metadata: authors: 0: author: Rouis, Mustapha
1: author: Razzak, Weshah
2: author: Mollinedo, Carlos
docna: 0: docna: The supply response to exchange rate reform
            in sub-Saharan Africa (empirical evidence)
docty: Policy Research Working Paper
subtopic: Currencies and Exchange Rates,International Trade and Trade Rules,Inflation,Macroeconomic Management,Crime and Society
teratopic: Environment
abstracts: cdata!: In the diversity of exchange rate
            regimes in sub-Saharan Africa (SSA) in the 1980s, there was
            a trend toward more flexible regimes and smaller parallels
            markets.  How particular exchange rate arrangements affect
            such factors as output supply cannot be determined for SSA
            countries on the basis of experience in other developing
            countries, because SSA countries differ in the composition
            of their exports and imports, in level of industrialization,
            and in development of the financial sector. The authors
            supplement a survey of the literature with empirical
            testing, using pooled time-series and cross-section data for
            22 countries in SSA for 1971-91.  Among their findings: (a)
            When macroeconomic policies are inconsistent and there is a
            failure to adjust to adverse shocks, fixed regimes lead to
            overvaluation and the development of widespread parallel
            markets for foreign exchange.  (b) SSA countries have
            attempted exchange-rate unification through occasional
            devaluations, a crawling peg, official dual markets, foreign
            exchange auctions, and a market pricing rule.  Most such
            experiences have been gradual, and their outcomes mixed.
            Success in exchange-rate unification (as experience in Ghana
            and Uganda shows) depends on three crucial elements:
            supportive monetary and fiscal policy, external budgetary
            and balance-of-payments support, and official commitment to
            a credible reform process.  (c) In the face of significant
            adverse real shocks (internal and external), built-in
            monetary and fiscal rules in fixed exchange rate regimes
            with currency convertibility (as in the CFA zone) may be
            inadequate to bring about the required short-term
            adjustment.  As elsewhere in the developing world, the
            effect of real devaluation on output in SSA is mixed in the
            short run (contractionary when demand elasticities are low)
            and neutral in the long-run.  Real depreciations have
            neutral effects on per capita growth of real output in the
            transition to steady state.   (d) Farm producers in SSA
            respond to price incentives for a single agricultural crop
            as farmers do elsewhere in the developing world: they behave
            rationally.  And econometric evidence confirms that growth
            in agricultural exports is not achieved at the expense of
            food production. (e) Applying the Granger-causality test to
            this data set reveals strong causality, running in both
            directions, between money growth rates and inflation.  It
            also shows causality running from output to inflation, and
            from inflation to nominal devaluation.
repnme: repnme: The supply response to exchange rate reform
            in sub-Saharan Africa (empirical evidence)
display_title: The supply response to exchange rate
            reform in sub-Saharan Africa (empirical evidence)
listing_relative_url: /research/1994/06/698288/supply-response-exchange-rate-reform-sub-saharan-africa-empirical-evidence
topicv3: Inflation m1326709 0870F4727ACED1CF8525815C00471347,Trade m1326924 698,Balance of Payments m1326965 441,Exchange Rate Policy m1327143 1124,Black Market m1439229 BLA-3388
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Environment
origu: Development Economics and Chief Economist
no_of_pages: 96
model_extractions: U.i.POLICY RESEARCH WORKING **PAPER** 1311

# Summary findings

In the diversity of exchange-rate regimes in Sub-Saharan Africa in the I980s, there was a trend coward morc flexible resimes and smaller parallel markets. How particular exchange rate arrangements affect such factors as output supply cannot be dctermined for Sub-Saharan African countries on the basis of experience in other developing countries, because Sub-Saharan countries differ in the composition of their exports and imports, in level of industrialization, and in development of the financial sector.

Rouis, Razzak, and Mollinedo supplement a survey of the literature witih empirical testing, using pooled timescries and cross-section data for 22 countries in SubSaharan Africa for 1971-91. Among their findings:

* When macroeconomic policies are inconsistent and there is a failure to adjust to adverse shocks, fixed regimes lead to overvaluation and rhe developmenr of widespread parallel markets for foreign exchange.

- * Sub-Saharan African countries have attempted exchange-rare unification through occasional devaluations, a crawling peg, official dual markets, foreign exchange auctions, and a market pricing rule. Most such experiernces have bcen gradual, and their outcomes mixed. Success in exchange-rate unification (as experience in Ghana and Uganda shows) depends on three crucial elements: supportive monetary and fiscal

policy, external budgetary and balance-of-payments support, and official commitment ro a credible reform processIn the face of significant adverse real shocks (internal and external), built-in monetary and fiscal rules in fixed exchange rate regimes with currency convertibility (as in the CFA zone) may bh inadequate to bring about the required shorr-term adjusrmenr.

> * As elsewhere in the developing world, the effect of real devaluation on output in Sub-Saharan Africa is mixed in the short-run (contractionary when demand elasticities are low) and ncutral in the long-run. Real depreciations have neutral effects on per capira growth of real output in the transition to steady state..

> * Farm producers in Sub-Saharan Africa respond to price incentives for a single agricultural crop as farmers do elsewhere in the developing world- **hey** tbehave rationally. And econometric evidenoe confirms that growth in agricuirural exports is nor achieved at the expense of food production.

- Applying the Granger-causality test to this data set reveals strong causality, running in both directions, between money growth rates and inflation. It also shows causality running from output to inflation, and from inflation to nominal devaluations.

This paper-a product of the Africa Regional Office, Office of the Chief Economist- is part of a larger effort in the department region to bettcr understand rhe supply rcsponse to cxchange rate rcform in Sub-Saharan Africa. Copics of the paper are available free from the World Bank, 1818 H StrcerNW, Washington, DC 20433. Please conractJocelyn Schwartz, room JS-255, extension _32250 (85_ pages). June 1994.

> _The Policy Research Working Paper Series disseminates the findings of_ **_uork_** _in progress to encourage tbe exchange of ideas about development issues. An objectiveofthesries is toget the findings out quickly, even if the presentations are less than filly polished The papers carry the names of the authors and shosld be usedand cited accordingly. ne fmdings, interpretations, and condusions are the_

> _authors own andshould not hbeatributd to the World Bank it Fxeci Board of Dfrcaors or any of its member countries_

## Prodiuced by the PoLicy Research Dissemination Center
The Supply Response to Exchange Rate Reform in Sub-Saharan Africa (Empirical Evidence) Mustapha Rouis Weshah Razzak Carlos Mollinedo The World Bank Africa Regional Office Office of the Chief Economist
# **_Table_** _of Contents_

Summary Findings i

**1.** Introduction _I_

II. Exchange Rate Arrangements 3

- A. Exchange Rate Unification 10

- B. Fixed versus Flexible Rates

- under Currency Convertibility 19

## III. Exchange **Rate** Reform and Supply Response 22

- A. Overview of the Theory 22

- B. Empirical Studies on Contractionary Devaludtion in Developing Countries 25

- C. Empirical Evidence on Contractionary Devaluation in SSA Countries 30

## IV. Empirical Evidence from Sub-Saharan Arrica 38

- A. Real and Nominal Devaluations Dynamic 38.

- B. Real Depreciations and Real Economic Growth _42_

- C. Inflation, Money Growth, Output Growth, and Devaluations: A Causality Test 49

- D. Real Export Growth, Output Growth, and Devaluations: A Causality Test _51_

- E. Conclusions _55_

Bibliography 59

## Text Tables

1. Multiple Foreign Exchange Markets in Sub-Saharan Africa 4

2. Parallel Markets Exchange Rate Premium (percent) 5 3. The Evolution of Exchange Rate Arrangements in Sub-Saharan African Countries: 1976-89 7 4. Exchange Rate Arrangements in Individual Sub-Saharan African Countries, 1990 _11_ _5._ Empirical Studies on the Effects of a Devaluation 27 6. Long-run Estimates of Aggregate Agricultural Supply Elasticity in Developing Countries 35 7. Export Values and Shares of World Exports for Selected Agricultural Commodities Elasticity in SSA Countries 37 8. 2SLS Instrumental Variables Results for the Augmented Mankiw, Romer and Weil Model with Pooled Time Series and Cross-Section Data, 1971-1991 47 9. Summary of Causal Inferences for Twenty Countries-SSA (1971-90) 52
10. Summary of Causal Inferences for Nineteen Countries-SSA (1971-90) _55_

# Annex Tables

Al. Evidence on African Smallholder Supply Elasticities _73_ A2. Ten SSA Countries: Cash-Crop Supply Elasticities 75 A3. Estimates of -Aggregate Supply Response to Agriculture in SSA 78 A4. Export Concentration and Export Share of Manufactures, and Fruits and - Vegetables in SSA, 1987-88 79 _AS._ Major Depreciations in SSA Countries, 1980-92 80 A6. Real Effective Exchange-Rate in SSA _83_ A7. Per Capita Real Growth Rates _84_ A8. Average Annual Inflation Rates _85_ Figure 1 The Parallel Premium and Auction Exchange Rate Relationship _15_
i

# **_Summary_** _Findings_

Empirical research into key exchange rate issues in Sub-Saharan Africa (SSA) is limited when compared with that in developing countries as a whole. Further, SSA countries possess significant differences from other developing countries in such structural features as the composition of imports and exports, the level of industrialization and the development of the financial sector. Consequently, the pros and cons of particular exchange rate arrangements for such issues as output supply, are not conclusively established from the experience of other developing areas.

Two issues are targeted in this paper. First, SSA countries are distinguished in terms of the exchange rate regimes they have adopted, and the achievement of objectives of exchange rate policy is contrasted across countries. Second, the output supply response of real devaluations in developing countries as a whole is reviewed; then the analysis focuses on SSA countries, with special attention given to the supply response in agriculture.

The review of the literature is supplemented by empiricai testing. We used pooled timeseries and cross-section data for 22 countries in Sub-Saharan Africa for the period 1971-1991 to address the following questions: the dynamic relationship between nominal and real devaluations, the impact of real devaluations on per capita income, and the causal relationships and the direction of causality between devaluations, inflation, income and exports.

## Exchange Rate Regimes

Our review indicates that there has Deen a wide diversity of exchange rate regimes in Sub-Saharan Africa during the 1980s, with the trend towards more flexible regimes and a reduction in the size of parallel markets. The lessons drawn from the SSA -experience concerning the choice of exchange rate arrangement are the following:

- When macro economic policies are inconsistent and there is failure to adjust to adverse macroeconomic shocks, fixed regimes lead to overvaluation and the development of widespread parallel markets for foreign exchange. Through their negative macro-effects this in turn leads to inflation, instability and decline in output growth.

- * The exchange rate unification has been attempted by SSA countries through several means: occasional devaluations, a crawling peg, official dual markets, foreign exchange auctions, and a market pricing rule. Most exchange rate unification experiences have been gradual and their outcomes have been mixed. Country experiences show that the success in exchange rate unification (the case of Ghana and Uganda) depends on three crucial elements: supportive monetary and fiscal policy, external budgetary and balance of payments support, and a credible reform process to which the authorities are committed.

- In the presence of significant adverse real shocks (internal and external), built-in monetary and fiscal rules in fixed exchange rate regimes with currency convertibility (e.g. CFA zone) may not be adequate to bring about the required adjustment in the shortrun.
..

# **Exchange Rate Reforms and Supply** Response

Many SSA countries outside the CFA zone have undertaken substantial real depreciations during the 1980s and the early 1990s. In January 1994, the CFA zone countries changed the CFA franc parity from 50 to 100 per French franc, the first such an adjustment since the establishment. of the zone in 1948. The objective was to reestablish the zone's competitiveness which has eroded significantly over the years, particularly since the mid-1980s. With the exception of this recent development which is not covered in this paper, the evidence of the supply impact of real devaluations in SSA countries reviewed here are summarized below..

