.<br>Exp/GDP|-5.55|-5.57|-5.63|-9.64|-9.71|-9.71|-11.54|

Source: Computed using mean values of fiscal variables and coefficients from TabLe 3.
<!-- Start of picture text --> 38<br>Figure I<br>CAPITAL & CURRENT EXPENDITURES<br><!-- End of picture text --> <!-- Start of picture text --> 0.12-<br>0.11-<br>0.10 a<br>0.09 /<br>0.07- - -<br>0.076 - - ,- 1 , , ,<br>0.06 II<br>79 80 81 82 83 84 85 86 87 88 89 90<br><!-- End of picture text --> (Capital Expenditure is the GDP share **of** ADP Expenditure) c apit al - Current
39 Figure 2

# TRADED GOODS BASED RER MEASURES

<!-- Start of picture text -->
1.4-<br>1.3<br>0.9<br>0.8<br>78s 79  s0  e1  82 83  84 85 88  87 88 89 90<br>R atis of different Jontrakdable  MOOc  to Traded Goodsl Frlfe<br>- RPT----RPTI<br><!-- End of picture text -->

# COMPOSITION OF GOVERNMENT EXPENDITURE

<!-- Start of picture text --> 00 P so ,,<br>WILUM Daaor ent PNontraAs a Sce to -Troea Gmandi Pra<br>.85 tOMPOSII-shar 80 8 28 GOVENMETa 485 of 8 7 EXPENDITUREl8 9 9<br>789 BO B1 B2 -3 Sr o 86 a 87 E e dt89<br><!-- End of picture text -->
40 <!-- Start of picture text --> Figure 3<br>RER WITH ALTERNATIVE FISCAL ADJUSTMENT<br><!-- End of picture text --> <!-- Start of picture text --> (Using RPT Equation in Table 3)<br><!-- End of picture text --> <!-- Start of picture text -->
1.14  -<br>1.12<br>1.1<br>1.08<br>1.06<br>1.04<br>1.02<br>1<br>0.98<br>0.96<br>0.94<br>0.92<br>0.9<br>8 1  82  83  84  85  86  87  88  89  90<br>Fiscal Years<br>0  ALL ACTUAL  +  ADPSHR RISING  O  ADPSHP CONSTANT<br><!-- End of picture text -->