# _Aggregate Output Supply_

*

As in the rest of the developing world, the effect of real devaluation on output in SubSaharan Africa is mixed in the short run (contractionary when demand elasticities are low) and neutral in the long run. This finding is supported by our own empirical analysis which is based on a growth model with real depreciations of exchange rates as an additional argument. The model shows that real depreciations have neutral effects on per capita growth of real output in the transition to steady-state.

## **_Agricdturlrd_** _Supply_

-* -

In the case of a single agricultural crop, the evidence shows that farm producers in SSA respond to price incentives as any other farmers in the developing world. In other words, African farmers behave rationally.

*

The evidence also shows that in Sub-Saharan Africa aggregate agriculture supply elasticities with respect to price incentives, including real exchange rate depreciation, are positive and comparable to that in other parts of the developing world.

*

The possibility that agricultural exports may crowd out food production was examined. Econometric evidence confirms that the growth in agricultural exports is not achieved at the expense of food production. Food production is positively correlated with export crop prices and real exchange rates, suggesting complementarity.

# _Export Supply and Sinultaneous Expansion_

A number of empirical studies confirm the response of real exports to changes in the real exchange rates in Sub-Saharan Africa (see for instance Balassa and Dorosh). Balassa in particular found that a 1 percent change in the real exchange rate is associated with 0.8 to 1 percent change in the ratio of exports to output. Our empirical testing of the Granger-causality model shows that there is no significant causal relationship between real exports growth rates and real depreciations. This result should, however, be interpreted with caution as fiscal policies are not controlled for in the model.

* Simultaneous devaluations by several SSA countries is unlikely to reduce their total export earnings with the possible exception of cocoa exports. Thus the "fallacy composition" argument, or the "adding-up" problem, does not seem to apply to African commodity exports, except for cocoa.
iii

# **Inflationary** Consequences

Our empirical testing shows that there is contemporaneous and long run significant relationship- between nominal and real devaluations. We find a 10 percent -nominal devaluation to have 7.7 percent real effects in the long run. This confirms that nominal devaluation can indeed be an effective tool to correct an overvalued currency if accompanied by restrictive monetary and fiscal policies.

: * Applying the Granger-causality test to our data set, we find strong causality, running in both direction, between money growth rates and intlation. We also find a causality running from output to inflation, and from inflation to nominal devaluations.
**_I_**

# Introduction

Research on exchange rate policy and its impact in Sub-Saharan Africa (SSA) has been fairly limited until recently. Up until the early 1980s, the majority of SSA countries had fixed exchange rate regimes. Apart from the CFA zone countries, which combine a peg to the French franc with full currency convertibility, most SSA countries had closed trade and capital accounts, and hence provided incentives for the emergence of parallel markets in foreign exchange. Following the adverse ternis of track shocks in the mid-1970s, and the tightening of controls in these countries, parallel markets expanded rapidly, becoming major markets in the macroeconomy. During the 1980s, with the emphasis on unification of official and parallel exchange rates, or at least a significant reduction in the size and importance of parallel markets, a wide diversity of exchange rate arrangements arose. In the context of structural adjustment programs, a broad range of initial conditions, macro-policy measures and exogenous shocks have resulted in a similar diversity of outcomes for unification. Research in the area has consequently been stimulated, and the World Bank has recently launched several large cross-country studies in this direction. y This paper examines the diversity of exchange rate arrangements undertaken in SSA during the 1980s, provides stylized facts and considers the relative merits of the different regimes. In particular, the successes and failures of exchange rate unification by adopting a more flexible exchange rate regime are evaluated for countries with closed capital and possibly current accounts, and substantial black markets. Lessons from the CFA zone countries are discussed with reference to recent empirical studies.

The paper also addresses a number of key exchange rate issues for SSA countries. First, the output supply response -to real devaluation in developing countries as a whole is reviewed. The paper shows how various structural features, such as the composition of exports and imports, and the level of industrialization, distinguish SSA countries from other developing countries. Then the analysis focuses specifically on SSA countries, with special attention given to the supply response in agriculture. Finally, in addition to the review of the literature on exchange rate policy 1/ These include "Exchange Rate Regimcs in Africa" (Pinto, 1989); "Macroecononmic Aspects of Foreign Exchange Markets in Developing Countries: Multiple Markets and Black Markets' (Kiguel and O'Connell, 1992); "Real Exchange Rate (RER) management in the Communauti Financiere Africaine (CFA) franc zone" (*); and "Foreign exchange auction markcts and exchange rate unification in Sub-Saharan Africa" (Aron and Elbadawi, 1993).
2 in SSA, the paper addresses three empirical questions using pooled time-series and cross-section data for 22 SSA economies for the period 1971-91. These are the dynamic relationship between nominal and real devaluations, the impact of real devaluations on per capita real GOP growth, and the causal relationships and the directions of causality between devaluations, inflation, GDP growth and exports.

It should be highlighted here that the real exchange rate is an endogenous variable and that nominal devaluation is just one of the instruments that affect its level. Nominal devaluations do not always result -in a change in the real exchange rate. The magnitude of such as change depends on the type of fiscal, monetary and income policies that accompany the devaluation. The paper is organized as follows. Chapter 2 discusses the evolution of exchange rate arrangements undertaken in SSA, examines the successes and failures of exchange rate unificationin adjusting countries without currency convertibility, and discusses the experience of the CFA zone countries in the 1970s and 1980s. Chapter 3 reviews existing literature on the effectiveness of output supply response of a real devaluation. And chapter 4 tests empirically the impact of real exchange rate devaluations on economic growth and exports and analyses the relationship between nominal and real devaluations.
32

# _Exchange Rate Arrangements_

A wide diversity of exchange rate regimes is present today in Sub-Saharan Africa. However, until the mid-197Os exchange rate policy had played a negligible role in balance of payments adjustments in SSA countries, and most SSA countries employed fixed exchange rate regimes, -These regimes appeared viable in the context of a relatively favorable external environment. However, witi the severe oil and commodities market shocks of the mid-1970s, foreign exchange reserves were drained, bringing the fixed rate regimes under pressure. These pressures were exacerbated by a slow fiscal adjustment in the recessionary circumstances. In most cases the response was to defend the overvalued fixed rates by rationing foreign exchange through imnposing or tightening exchange and trade conwols. The emergence and subsequent rapid expansion of black markets for foreign exchange had their origin in these controls.

At least until the mid-1980s black markets were widespread in SSA. The extent of illegal or quasi-legal black markets in the SSA region is shown in Table 1. Relative to other developing regions (notably Latin America), the parallel markets in SSA countries have tended to be large and thriving markets, with substantial spreads (pr2mia) between the official and black rates (Kiguel and O'Connell, 1992). The size of the black market premia for a number of SSA countries over the periods 1974-80, 1981-86 and 1990-91 is shown in Table 2.

There is a large literature concerning the determinants of these spreads or premia (e.g. Agenor, 1992; Lizondo, 1990). In standard models, expectations and portfolio considerations are likely to be important determinants in the shor-run. The long-run steady state premium depends on macro-fundamentals such as the terms of trade, the budget deficit, capital flows and the trade regime. Thus, the prevalence of black markets in SSA have been attributed to inconsistent policies and failure to adjust to adverse macroeconomic shocks, current account deficits, and extreme overvaluation of exchange rates; and the markets have tended to expand during periods of expansive macro-policies (Kiguel and O'Connell, 1992). Several empirical studies on SSA countries have found support for the theoretical determinants of the premium and have shown its
Table 1: Multiple Foreign Exchange Markets in Sub-Saharan Africa.

|_COUmN7Y_|_PA YMEN7 RESI7_<br>_ON:_|_UCn7ONS_|_NATURE OF_<br>_DUAL_<br>_MARKET_|_FREE RAE _|_MANMEMEP_<br>_OFFICIALR _|_r OF_<br>_ATE_|_ADDI77OA?L_<br>_EXCHANGE_<br>_RtATE_|
|---|---|---|---|---|---|---|---|
||_Capital Accouns_|_Curmrnt_<br>_Accomnt_|||_WJIEN_<br>_MFRS_|_POST_<br>_MERS_||
|Angola|yes75-90|yoe75-90|lllogaltolerated|black 75.90|fixod|not unifid||
|Burundi|_yos_70-90|yes 70.90|illegal 70.90|black 70.90|fixed 70-86<br>peg_16-90_|notIfnid<br>ed||
|Ethhopia|yes70-90|yes70-90|illegal tolerated|black 70-90|peg|not unified|no|
|Ghana|ye. 70.90|yes 70-90|illcgal tolerated|black 70488<br>legal 85-90|fixed70-13<br>peg 13-88|r.<br>unirted 4.88|yeau 73.90|
|_Kenya_||||black 70.90|peg|not unified|yes 79-90|
|Malawi|ye. 70.90|ye, 70-90|illegal tolerated|black 70-90|peg|not unified|no|
|Nigeria|yea 70-90|yes 70-85<br>no86-90|illegal tol. 70-87<br>legal 87-90|black 70-87<br>lgal 87-90|peg 70-90|free<br>unified 8.90-|yes 86-89|
|Rwanda|ye 70-90|yes 76-90|||fixed|||
|S. Lcono|ye. 70-5.86<br>no 6.1C4.87<br>yea 587-90||illegal 70-12.12<br>leg. 12.82-7.83<br>leg. 1.84-9.84<br>leg. 6.86-4.87|legal 12.82-7.83<br>legal 1.84-9.84|fixed|unified83<br>unified8S|yes 70-86|
|Sudan|yea 70-90|yes 70-90|illegaltol.7-87|black 70-90|fixed|nolunified|yes|
|Tan-ani|yes 70-90|yes 70-90|illegal tolerated|black 70-90|peg|not uified|yes 82-85|
|Thc Gambia|yea 70-86|yes 7175|illegal 70-86|black 70-86|fixed 70-86|unified||
||no 87-90|no 77-S0<br>yes 81-86<br>no 87-90|legalS6-90|legal 87-90||||
|Uganda|yes 70-86<br>yes 88-90|yea 70-90|legal 70-82<br>illegal 83-84<br>legal85-90|black 70-90|peg|not unified|yes|
|Zaire|yes 71-90|yes 71-90|illegal tol. 70-83<br>legal 13-84<br>illegal tol. 84-90|black 70-13<br>legal 83-84<br>black 84-90|peg|free<br>unified 8.19|yes 9.78-83|
|Zambia|yea 70-90|yes 70-90|illegal tol. 70-85<br>legal 85-87|blick 70-85<br>legal 85-87|fixed 70-76<br>peg 76-87|not unified|yea 2.80-87|
||||illegal 87-90|black 87-89|fixed 87-90|||
|Zimnbabwe|yes 80-90|yes 80-90|illegal 80-90|bliek 1090|fixed|not unified|yes 84-90|

MERS : Multiple Exchange Rate Systems.

ADDITIONAL ER: Special exchange rates for cenain transactions. In some Cases, there was no dual market, even though the official exchange rate was fixed or pegged.

Source: Kiguel and O'ConneL (1992); IMF and World Currency Yearbook (various issues).
_5_ Table 2: **Parallel** Market Excbange Rate Premium (percent)

|Country|1974-80|1981-86|1990-91|
|---|---|---|---|
|Sub-Saharan adusters la<br>Extremely**hig**premiums in 1990-91||**-**<br>1<br>|16.|
|<br>Mauritania<br>.<br>Mozarbique<br>Sierra Leone<br>Tanzania<br>Zambia|62.3<br>468.5<br>21.0 /b<br>125.7<br>117.3|121.5<br>2,110.8<br>49.4<br>248.8<br>46.3|166.6<br>62.6<br>104.4<br>74.5<br>149.7|
|M.|37.7 /c|43.7|I<br>47.5|
|Medium premium<br>Burundi<br>The Gambia<br>Malawi<br>Nigeria<br>Uganda<br>Zimbabwe|20.3 Ic<br>-5.4 /c<br>74.5<br>63.3<br>728.3<br>102.2|24.1<br>13.8<br>53.6<br>232.7<br>190.0<br>81.3|20.9<br>21.3 Id<br>29.4<br>25.1<br>24.6<br>23.5|
|Low premium<br>Ghana<br>Guinea<br>Guinea-Bissau<br>Kenya<br>Madagascar|276.6<br>130.7<br>..<br>12.5<br>19.3 Ic|1,098.2<br>655.2<br>59.7<br>15.1<br>42.0|3.4<br>7.6<br>-2.3/d<br>7.3<br>7.1_Id_|
|Mean<br>Excluding Mozambique<br>Median|140.9<br>119.1<br>68.9|299.2<br>186.0<br>59.7|45.5<br>44.4<br>24.6|
|Other**adjusting**countries||||
|<br>Argentina<br>Bolivia|_94.5_<br>8.3|32.8<br>-136.2|42.4_Id_<br>1.5 Id|
|Costa Rica<br>Indonesia<br>Mexico|9.2<br>2.4<br>1.7|204.7<br>4.2<br>13.9|15.9 Id<br>2.6 /d<br>6.8 /d|
|Morocco<br>Philippines<br>Thaiand-|5.3<br>7.1<br>-06|6.0<br>12.3<br>-22|13.1 Id<br>7.1 /d<br>20 /d|
|<br>Turkey<br>Venezuela|.<br>25.7<br>0.0|.<br>9.6<br>110.3|.<br>2.4 /d<br>5.2 /d|
|.Mean<br>Medianm|15.3<br>6.2|52.8<br>13.1|9.9<br>6.0|

..Not available Note: The parallel market exchange rate premium is calculated as the parallel market exchange rate minus the official exchange rate (in domestic currency at the end of the period), multiplied by 100.

a. Data are only for the countries with flexible exchange rates b. Data are for 1979-80 c. Data are for 1976-80 d. Data are for 1990 Sources: "Adjustment in Africa Reforms, Results and the Road Ahead". Policy Research Department, The World Bank, 1993.
6 strong links to the macroeconomy (Kiguel and Ghei, 1992) covering a large sample of developing countries (six of which are in SSA) during 1970-89; Aron and Elbadawi (1992) for Zambia; Elbadawi (1992) for the Sudan; Kaufmnann and O'Connell (1991) for Tanzania; Chhibber and Shafik (1990)).

These strong macro-linkages emphasize the importance of the negative macro-implications associated with multiple exchange markets (well-known to exist for the Latin American case of official multipSe marketsa, they have been shown to apply too for the SSA case of unofficial multiple markets (Miguel and O'Connell; 1992)). These include the diversion of trade and productive activity into unofficial channels, narrowing the-tax base; an implici **t** ax on exports due to real overvaluation; prices influenced by the black market, and subject to considerable fluctuations; afall in savings with the flight from domestic currency, limiting domestic investment and constraining long-term growth. Further distortions were introduced by the administrative allocation of foreign exchange.

Thus, with substantial parallel markets present in SSA from the mid-1970s, the traditional reform objectives of stabilizing the macro-economy and achieving real depreciation became equivalent to the objectives of integrating the parallel marlket into the official economy and unifying the exchange rates.3a Allied with this objective is the removal of distortions in the allocation of foreign exchange. Consequently, as part of broader reform programs, a divergence away from fixed exchange rate regimes (in countries without convertibility) towards more flexible regimes has been evident in SSA during the last two decades. The pattern of changes in exchange rate arrangements for the SSA countries as a whole is illustrated in Table 3.

2! The typical arrangement involves an official market with tie exchange rate detcrmined by the authorities, and a second market where market rorces determine the rate. The official market usually channels current account transactions of the public sector, and selected trnsactions of the private sector; while the second markct channels the remaining transactions.

3! The relevant concept of unification where capital controls are retained to some degree, is not eradication but a substantial reduction of the paralle market, in order to delink it from the major sectors of the economy.
> : ~~~~~~~~~7

*:

# Table 3: The Evolution or Exchange Rate Arrangements in Sub-Saharan African Countries: 1976-89.

|_ExchangeRate Regime_|_1976_|_1980_|_1963_|_1989_|_1991_|
|---|---|---|---|---|---|
|Pegged to a Single Currency|77.7|63.4|53.5|51.2|45.7|
|US Dollar|25.0-|19.5|14.0|12.8|10.9|
|French Franc|36.0|34.2|30.2|35.9|30.4|
|Other Currencies|16.7|9.7|9.3|_2.5_|_4.3_|
|Pegged to a Composite of Currencies|19.5|31.7|37.2|30.8|23.9|
|Limited Flexibility|2.8|0.0|- 2.::|0.0|0.0|
|More Flexible Arrngements|0.u|4.9|6.9|17.9|30A.|
|Adjusted According to a Set of Indicators|0.0|0.0|0.0|2 5|6.5|
|other Managed Floating|0.0|4.9|6.9|7.7|10.9|
|Independently Floating|0.0|0.0|0.0|7.7|13.0|
|Toial (percentage)|100.0|100.0|100.0|100.0|100.0|
|More flth One Rate for Imports andlor<br>Exports|11.1|12.2|20.9|12.8|10.9|

SOURCE: IMF, Exchange Arrangements and Exchange Restrictions (various issues)
8 The proportion of countries pegging to a single currency declined from 78 percent in 1976 to 46 percent in 1992; with pegs specifically to the US dollar falling from 25 to I I percent. However, excluding the countries in the CFA zone, which maintained a currency union arrangement pegging to the French franc throughout the period, the table shows single currency peg regimes declined by two-thirds between 1976 and 1992. To neutralize the negative impact of fluctuations in exchange rates of major currencies, an increasing number of countries chose to peg to a composite basket of currencies (notably the SDR): the proportion rose from 20 to 24 percent between 1976 and 1992. By 1992 some form of flexible exchange rate arrangement was introduced in nearly a third of SSA countries, increasing from a negligible 3 percent in 1976. Also notable in the table is the extent to which official multiple exchange rates were utilized during the early 1980s as a transitional medium to more efficient exchange rate regimes. Overall, however, fixed rather than flexible rate regimes remain dominant in SSA.

The impact of exchange rate reform on the black market premia during three reform periods, shown in Table 2, presents a rather mixed picture: some clear successes (e.g. 'Ghana); some improvements (e.g. Mozambique, Tanzania) and several policy reversals (e.g. Zambia). In the light of the preceding discussion, the objective of a realistic exchange rate reflecting market conditions should be the primary objective for a hig. premium economy undertaking exchange rate reform. Initially this objective should have greater priority than a second objective of stabilizing the exchange rate.4r Stabilization is crucial in some Latin American countries where the feed-through coefficient from official devaluation, to inflation in near hyper-inflationary conditions is high (e.g. 0.6 for Bolivia, Dominguez (1991)). In SSA countries with large premia, many prices already reflect the parallel exchange rate so that official devaluation is unlikely to have a significant effect on inflation (Aron and Elbadawi, 1992; Chibber and Shafik, 1990). With the achievement of sufficient real depreciation to create a sustainable unification of multiple rates, a stable exchange rate will -assume increasing importance. At this point, exchange rate policy in

-4/ The measurenent of exchangcrate instability poses some problems. Pritchett (1991) suggests that the **third** momcnts about the mean (skewness and kurtosis) are a feasible measure of exchange ratc uncerainty (volatility) given that variance is not defined for sernes that exhibit persistence (the official and black rates usually foliow a non-stationary series process - see for instan'e Aron and Elbadawi, 1993a).
9 small, open economies is driven by two conflicting objectives.51 Allowing flexibility in the exchange rate can achieve and maintain international competitiveness6/ in the face of internal and external price shocks, and ensure a viable balance of payments; on the other hand, a stable exchange rate can anchor domestic prices.

What lessons can be learned from the recent experience of SSA countries in fDrmulating exchange rate policies, and in the choice of an exchange rate regime to achieve these policy objectives? In particular, what explains the successes and failures of unification in SSA countries? And for countries without significant black markets (due to unification, or currency convertibility (CFA zone)), what evidence is there for the comparative benefits of fixed versus flexible rates? Table 4 classifies the individual SSA countries according to the exchange rate arrangements outlined in Table 3. In terms of broad policy regimes, these countries can be placed into the following three groups:

- (i) Countries with fixed exchange rates, closed capital accounts, and selective price controls (e.g. countries pegged to a basket of currencies);

- (i) Countries with flexible exchange rates (devaluing periodically, using a crawling peg, employing an auction or floating with an interbank market), a closed capital account, and a closed/open trade account;

- 3iii) Countries with fixed exchange rates, fully convertible currencies and no price controls (CFA zone).

The successes and failures of the countries from Group Q) in achieving exchange rate unification through more flexible exchange rate regimes (Group (ii)) are examined in the section below, with recourse to various empirical studies, and policy lessons are drawn. Then recent studies on the CFA zone are explored to draw lessons for the usefulness of fixed versus flexible exchange rates for countries with currency convertibility, but subject to SSA struchural conditions of susceptibility to terms of trade and other exogenous shocks, and fragmented or poorly developed markets in various sectors (including banking).

Cordcn (1990) discusses **thd** dual roles of the xchangc **mte in macroecononic** policy, defining the **disinct 'rea)** targets' and **'nominal** anchor" approaches.

**61 The** real exchange **ae, defined** as the relativc prices of naontradablcs with mspect to tmadables, **is** a **proxy** for a country's international competitivcness.
10

# A. Exchange Rate Unification: Lessons From Successes and Failures Using Flexible Rate Regimes in SSA.

The implementation of exchange rate unification has varied across countries and as shown above has resulted in successful cases - Ghana, Uganda and Tanzania - and not so successful cases - Zambia and the Sudan. The different outcomes result from the speed of the unification process, the sequencing of accompanying policy measures, the commitment of the authorities to the reform and the availability of external budgetary and balance of payments support. According to Kiguel and O'Connell (1992), unification in SSA countries must be done as quickly as possible, at least for current account transactions. In many of these countries, because of the scarcity of foreign exchange, unification has the limited objective of allowing the most current account transactions to take place in one officially recognized market, keeping some control on capital movements, and thereby justifying a secondary market for foreign exchange (which may be illegal or quasilegal - a black market; or legalized - bureaux de changes). Most of the unification experiences in SSA have been gradual. However a few countries have moved directly to currency convertibility in an interbank foreign exchange market CThe Gambia).1i There are a number of means by which a gradual unification has been attempted by SSA countries:

- (i) Occasional devaluations whilst pegged to a currency basket or single currency.

- (ii) A crawling peg, where the rate moves in a pre-announced fashion (e.g. Ghana 198386; Zambia 1983-85).

7/ Since 1986, the Central Bank and the three commercial banks in the Gambia have traded at weeldy "fixing" sessions, establishing a rate of exchange closely linked to the previous week's interbank rate, but used only for statistical purposes and immediately superseded by the interbank rate. Bureaux de change were legalized in 1990, and have joined the weekly session, improving competition. The weekly meeting has given the Central Bank a handle on market developments and also a monitoring presence. The Central Bank is a net purchaser in the interbank market for reserve accumulation purposes. The interbank market seems to have functioned relatively smoothly in The Gambia: however, there have been only modest transactions between the banks, and despite the early removal of capital controls, it functions more as a flow than an asset market.
# Table 4: Exchange Rate Arrangernents in Individual Sub-Saharan African Countries, 1990

# Exchange Rate Pegged to US Dollar

- Angola** - Liberia

- - Djibouti - Sierra Leone - Ethiopia"<sup>t</sup>

# Exchange Rate Pegged to French Franc

- Benin - Cote d'Ivoire

- - Burkina Faso - Equatorial Guinea - Cameroon - Gabon - CAR - Mali - Chad - Niger - Comoros - Senegal - - Congo Togo

**Exchange Rate Pegged to South African Rand** = Lesotho - Swaziland

# Exchange Rate Pegged to a Basket of Currencies **SDR**

**- Burundi** - Seychelles - Rwanda - Zambia* Other - Botswana - Mozamnbique** - - Cape Verde Sao Tome and Principe* - Kenya - Tanzania* - Malawi* - Uganda* - Mauritius - Zimbabwe

# Managed Floating Exchange Rate

- Guineat - Madagascar*

- - Guinea-Bissau* - Mauritania

# Independently Floating Exchange Rate

- The Gambia* - Zaire* - Ghana - - Nigeria - Sudan

# Multiple Exchange Rates

- Ghana - Somalia

Countries with widespread black markets, restrictions on capital accounts and selective price controls. -Countries wilh widcspread black markcts, rcstrictions on capital accounts and cxtensive price controls but with a lack of effective implementation.

(In Ethiopia, the controls are effective).
12 (iii) Official dual markets, with one exchange rate determined by the authorities and applying to public sector and selected private sector transactions, and a second rate determined by market forces for the remaining transactions (e.g. Z;ambia 1990-91). (iv) Foreign exchange auctions, where the rate is determined weekly or fortnightly as the marginal or average rate bid when auctioning a fixed supply of foreign exchange to importers or banks (e.g. Zambia 1985-87; Ghana: 1986-92; Nigeria 1986-92; Uganda 1983-85, 1992-93).

(v) A market pricng rule for administered allocation of foreign exchange: currently a number of countries allocate foreign exchange by means of a first-in-first-out queue, pricing at the free rate in the legalized bureaux de change market (e.g. Zambia 1992-; Mozambique 1992-). Another example would be following a purchasing power parity rule.

The experience of the first two approaches is that wit adverse external shocks, large fiscal deficits and low policy credibility, occasional devaluations or an accelerated crawl have failed to provide sufficient adjustment to sustainably unify multiple markets (Elbadawi, 1990). Nevertheless, significant reductions in black market premia have been achieved with a crawling peg (e.g. Ghana, 1983-6). Tanzania provides another example: in 1986, a reform program was launched, which included significant adjustments in the exchange rate, monetary and fiscal policies, increases in the interest rates and producer prices, and relaxation of price controls. The premium dropped from above 700 percent in early 1986 to about 50 percent in mid-1990 (KCiguel and O'Connell, 1992). Zambia in the period July 1983 to October 1985 adopted a crawling peg system for the official rate, accompanied by restrictive monetary and fiscal policy. This effort was unsuccessful, however, due to large exogenous shocks in terms of trade shocks, and foreign aid, and to "the fundamental endogeneity of the parallel premium with respect to macroeconomic and trade policy" (Aron and Elbadawi, 1992).

Official dual exchange rates have frequently been used as a temporary measure: there is a gradual transfer of transactions from the various exchange markets (including the black market) into one particular ket. Ultimately the official rates are unified. Both the Sudan and Zambia used dual markets, but without striking success in eitier case. Sudan allowed a secondary legal market with a floating exchange rate to operate alongside the official market, shifting import
13 categories from the official market to the secondary market over time. These efforts were accompanied by successive devaluations in the managed rate, in the context of liberalization programs. However, the lack of suppoiting fiscal policy resulted in depreciation in the legal secondary market. As the authorities tried to enforce a more appreciated rate, transactions shifted to the black market, and there was a reappearance of a large black market premium. A similar story holds for Zambia. Early in 1990, an official rate was designated for -government imports, debt service, purchase by govermnent of copper receipts from the state-owned copper sector, and imports not on a positive list for the secondary official market. A more depreciated market rate was applied to all transactions on the positive list: initially only 10 percent of imports by item were on the list, but at the unification of the official rates in April, 1991, over 90 percent of imports had been transferred to this window. Unfortunately the term "market rate" was a misnomer: the second rate was managed and real depreciation resisted by the authorities. Given the high levels of inflation in the period due to insufficiently supportive fiscal policy, at "unification' a thriving black market persisted with a premium of over 100 percent.

Since the early 1980s, foreign exchange auctions have been fairly widely used outside SSA (e.g. Jamaica, Bolivia, Romania, Russia, Khazakstan), as well as in over nine SSA countries. Auctions operate like a hybrid between a crawling peg system and a floating rate: the pricing and allocationt of foreign exchange are fully market-determined, but this rate persists until the next auction. Auctions in SSA have typically been held weekly or fortnightly (e.g. Ghana, 1986-92, Zambia 1985-87, Uganda 1992-93). However, auctions have also been used as an allocation mechanism for governLment foreign exchange in the context of an interbank market determination of the exchange rate (Nigeria 1989-92). Auctions may have advantages over moving directly to a floating rate in al. nterbank market where there is insufficient institutional depth to allow effective functioning of a decentralized foreign exchange market, where a few commercial banks have historically been dominant and there is danger of collusion, or where there are limited sources of foreign exchange (Krumm, 1985; Quirck-et al, 1987).

In a typical auction the bidders are importers or commercial banks acting as direct agents of importers (retail auctions e.g. Zambia, Ghana); or commercial banks bidding only for themselves, later allocating freely to importers in a secondary market (wholesale auctions e.g. Nigeria, Ghana). The bids are integrated price and quantity bids. These bids are lined up from
14 highest to lowest price, and the marginal rate is that rate which fully exhausts the available (perhaps pre-announced) supply. In a competitive auction the marginal rate is the exchange rate and is paid by bidders regardless of their bids. In a Dutch or discriminatory auction, bidders pay their own price, and the exchange rate may be a quantity-weighted average of the bids, or the marginal price.

Auctions also offer various control variables to the authorities: the supply offered, a choice of pricing mechanism- (competitive or discriminatory), the use of a reserve price (below which the authorities will not accept bids), the possibility of revealing information about the bids, and the right to impose entry restrictions of various kinds. Thus, unless the operation of the auctions is fully transparent, adhering to published rules, the potential exists for government manipulation of the exchange rate. A recent statistical and econometric study using weekly data for foreign exchange auctions in- four SSA countries (Ghana 1986-92, Nigeria 1986-88, Zambia 1985-87 and Uganda 1992-3) found a clear distinction between two sets of countries in terms of design features, auction policies and outcomes (Aron and Elbadawi, -1993 a,b). Ghana and Uganda represent a set where auctions have been largely on target in terms of the three policy objectives of exchange rate unification, stabilization of the exchange rate and an efficient allocation of foreign exchange (Figure I b,c). On the other hand, the auctions in Zambia and Nigeria were subject to frequent policy interventions, with the consequence of unsustainable auctions, inefficieut allocation through ad hoc disqualifications (at least in Zambia), limited unification, and a rather volatile exchange rate (Figure 1 a,d). A distributional analysis found the distribution of the auction rate exhibits left skewness (tendency towards appreciation) in Nigeria and Zambia; while the opposite was observed for Ghana and Uganda.
15 FIGURE **1** a,b,c,d: The prallel **premium** and auction exchange rate relationship (source: Aron and Elbadawi, 1993a).

<!-- Start of picture text --> ZAMBIA: monthly black market premiurm<br>16.0_ 2.00<br>-1.00<br>1 4.0<br>1.180<br>12.0 1. 7<br>6.0 ~~~~~~~~~~1.5 20<br>8.0 1140<br>6.0~~~~~~~~~~~~~~~12<br>1 5 9 13 17 21 25 29 33 37 41 45 49 53 57 b1 65<br>3 7 11 15 19 23 27 31 35 39 43 47 51 55 59 63 67<br>auction mxtrw<br>la cucdtan rate bka/oucltn reta<br><!-- End of picture text --> <!-- Start of picture text --> UGANDA: weekly bureaux premium.<br>1050 . -1.32<br>1040 - Vo -1.30<br>1030 - , ,.1.28<br>1020 - 1.26<br>fIo 1010 - -1.24E<br>1000 .1.22<br>990 -1.20<br>980- ,1.18<br>970 -1.16<br>15 9 13 17 21 25 29 33 37 41 45 49 53 57 61<br>3 7 11 15 19 23 27 31 35 39 43 47 51 55 59<br>aulion n±rter<br>acticn u- rate bersa TC/aucllan<br><!-- End of picture text -->
16 <!-- Start of picture text --> UGANDA: weekly bureciux premium.<br>1050 1.32<br>1040- 1.30<br>1030 -1.28<br>1020 t.26<br>1010 e 1.24<br>1000 5 1.22 f<br>990- < - - 1.20<br>980 71.18<br>970 ......... ....... .. ........... ...... 1.16<br>1 5 9 13 17 21 25 29 33 37 41 45 49 53 57 61<br>3 7 11 15 19 23 27 31 35 39 43 47 51 55 59<br>ouclion rn.bter<br>IB axtlon role A- buram TC/ouctlon<br><!-- End of picture text --> <!-- Start of picture text --> NIGERIA: weekly black market premium.<br>4.5 - 1.50<br>3~ ~~~~~~~~~~~~~~13<br>1 5 9 13 17 21 25 29 33 37 41 45 49 53 57 61 65<br>3 7 11 1519232731 353943475155596367<br>auction rtunbe<br>- atTon rae - blcrk/cuctlon role<br><!-- End of picture text -->
The study found that in large measure, the failure to achieve exchange rate unification and a stable exchange rate in Zambia and Nigeria could be attributed to the absence of a reserve price rule. The results suggested that use of a fairly predictable reserve price stabilizes foreign exchange auctions, given the limited depth of SSA financial markets. The rule is learned by bidders, and diminishes speculative bidding. The management of a sustainable and credible reserve price pol icy requires an efficient secondary market. The use of legalized bureaux markets in Uganda and Ghana had two advantages in this respect: they are likely to be deeper markets, and moreover eliminate the risk-premium associated with illegality. Macro-economic policy remains crucial to the success of the reserve pricing policy (Aron and Elbadawi, 1993a). A stable and consistent macro-economic environment, permitted the development of a stable and steadily depreciating bureaux rate in Ghana and Uganda, while the highly volatile illegal parallel rate was not suitable as a guide for policy in Zambia and Nigeria. Auction rate depreciation as a consequence of increased liberalization and hence competition in the auctions, is consistent with fundamental market behavior, and as such stabilizes the auction and fosters long-term unification. This has been the experience of Ghana and Uganda. In contrast Nigeria and Zambia attempted to stem depreciation through increased entry restrictions (and ad hoc disqualifications) over time: these policies back-fired and merely increased damaging speculative behavior. Given the initial conditions of thin and rather rudimentary financial markets in SSA, an important lesson from Ghana and Uganda is that there may be advantages from a more gradual liberalization for allowing institution-building and learning by agents in the market (bidders, bureaux, commercial banks, and the auction managers (Central Bank)). This may facilitate the transition to a more competitive interbank market, as was the case in Ghana Qn contrast to Nigeria). Gradualism may also be justified from a macro-perspective, given the substantial macro-imbalances and the low credibility that often characterize initial conditions in reforming SSA countries.

Estimations of the equilibrium exchange rate established that choosing Dutch over competitive pricing does not provide an automatic revenue advantage, except when there are a small number of bidders engaging in strategic behavior, or where risk-aversion is paramount. However, the Dutch auction may introduce other undesirable features such as enhanced opportunities for collusive practices, a reduced pool of bidders and inefficiencies associated with a multiple rate system- The estimation results found that while supply volatility does not produce
a risk-premium on the level of the auction rate, there is evidence that it is important for auction rate volatility. Thus, the stability of foreign aid could play an important role in compensating for fluctuations in export earnings induced by trade shocks and/or natural disasters. Anecdotal evidence suggests that under the auctions system the efficiency of allocation does improve compared to the previous system of ad-hoc allocation under a fixed rate. However, it is to be expected that ad hoc disqualifications as occurred in Zambia diminished these advantages. Finally, the evidence fTom Ghana and Uganda as against Nigeria and Zambia, suggests the paramount importance of transparent policy rules and conduct of the auctions. Lack of transparency is tantamount to unnecessary increased discretion by the auction managers, thus exacerbating one of the major potential weaknesses of the auction regime. Most of these results are supported by an earlier study (Mills,- 1988). In their policy dialogue and adjustment lending, the IMF and the World Bank have favored the unification of exchange rates (particularly official and black market exchange rates) on the grounds that multiple rates misallocate resources. However, using the experience of Ghana, Nigeria, and Sierra Leone, Pinto (1989) shows that this argument tends to overlook an important consideration which is inflation, "when multiple rates are means of taxation, the widened deficit from unification increases inflation." Pinto (1989) argues for the primacy of fiscal policy and the need to design the pace of exchange rate policy to be consistent with fiscal reform. The driving idea behind this prescription is that, if the fiscal deficit is not sufficiently reduced, premature policy of an accelerated crawl, for example, when the public sector is a net buyer of foreign exchange, would lead to unsustainablepost unification inflation as the authorities find themselves forced to rely exclusively on inflation tax to replace the foregone implicit revenue derived from the taxation of exports through premiums. This begs the question: What has been the trade-off between the benefits of' the unification of exchange rates for resource allocation and its costs for inflation in SSA? Evidence is provided by Kaufmann and O'Connell (1990) for the case of Tanzania. To study the fiscal impact of the unification, Kaufinann and O'Connell have calculated the financial position of the government vis-A-vis the private sector to determine whether the government is a net buyer of fbreign exchange from the private sector. Preliminary calculations suggest that Tanzania is on the favorable side of this calculation. Given the large inflows of aid being channeled by the government, increases in the official exchange rate provide a fiscal bonus, lowering the fiscal
19 deficit in domestic currency terms. Devaluation will have a positive effect on revenue collection. This **study** suggests that official exchange rate adjustments, in the course of unification, are not likely to contribute to inflation by way of fiscal channels.

# **B.** Fixed vs. Flexible Rates Under Currency Convertibility: **Lessons From** the CFA Zone.

Until the end of the 1970s, CFA countries!? had better inflation records than other SSA countries9/ and a superior growth rate. Early studies examining the performance of CFA zone countries in the 1970s and first half of the 1980s attributed the long-run growth of output and investnent (including foreign investment) to monetary stability, low inflation, the convertibility of the CFA franc and built-in restraints on fiscal and monetary policy (e.g. Guillaumont and Guillaumont, 1984; Devarajan and de Melo, 1987; Guillaumont, et a]. 1988b). It has been argued that the fixed exchange rate regime for CFA zone countries has been a contributing factor to their low inflation rates (Guillaumont, et **al,** 1988b). However, Chhibber (1991) and Honohas (1990) consider that lower inflation in countries with fixed exchange rates has more to do with the underlying financial and monetary arrangements, and the openness of the capital accounts between countries, than the fixed nature of the exchange rate.lio Moreover, depreciation of the French fainc (CFA currency peg) in the 1970s helped to counteract worsening terms of trade in the region, especially after 1973 (Elbadawi, 1991).

The performance of the CFA countries relative to other SSA countries changed dramatically after 1985, with a severe economic decline in the zone. Greater turbulence in terms of trade patterns were experiencediis, as well as an appreciating French franc vis a vis the US _!/_ The countries comprising the CFA zone were shown in Table 3.

9/ Median annual inflation in **CFA** countries was 11.6 percent in the 1970s, declining to 4 percent in the 1980s; whereas inflation in **aU** SSA countries was 14 percent in the 1970s, and about 17.3 percent in **the 199S0s.**

**10/** For instance, countries such as Ghana, Uganda and Sierra Leone experienced th-x digit inflation rates **even** when the **cxdcnge rate** was fixed (most prices being influenced by the parallel exchange rate).

1Il Elbadawi and Majd (1992a) (sec Table 3, **p.15)** evaluated the external shocks for SSA countries and for CPA countries. Comparing 1982-85 with **1l973-81 extemal** shocks (computed as the sum of **tenns** of trde and real interest - effects) and internal shocks (narrowly defined and proxied by the index **of** food production) were higher in SSA.
20 dollar. Furthermore, significant real depreciation occurred in key export competitors in SSA. CFA countries were unable to use nominal realignments as a tool to cope with real shocks; instead, they relied on the tight domestic policies through credit controls and fiscal discipline. Whether adherence to a fixed rate regime in the presence of large real shocks disadvantaged the zone is considered in a recent study by Elbadawi and Majd (1992). CFA membership is evaluated in two periods: the 1980s relative to the 1970s, and 1986-89 relative to 1982-85; and economic performance is compared to other SSA countries, and to a broader set of similar developing countries (including SSA).

The first part of the analysis compares long-run and short-run economic performance of these three groups by IDoking at the evolution of simple averages of key macroeconomic indicators. Contrasting the 1980s witd the 1970s, CFA countries appear to have been outperformed by countries in the other two groups; moreover, the competitive position of CFA countries was weaker in the second half of the 1980s than in the first half. These results are consistent with the conclusions of Devarajan and Rodrik (1991) that fixed exchange rates have been, on the whole, a bad bargain for CFA member countriesr: **" ....** for most of the CFA members, the inflation benefits do not appear to have been large enough to offset the costs on the output side. Under "reasonable" output-inflation tradeoffs, these countries would have been better off having the flexibility to adjust to external shocks." However, the second portion of Elbadawi and Majd's analysis adjusts for te selectivity bias in the CFA membership decision and uses a modified control group approach (Corbo and Rojas, 1990). This approach leads to more shaded results controlling for initial conditions, internal and external shocks and policy stance, the CFA members wereritperformed in the shortrun by other SSA and low-income countries in output growth, export, investment, and savings performance (though not in inflation). This suggests that the CFA monetary rules, while producing inflation stability, were inadequate in bringing about the necessary short-run adjustment. On the other hand, the CFA countries seemed to have done relatively well in the Comparing 1986-89 with 1982-85, external shocks where significantly higher in CFA than SSA but intemal shock were lower. Comparing 1982-89 with 1973-81, CFA recorded higher exlernal shocks and SSA higher intcrnal shocks.

121 These results are based on Devarajanand de Melo's (1990) reassessment- in view of the performanceofthe CFA countries in the 1980s - of the empirical evidcnce found in Devarajan and de Mclo (1987).
21 long-run. But, this is not a strong conclusion as sufficient evidence is lacking; the study shows a higher long-run growth rate for CFA countries vs. other SSA countries in only one of its numerous regressions. The study does not resolve the apparent trade-off between growth and inflation in the zone.
22 3

# _Exchange Rate Reform and Supply Response_

This section is organized as follows. First, the theoretical literature is briefly reviewed. Second, comparative studies on the impact of devaluation on output, and on economic performance in developing countries, including SSA countries, will be discussed. Finally, the supply response of devaluation in SSA countries will be examined in detail, with a particular focus on agriculture.

## A. Overview of the Theory

While it is widely accepted that a properly administered devaluation will improve the trade balance and change relative prices, there is little consensus in devaluations' effect on output and employment. Devaluation will either have an expansionary effect on aggregate output, or, in the worst case, will reduce aggregate output.13f Typically in the literature, the distinction is made between elasticities, absorption, and monetary approaches. The crucial assumption in these models are price flexibility, the degree of capacity utilization, and the emphasis on the demand side of the economy.

The elasticities approach assumes that prices are fixed, and that a nominal devaluation will result in an equiproportional real devaluation. Because the analysis takes place in a partial equilibrium framework _1o/_ the effects on output and employment are not explicit. If the elasticities approach is embodied in a Keynesian model where output is assumed to be demand _13/_ Some alathors **consider** that, in the **long run, the** loss of output due to the tempomry **eallocation** of factors of production towards trmdable goods is possible.

**_10f_ The** elasticities approach assumes that the **economy** is **small** and in **external** equilibrium; **this** approach **sts that** a devaluation **will be cffcdive** Cumprove the **balance** of payments) as **long as the** Marshall-Lerner conditions **hold.**
23 determined and there exists unutilized production, then the impact of a nominal devaluation on output and emnployment is positive.

According to the absorption approach, the effectiveness of a nominal devaluation will depend on its ability to generate expenditure switching (the composition of expenditures must move from foreign to domestic goods) and expenditure reducing (expenditures must fall with respect to income). If a nominal devaluation induces expenditure switching, then it will affect relative prices and thus, the real exchange rate. If there are unutilized resources, expenditure switching will generate an increase in real output and thus, improvement of the current account. For aggregate output, a devaluation that has a positive effect on the real exchange rate, and that generates expenditure switching, will have a positive effect on the aggregate level of activity.

The monetary approach focuses on the interaction between the external sector and the monetary side of the economy. The monetarist model assumes that resources are fully utilized and that the uncovered "interest parity" condition and the "purchasing power parity" condition hold. Consequently, domestic prices cannot fall out of line with respect to foreign prices. A devaluation will be offset by an increase in domestic prices and the real exchange rate will not be affected. Similarly, output will stay at its full employment level. In this setting, however, if domestic credit is kept constant, a devaluation will have a temporary effect on the trade balance. The trade balance will improve to the extent that the real balance effect will depress absorption and, through price increases, will reduce the real value of household wealth. Contrary to the Keynesian model, even in the absence of a devaluation, the full flexibility of prices guarantees that the automatic adjustment mechanism will work quickly and effectively to remove any disequilibrium in the economy (and there would be no need for devaluation).

In contrast to traditional views discussed above, several theoretical arguments have been put forth to explain why a devaluation can have a negative effect on output. The emphasis was initially put on the demand side. Diaz-Alejandro (1963) was among the first to raise this possibility.nL; He shows that a devaluation may lead to a reduction in real income using a model with relatively price-inelastic exports, imports and consumption functions based on higher propensities for non-wage earners. This result is produced by transferring real income from II/ **Se Cooper** (1971).
24 workers who receive a fixed nominal wage, to capitalists with higher propensities to save factor income. Krugman and Taylor (1978) have extended and formalized this view. They argue that a devaluation can be contractionary to the extent that it generates, through its effects on the price level, a negative real balance effect. This, in turn, will result in lower aggregate demand and, under some circumstances, lower output.jLyIn addition to these demand effects, there are a number of supply-side channels through which devaluation can be contractionary (besides being inflationary). Bruno (1979) makes two arguments to support the view that, in a developing country, a devaluation will increase firms' input costs and need for working capital. First, he argues that inputs for manufacturing are imported and not easily substituted domestically. Bruno also states that a devaluation will increase the need for working capital for firms whose acquisition of working capital is dependant on banks subject to rationing. This will increase interest rates and the demand for funds, which may lead firms to reduce production. Thus, the positive effect of increased production will be offset by higher relative prices. If relative prices are delayed, in the short run, it is possible that the negative effect on aggregate supply may prevail. Van Wijnbergen (1986) developed a model with intermediate goods and a financial (curb) market. Like Bruno, he stresses the impact of a devaluation on the domestic currency costs of imported inputs, as well as its negative effect on firms' working capital. He also discusses the effect of parity changes on external debt repayment and on nominal wages in the presence of wage indexation. **i** Finally, Buffie (1986) warned against the negative effect on supply which could be compounded, in the long run, by a nominal devaluation that depresses investment because of a higher cost of imported capital equipment.

How usefuil are these models in understanding the impact of devaluation on SSA economies? In other words, how relevant are the assumptions of these models for SSA countries? The assumption of full employment in the monetarist model is weak in the SSA context because structural and cyclical factors keep the economy in under-capacity utilization. Often, SSA countries cannot take full advantage of price changes because of constraints such as poor

**121 Kzugman and Taylor results rely on very restrictive asswmptions (exports are fixed, the marginal propensity to save of the govenmuent is equal to one, and so on).**

**131 See Buffic (1984).**
25 transportation facilities, inefficient research and, extension services. The Keynesian approach is also lacking, given the disproportionate attention to demand factors.

Arguments supporting the contractionary devaluation hypothesis need to be examined. In the case of the demand-side approach, it is important to consider the underlying elasticities in SSA countries. Are the elasticities lower in SSA than in other countries? For the supply side approach, the negative effect due to intermediate goods has diminished due to an increase in production of primary products in most SSA countries. Intermediate inputs in agriculture are not domestically substitutable, but are used in iarge farms that are generally financially better off. Therefore, these inputs are not subject to rationing.

The impact of sustained devaluation on SSA economies is an empirical matter, yet there has been little empirical work done on the :ontractionary effect of exchange rate changes on economic activity in developing countries. Empirical work exists on Latin America, but few studies have been done on the SSA region. Interestingly, there are several studies on the supply response of agriculture based on SSA countries. In the study of effects of devaluation in SSA countries, there is an overlap between analysis of devaluation on economic performance and analysis of the supply response of agriculture to devaluation.

# B. Empirical Studies on Contractionary Devaluation in Developing Countries

A number of methodologies have been presented in the literature to analyze the effects of devaluation on economic performance.14/ The first approach examines changes in country performance at the time of devaluation, usually referred to as the "before and after" approach. The flaw of the "before and after" approach is that it relies on the assumption that other things are being held equal which is highly implausible. The second approach, the so-called "control group," in principle, overcomes the shortcoming of the "before and after" approach by distinguishing the effect of devaluation from other factors on output. The "control group" approach compares the performance in devaluing countries with performance in a reference group of non-devaluing countries to estimate what would have happened in the devaluing countries had 141 See Goldstein **and** Montiel **(1986)** for **a** fronma prescntation of these methodologies.
26 devaluation not occurred. The third approach applies econometric methods to time-series to determine the impact of the exchange-rate changes on various performance variables. This approach has a number of limitations since the specification of the output equation estimated is essentially ad-hoc. Finally, the fourth, somewhat less direct approach, uses simulation models or reduced-form equations to analyze the effect of the exchange rate on output. This approach has a major advantage-it gives more information on the short run dynamics of the effects of a devaluation. However, the results rely often on "guess estimates" of values of elasticities and parameters. **_15/_** Table 5 is a matrix giving an overview of empirical studies done on the effects of devaluation. In a seminal paper, Cooper (1971) employs the **"before and after"** approach to examine 24 devaluations between 1959 and 1966, involving 19 developing countries (none of which belongs to SSA). The study assessed the extent of the response (one year before and one year after) of various elements of aggregate demand, balance of payments and inflation. Cooper's results show that some elements of aggregate demand demonstrate contractionary tendencies after devaluation. Results show, however, that the trade balance and the balance of payments did improve in most cases. While Cooper attempted to control for changes in the international and domestic environment when measuring responses to devaluation, his focus on one-year changes was limiting. Typically, a devaluation cannot be expected to have its principal effect in the year after its implementation.

Kamin (1988) is one of the first studies based on the "control group" methodology. This study follows the evolution of different variables for seven years (the year of the devaluation, three years before and three years after). Kamin's research exploits data for 50 to 90 devaluations out of a sample of 107 (including 22 devaluation episodes in twelve SSA countries) that took place between 1953 and 1983. Kamin's results show that devaluation has a positive or at least no effect on output, but a sharp and significant decline in output growth is registered by the devaluing countries, in the year preceding the devaluation. This lower rate

**_15/_** Empirical studics **based** or **_the_** "before and aiter" appmach include Dinz Alejandro (1965), Cooper (1971), **Krueger** (1978). Regrssion analyses **are** applied in Khan (1974), Goldstein (1974), Miles (1976), Edwards (1986), Edwards (1989) **and** Faini (1992). **Results** presented in **simulations** models **are presented** in **Gylfasn and** Shnmid **(1983)** ,Gylfason and **Risagcr** (1984), Solimano **(1986),** Brnson (1986), Gylfason (1991), and Agenor (1991).
27 Table 5: Studies on the Effects of a Devaluation

|_AU7hOR_|_COVERAGE_|_ME77I0D_|_DEVALUA77ON_<br>_EFFECT_|
|---|---|---|---|
|Cooper (1971)|24 devaluations (1959-66) in LDCs<br>(Africa: Morocco, Tunisia)|Control group approach|Contraction: trade balance and<br>B&P improve|
|Shechey (1986)|16 Latin Americancountries|Economeiric approach|Highly contrctionary|
|Edwards<br>(1 986b p. 139)|12 devaluations in LDCs (1965-80)<br>Africa: South Africa<br>._____________|Economelric approach<br>(dependenteconomy model<br>with intermediate inputs.<br>wage indexation and foreign<br>debt)<br>-|Short-run contraction,long- run<br>ncutrl<br>.<br>____________________dcb|
|Ahluwalia and<br>Lysy<br>(1981)<br>-|Malaysia<br>.|Macromodel<br>.<br>.|Contraction when export demand<br>elasticityless than_0.5_<br>.<br>_ _|
|Gylfason and<br>Schmid (1983)|5DCs (Brazil, India, Pakistan,<br>Philippines, Turkey) and 5 DCs|Macro-simulation<br>model<br>(intemnediate goods and open<br>economy)|Devaluation iaexpansionary<br>in 8<br>of 10 countries.<br>Long-nm neutrality|
|Gylfason and<br>Risager (1984)|3LDCs, 7 DCs<br>(Africa:Kenya,Morocco)|Macro-simulation model|Contrction in LDCs; expansion<br>in DCs; imnproved<br>CA all|
|Hamilton<br>(1987)|Australia|Macromodel|Short-runexpansion:<br>long-run contraction|
|Diaz-Alejandro<br>(1965)|Argentina<br>_|lBcrorcand aftcrapproach<br>_|Short-run contraction<br>_<br>_<br>_|
|Kamin (1998)|107 devaluations in LDCs (SSA:<br>Botswana. Burmndi, Ghana, Rwanda,<br>Sicrra Leonc,Somalia. Sudan. Swaziland,<br>Tanzania, Zambia)|Control group approach|Expansion or no effect.<br>Contraction occurs before<br>devaluation and can last after<br>devaluation|
|Edwards<br>(1989a)(1939b<br>p.320.24)|18 devaluations in Latin America (1962-<br>1982)|Control group approach|Observed decline in growth<br>when observed not a<br>consequence of devaluation but<br>ratherdue toaccompanying<br>measures|
|Faini and de<br>Melo (1990)|Largc sample of LDCs|Econometrcapprtoacb|No effect on the trade balance<br>and output forexportersof<br>ptimary goods-In the long mru<br>expansionary<br>for cxporters of<br>rnanufactured goods|
|Gylfason and<br>Radetzki<br>(1985)|12 LDCs (SSA: Sudan, Botswana,<br>Burundi. Ethiopia, Malawi, Rwanda,<br>Somnalia, Sudan, Tanzania)|Macro-simulation model|CA improves, decline in output<br>if wages arm downwards<br>inflexible,specially if there is<br>wage indexation. Evidence of<br>contractionaryeffectsin LDCs|
|Donovan<br>(1981)|12 IMF-supported devaluations<br>(1970-76)|Control group approach|Export growth improves in the<br>longrun, thoughnoL initially(3<br>curve).Iportgrowth rise but<br>lessthan export growth|
28

|_AUTH77OR_<br>Donovan<br>(1982)|_COVERAGE_<br>78 IMF-supported devaluations (1971 -0)|_METOD_<br>Control group *pproach|_DEVALUA77ON EFFECT_<br>Output rall more than LDCa<br>avercge in one year comparisons<br>but by les in 3_yearm_<br>conpariuons|
|---|---|---|---|
|Gylrason<br>(1987)|IMF supponed programs (1977-79)|Control group approach|B&P improves, effect on output<br>is inconclusive|
|Khan (1990)|69 LDCs (1973-88)|Control group approncli|Negative effect on growth<br>(however thc coeircients arc not<br>statisticafly<br>significant)|
|Solimno<br>(1986)|Chile|Macro-simulation model|Contraction in the short-run and<br>in the medium-run|
|Branson (1986)|Kenya|Macro-simulation model|Contractionasy effect|
|Rocaand<br>Priale (1987)|Peru(1977-78)and (1980-82)|Macro-simulation model|Contractionary effect due to<br>increase in cost of working<br>capitalof_firms_|
|Agenor (1991)|23 LDCs (1978-87)<br>(SSA: Burundi,. Canmeroon, Gabon,<br>Malawi, Nigeria, Sierra Leone, Togo.<br>ZaireandZambia)|Econometric approach<br>1-|Anticipated depreciation is<br>contractionary while<br>unanticipated depreciation is<br>expansionary|
|Bhagwat and<br>Oatsuka<br>(t974)|LDCs (1960-70)<br>_|'Before and after' approach|PosiLive expon response in the<br>long-run, litle indication of<br>significant imnpoutrespOnSe|
|Edwards and<br>Santelln (1992)|48 devaluations in LDCs (SSA:Ghana,<br>Zaire)|Control group approach and<br>econometric approach|Devaluation when accomnied<br>by restrictive and consistent<br>macro-policies an effective|
|Taylor (1979)|22 countrics<br>-______________________________|Econometric approach<br>____________________<br>_|Support of expansionary<br> <br>-hypothesis|
|Salant (1976)|101 devaluation in LDCs and DCs|'BfGore and aficr' approach|Balance of trade impsroves only<br>in 46 cases, B&P improves in<br>76 cases|
29 appears to have been maintained unchanged throughout the year following the devaluation. Insubsequent years, the effeces of the devaluation on output are positive. Edwards (1989a) is another study that uses the control group approach. Analyzing devaluation episodes in Latin America, Edwards found contractions of output in the periods before and after the devaluation. Edwards points out that negative output performance in the short run may have been the consequence of underlying policies that accompanied the devaluation, rather than devaluation itself.161 Edwards (1986) is one of the few empirical works using econometric methods. His empirical analysis was based on estimating a reduced-form real-output equation using data for twelve developing countries (the only African country included was South Africa).r71 The results show that, with other things being held equal, devaluation has a negative short-run effect on output. After one year, however, this negative effect on output was completely reversed. In the long run, devaluations were found to be neutral. Sheehey (1986) is another study which uses the econometric approach. Sheehey analyses devaluation episodes in twelve Latin American countries, focusing on the short run. His results provide evidence which supports the contractionary hypothesis. In a recent study, Agenor (1991) also used an econometric approach to analyze devaluation episodes in 23 developing countries-among them nine SSA countries-over the period 1978-87. His output equation was based on a rational expectations model. Contrary to the results produced by Edwards (1986) (who used the same apprcach), Agenor's results show that an anticipated depreciation of the real exchange rate has a negative effect on economic activity, while an unanticipate **d** epreciation has a positive impact on output. Moreover, the contractionary effect of anticipated depreciation remains significant, even after a year.

A paper by Faini and de Melo (1990) shows that, for primary-goods exporters, a real devaluation has no effect on the trade balance, and thus on output, whereas for manufacturing exporters a real devaluation does have an effect. Employing the econometric approach, Faini and de Melo argue that this result is due to the lack of opportunity to expand exports which are

# **161** See Donovan **(1981).**

**171** The **variables** inclttdcd in the **right and** side **were:** moncy **growth** surprises, **government expenditreb, tenns** ortrsde and **real** exchange **intes** (a problem of auto-corelation **can** occur **due** to the endogeneity **or the** real **exchange** variable).
30 concentrated in so few primary commodities. This argument is relevant for SSA countries where export concentration is high. As of 1988, two commodities provided at least 60 percent of export earnings in 30 out of the 43 SSA countries for which export data by commodity are available. (Table A4). Faini and de Melo's results assume that the terms of trade are given. It is important to note, however, that in the econometric approach, it is difficult to determine which channel. suggested by the theory is more important since the analysis focuses on the net effect of devaluation on output.

Evidence from macro-simulation models provide information that distinguishes the effects of devaluation on output through different channels. Gylfason and Risager (1984) provides evidence from cross-country macro-models on the impact of devaluation on real output. Their study shows that, while a devaluation is likely to have a positive effect on output in developed countries, it is generally contractionary in developing countries. Using the same approach, Gylfason and Radetzki (1985) obtained a similar result: contractionary devaluation is more likely to occur in developing countries than in developed countries-even more so when demand elasticities are low.1Us/ To summarize, many studies exist on the impact of devaluation on output in developing countries. (See Table 5). The conclusions are as follows. First, contractionary devaluation is true in some countries but not in others. Second, where contractionary devaluation occurs, it is short lived; in the long run, devaluation effects seem neutral. Third, contractionary devaluation is more likely to occur in developing rather than in developed countries-more so when demand elasticities are low. Finally, the impact of devaluation on output appears to be less effective (or even ineffective) in countries exporting primary products than in countries exporting manufactured goods.

# C. Empirical Evidence on Contractionary Devaluation in SSA Countries

Are conclusions drawn from studies done on developing countries in general relevant for SSA countries? There is a _priori_ belief (especially among some policymakers in Africa) that _IB/_ Although Gylfason **and** Risager's **study** emphasies **the roe of** intercst 'tes, the Gylfason and RadelizW's paper emphasizes the role of wage indexing.
31 devaluation in SSA economies results in output contraction and high inflation. A few empirical studies seem to confirm this. For example, a study conducted by Demeke (1992) on a sample of 30 SSA countries for the period 1980-88 concluded that the effects of currency depreciation on output and export was at best insignificant and that it triggered a high rate of inflation. The effects on the current account balance were positive but due largely to import compression. Two methodologies were used in this study: the before-after approach and the econometric techniques. However, using data from the period 1965-89, Balassa (1989) analyzed SSA economic performance in general and agriculture exports in particular. He found that a 1 percent change in the real exchange rate is associated with a 0.8 to 1 percent change in the ratio of exports to output in SSA countries. Balassa also found that the response of the export-output ratio to the real exchange rate changes for SSA countries is higher than for other parts of the world. His evidence on export shares argues against the prevailing pessimistic export position.L9/ Using a CGE model for two African countries, Madagascar and Niger, Dorosh (1994) and Dorosh, Essama Nssah, and Samba-Mamadou (1994) found positive association between real exchange rate depreciation and changes in real exports. A RER depreciation of 10 percent was associated with an increase in real exports of 5.9 percent in the case of Madagascar and 3.4 percent in the case of Niger.

In SSA economies, the tradeable sector is constituted essebtially by the agriculture sector. For this reason, supply response by tradeables will be measured by the supply response of the agricultural sector. Two caveats should be borne in mind. First, imports of manufactured goods are important, especially the essential products that cannot be domestically produced. Second, tradeables, on the export side, are made up of not only agricultural products, but also non-primary commodities (including mineral products and oil). It is believed that the results are essentially the same for mineral producing countries as for agricultural producing countries except that the underlying elasticities involved are lower.

Although SSA countries differ greatly in their geographical and physical conditions, weather patterns, and cultural heritage, the similarity of their economic structures is striking. In most SSA countries, agriculture dominates the economy and for many, accounts for 30 to 60

**_191_ BDlaa's results rely on regrcssions hlving low coefrciunts of detecnination (the highcr is equal to 0.092), and, thexefom, must be interpreted with caution.**
32 percent of their Gross Domestic Product. Except where metals and minerals oonstituto a country's main export, agricultural commodities account for two-thirds or more of their export earnings.4g In some cases-Burundi, Chad, COte d'lvoire, Mali, Rwanda, Somalia, Sudan and Uganda-agricultural products are virtually the only merchandis **e** xport.; Thus, a knowledge of the agricultural sector's responsiveness provides tho means to gauge the effects of real exchange rate depreciation on overall economic performance for two reasons: the nature of the agriculture sector, it is usually more labor-intensive and less import-intensive than the rest of tho economy; and the agriculture sector's Importance in the tradeables sector, and in the overall economy.

# **SUPPLY REsPoNsE OF MACROECONOMIC INTERVENTIONS ONAGRICULTURE.**

Macroeconomic policies have a direct and an indirect impact on the agricultural sector.wv Krueger, Schiff, and Valdes (1988) show that the indirect effects on agriculture generally dominate the sectoral direct effects of price interventions in SSA countries such as Ghana, Cdte d'Ivoire and Zambia. Thus, typically, the empirical work on the supply response of agriculture is measured by numerical estimates of elasticities of aggregate, sub-sectoral (cash crops and food crops), and individual crop supply response to price and non-price variables. The values found for the underlying elasticities -for the developing. countries are compared to the corresponding elasticities for the SSA countries.

SUPPLY REsPoNSE OF **AGRICULTURE IN** A **SINGLE CRop SuPPLY** ELAsncInEs.z/ Price incentives are an important element of any exchange rate policy aimed at stimulating agricultural supply. Measuring the price elasticities of agriculture is necessary to make a realistic

**_201_** Congo, Gabon, Cameroon **and** Nigeria (oil); Niger **(umnium);** Siera Leone (diamonds); Togo (phosphates); Zaire and Zambia (copper); **Liberia** and Maurituia (imn ore).

21/ Oil producing countries and counties whose principal exports **ane minels ac** different **CaWb. These cases** will be examined in the **Annex Country** Case Studies of this report.

**22/** For exmnple, agriculure **can** be taxed **relative** to **inport** gubstitutes through a **direct** effect **(export** tae and import proection polieies) or agriculture **can be** taxed indirectly through the ovwevalued exchange **nate.**

**23/** Fora discussion on **the caveas** associated with the **estimates** of **the elasticities** of wuppiy zsponm, se Oyejide (W90).
33 assessment of the supply response of agriculture. However, it is useful to keep in mind that most empirical works are based on a partial equilibrium set up. Non-price incentives, such as policies affecting infrastructure, roads, and so on, are also important.241 Studies of the supply response on SSA agriculture have discussed whether or not the African smallholder responds normally, quickly and efficiently to relative price changes, or whether the institutional constraints limit their response. Empirical evidence exists for SSA countries, assembled by Helleiner (1975) and Bond (1983), which shows that the response of single crop output to price incentives is high. Tables Al and A2 summarize the elasticity ranges for SSA countries. The evidence shows that farm producers in SSA respond to price incentives as any other farm producer in the developing world-they behave rationally.

FOOD CROPS **AND** CASH CROPS SUPPLY ELASTICITIFS. It is quite useful to distinguish between cash crops and food crops because of the large difference in the marketing magnitude of their inputs. Statistics are generally available for cash crops because farmers record the sale of their harvests when their output is either exported or processed in factories. In the case of food crops, however, traded production is often too small, making the availability of statistics inconsistent. In general, supply elasticities of food crops are low as can be inferred **by** Krishna (1963) from his study on single crop supply elasticities. In another, more recent study, Jaeger (1991) combined cross-section and time-series data for 43 SSA countries and assessed the responsiveness of prices, policies, natural disasters, and rainfall on the supply of exports and food crops. Natural disaster was represented by the percentage of population affected by disasters, rainfall was proxied with the residual from estimating a regression trend line for cereal yields.25/ In the short run, annual export crops price response was found to be elastic (above 0.9), and export supply elasticities with respect to **the** real exchange rate for annual crops

**241 Most of the litemturc on supply response in SSA dcaling with a single commodity includes non-price factors variables. For example, Olii (1969), Adesimi (1970), and Mnitha (1970), (sec the note** in **Table Al), anong others, include a time trend variable to represent eithcr technology or infrastructure, or population: the use of proxies for the weather variable are also common. However, there are** factors **that** influence price responsiveness which **are** not **considend** in these **models.** In particular, the level of prices **received** by **farmers may** not **be** as **important as** the timeliness of their receipt, or the political stability, or the rura **infrstructure.**

**25/ The use** of this **proxy** for **rainfall** was based on **the** assumption that for **most countries, variations** in **average** yields **will** result primarily **from variations** in weather. **Furthermore, for** the regression equation **it** is assumed that this proxy is not corrclated with the dependent variable. But, if this proxy is a fiintion of **the dependent** variabk, then **the** estimates **are** biased.
34 exported were found to be about-0.6. The possibilitythat export agriculture may crowd out food production was examined. It appears that growth in agriculture exports is not at the expense offood production. Food production is positively correlated with export crop prices and real exchange rates, suggesting complementarity.

AGGREGATE **SuPPLY ELASTICrnES.** Even when individual crop-supply response is strong, it does not eliminate the ambiguity of the aggregate agriculture supply response. If the aggregate elasticity is low, then export crops may increase at the expense of food crops. Econometric evidence confirms that the elasticity of aggregate agricultural response is positive, so cash crops are not obtained at the expense of food crops. However, there is little reliable or robust data estimating aggregate agricultural supply response for SSA countries. This limited evidence is presented in Table A3 and is drawn from Bond (1983), and Berthelemy and Morrisson (1989). In Table 6 Chhibber (1988) provides data on available estimates for long-run elasticities for developing countries derived from at least four types of models. These models include cross-country, cross-section (farm households), inter-sectoral general equilibrium, and time-series. In general, the first two models produced relatively high estimates of elasticities. (Cavallo and Mundlak (1982), and Peterson (1988)). Cross-section models give lower values, yet they suffer from the unreliability of farm-level price data. Time-series models rely directly or indirectly on the Nerlovian (1958) dynamics-of-supply model.

As noted by Chhibber (1991), elasticities of aggregate supply response m agriculture in SSA countries seems to be comparable to those in other parts of the developing world. One important paper written by Pritchett (1992) must be taken into account when considering the effects of a tradeables supply response. Pritchett shows that in an economy subject to foreign exchange rationing, like many economies in SSA, a real depreciation will affect exports in the "normal" sense, but imports may exhibit a perverse response. If the flow of total imports is constrained by the availability of foreign exchange, a real depreciation will have two conflicting effects: on the one hand, it will increase the price of imported goods, and on the other hand, it will increase the export receipts and, through this channel, induce higher demand for imports. Empirical evidence provided by Moran (1988) and Faini et al. (1992) indicates that the effect on imports can be quite strong and therefore account for the overall low responsiveness of the trade
35 balance and output. Additional supporting evidence is provided by Faini (1991) for six less developed countries (among them, Kenya, Malawi, and Zambia).

Table 6: Long-run Estimates of Aggregate Agricultural Supply Elasticity in Developing Countries

|_Model_|_Range of Estirnates_|
|---|---|
|Cross-farm|(-0.02)- _0.15_|
|Time-series|0.13- 0.78|
|Inter-sectoral general equilibrium|0.09|
|Cross-country|1.27-<br>1.66|

**Source:** Chhibber, (1988) p. 10.

# **THE FALLACY OF** COMPOSITON ARGUMENT.

The fallacy of composition presumes that markets would not be -able to absorb all of the exports that would materialize if developing countries" jointly promoted an export-led strategy (for example, by a series of devaluations). Furthermore, if such markets were found, "they would be closed by protectionist measures, provoked by the import penetration and outcries of market disruption" (Bhagwati, 1988). The fallacy of composition argumen **t** akes account of the concept of aggregate demand behavior. In other words, it does not assume that countries are small and therefore international prices are fixed. Effectiveness of a devaluation in improving the external balance depends on the behavior of international competitors. It is often argued that, if a wide range of developing countries-commodity-exporter countries-devalued their currencies to increase the volume of their exports, the consequent expansion in the world commoditie **s** upply would deteriorate the country's terms of trade. A recent paper by Faini et a]. (1992) argues that the so-called fallacy composition argument applies to manufacturing products (in developing countries) as well. Can it therefore be inferred that the fallacy composition argument is relevant to SSA countries (and to various sectors in SSA)?
36 Agricultural exports from SSA are concentrated in a few products.2w The share in world exports of these commodities is generally low, with the exception of coffee, tea, cotton, sisal, groundnut oil and tobacco (Table 7.) Also, SSA economies are generally vulnerable to world prices.

Several studies have been recently done to empirically shed light on the debate. Akiyama and Larson (1993) estimated the elasticity of export revenue with respect to export volume for the main primary commodity exports of the region. Their results show that cocoa is the only commodity for which increases in export volume causes export revenue to fall. All other commodities - coffee, sugar, tea, vegetable oils, cotton, tobacco, sisal, oranges, and pineapples have positive elasticities which means that increases in export volumes lead to increases in export revenues. Investigating the cotton market, Coleman and Thigpen conclude that an adding-up problem does not exist for cotton. In another study done by the World Bank (1993), a comparison of the effects on export earnings of a 5 percent increase in total African exports of cocoa, coffee and tea revealed that only for cocoa, and that too in the short-run, does Africa face the "fallacy of composition". Coleman, Akiyaman and Varangis (1993) studied the effects of structural adjustment programs in Sub-Saharan Africa on the cocoa sector using a global econometric model. They focussed on Ghana and Nigeria that are major cocoa producers that undertook structural adjustment programns. They find **that** the impact on world cocoa prices was relatively small. In examining nine cocoa-producing countries, Panagariya and Sciff (1991) showed that a depreciation can lead, in the short run, to lower combined export revenues for all cocoa producers with some winners and some losers. In the long run, the impact is positive but small.

It is concluded that simultaneous devaluation by several SSA countries is unlikely to sufficiently reduce world commodity prices, and thus to reduce their total export earnings.z7/ The one possible exception is cocoa producers, "who would face a temporary decline in the short run" (DeRosa and Greene, 1991).

**26/** In **contnmst, the products contributing to import eanLings am much less concentratod.**

**27/ Chhibber (1991)** shows **evidence of the fallacy composition argumcnt, but** swacs **that asticities am such that export revenues will increase in spite of the argument.**
37 Table 7: Export Values and Shares **of** World Exports **for** Selected Agricultural Commodities Elasticity in SSA Countries (US$ millions, _I%)_

|||_1980_||_1991_|
|---|---|---|---|---|
|_Product_|_Export Value_|_Percentof &ports_|_Erport Value_|_Peircent ofExports_|
|_Cocoa Beans_|2055.3|72.5|1410.0|67.2|
|_Pabn Oil_|79.B|3.9|74.0|2.7|
|_SIsal_|63.4|48.4|18.6|40.4|
|_Coffee_|2794.4|22.4|1137.0|15.0|
|_Groundnut_|||||
|_Oil_|89|23.9|92.3|31.9|
|_Tea_|281.6|14.0|385.4|15.5|
|_Coffton_|1170.6|15.0|937.8|11.1|
|_Tobacco_|339|8.9|837.3|14.6|
|_Groundnut_|79.5|15.0|22.7|2.7|

Souse: UNCTAD Ycabook. (1987 and 1993)
38 _4_

# _Empirical Evidence from Sub-Saharan Africa_

This chapter addresses three empirical questions. One, is to investigate the long-run effects of nominal devaluations on the real exchange rates. Two, is to test the effects of real depreciations on per capita real GDP growth in the transitional period to steady-state. Three, is to analyze the causal relationships and the directions of causality between nominal devaluations and money growth, and between real devaluations and real exports growth.2s; In a sample of twenty-two SSA countries29r during the period 1971-1991, we find a statistically significant long-run relationship between nominal devaluations and real depreciations. We find real depreciations to have a neutril effect on real per capita GDP growth. Further, we find significant causal relationships that run from money growth to inflation, from output growth to inflation, from inflation to nominal devaluations, and from inflation to money growth. Finally, we cannot find any causal relationship between real depreciations and real exports growth.

## A. Real and Nominal Devaluations Dynamic

It is commonly believed that economic policy weaknesses in general and- expansionary macroeconomic policies in particular are responsible for the poor economic growth in the countries of Sub-Saharan Africa (SSA) during the past two decades. It has been argued that one of the channels through which growth can be hurt the most is through the decline of the extemal 28/ Causality is in the framework of Granger-Causality (Granger, 1969 and 1980).

29/ The countries are Benin, Botswana, Ivory Cost, Cameroon, Congo, Gabon, Ghana, Gambia, Kenya, Lesotho, Madagascar, Mali, Mauritania, Mauritius, Malawi, Niger, Nigeria, Rwanda, Senegal, Togo, Zaire, and the Zambia. The choice of this sample is dictated by the availability of the data.
39 competitiveness caused by overvaluation of the real exchange rate (RER).2w Given the need to correct overvaluation in the RER, and hence to improve external competitiveness and resume growth in the region, many countries in the region devalued their currencies in the 1980s.

The aim of this paper is to investigate the effectiveness of nominal devaluations in inducing permanent real depreciations of the RER in SSA. Using regression analysis, Edwards (1988) has shown that nominal devaluations are effective in bringing about real depreciations for a diverse group of developing countries. In a theoretical paper Khan and Lizondo (1987) have shown that the effectiveness of nominal devaluations on the RER in the long run depends on supporting restrictive fiscal measures (and by implication monetary measures) to accompany the devaluations.31y _An implicadton is that when analyzing the effectiveness of devaluations on the RER, the effects of monetary and fiscal policies have to be accounted for._

# **Theoretical and Empirical Considerations.**

The analytical framework used is an extension of Meltzer (1993). Let the actual RER has both permanent and transitory components given by: where RERP, is the permanent component and U1 is **the** transitory disturbance component. Furthermore, the current permanent value is a weighted average of the last period's RER and any persistent effect of fiscal and monetary policies. Let F, be a vector that consists of fiscal deficits and real money balances. Then the RERP is given by: _RERP =PRERt1_<sup>_+ (-_</sup> _P)F_ **_+ vt_ (2)**

# Combining equations (1) and (2) gives:

where et is an error term.

30/ Ghura and Grennes (1993) have shown that the RER was cvervalued in several countries of the region during the **period** 1970-1987, and that macroeconomic performance was adversely affected by **overvaluation. See** also the papers by Agarwala (1989, Edwards (1989 and **Cottani et al.** (1990) **for empirical** evidence of the deleterious effects of the overvalued **real** exchange **rates** on economuc performance.

**31/** See also the papers by Berglas and **Razin** (1973) and **Edwards** (1989).
40

- _~~RER =ARER_ **__+(I-P).F_** _+et_ t3)

Let the real money balances be M/P, where M is the stock of money and P is the price level. To separate the effects of prices from the effects of money on the RER, Meltzer (1993) totally differentiates the real money stock to obtain: The first term in equation (4) is the real value (expressed in past prices) of the current change in nominal money balances. The second term is the revenue from the inflation tax on real money balances. The inflation tax captures the fiscal implication of monetary policy. Taking the first difference of equation (3) and substituting A(M/P), by the expression in equation (4) gives: The RER is measured as (S .P)/P, where S is the spot nominal exchange rate, defined as the bome currency price of the U.S. dollar, P is the domestic GDP deflator, and P is the U.S. wholesale price index. To estimate the effects of nominal devaluations on the change in the RER, equation **_5_** is augmented by the contemporaneous and k lags of a variable measuring nominal devaluation (NDEV). NDEV is defined as the percentage change in the nominal exchange rate. We also include the expected change in the cost of holding money, r, as an additional explanatory variable to capture the effects of real interest rates on the change in the RER. This variable is measured as the A(inflationX ,, where inflation is the rate of growth of the GDP deflator defined as the percentage change of the price level, **_P._** We do not have a complete time series for the deficits, therefore we do not include them in the regression. This yields the following equation that we test: <!-- Start of picture text --> (6)<br><!-- End of picture text -->
41 Empirical Results.

The number of lags k is determined by two methods-the Akaike (1974) Information Criterion Statistic (AIC), and Hall's (1992) General-to Specific method, where a general lag structure is fitted (4 in this paper) and an F test is used to test backward.L2y The optimal lag length k is found to be three. Equation (6) was estimated by OLS for twenty countries over the period 1971-1991- with pooled timeseries and cross-section data.33L The regression is tested and corrected for hetroskedasticity.4/ The results are: ARERt= 0.05A(RER),1 +0.88(NDEV), -0.05(NDEV)1<sup>.</sup> 1<sup>-0.05(NDEV),.</sup> 2<sup>-0.04(NDEV)</sup> 1<sup>.,</sup> (1.34) (44.61)* (-1.42) (-2.31)' (-2.358)* -0.03(ZNFTAX) -0.Ol(QMtP1,J) + 0.02(rJ. (-24.66)' (-1.50) (0.62) R<sup>2</sup> = 0.88 F= 295.9{T N=339.

The t ratios are in parentheses. The estimated coefficient on ARER.1 is significantly different which indicates that there is no significant persistent in real devaluations. The estimated coefficient 'yb gives the contemporaneous relationship between nominal devaluation and real depreciations and is equal to 0.88. It is found to be statistically significant at the 5 percent level. This coefficient implies that a 10 percent noniinal devaluation at time t yields about 8.8 percent real depreciation at time t, other things remain unchanged The other estimated coefficients 71, y7, and 73 are all negative (-0.05, -0.05, and -0.04, respectively) and (with the exception of y,) statistically significant at the _5_ percent level. Their magnitudes, however, are very small. We test the null hypothesis that the sum of all contemporaneous and lagged nominal devaluation terms is equal to zero, (H: li-. oy y=0). The F value is found to be 32/ We test for the significance of the fourth lag, then the fourth and the third, the fourth, third, and the second, and finally, all four lags together.

**_331_** The list of countries included in the sample are in footnote 2 except for Rwanda and Lesotho, where complete time series data cannot be found.

34! The Breusch-Pagan and the White tests are used to test for hetroskedasticity. The correction is accomplished by scaling all variables including the intewrept and instnuments in the regression by the estimated standard deviations of the residuals for each country.
42 584.2, which leads to the rejection of the null at the 5 percent level. This implies that there exists a longrun effect of nominal devaluations on the real exchange rate. The sum of the coefficients **_iiI48_** (i = 1, 2, 3) gives the long-run impact, and is computed to be 0.77. This implies that a 10 percent nominal devaluation at time t gives a 7.7 percent real depreciation in the long run, holding all other things equal.

The estimated coefficient on the inflation tax (-0.03) is statistically different from zero at the 5 percent level. The negative sign implies that the inflation tax that results from expansionary monetary policies results in an appreciation of the real exchange rate. A 10 percentage points increase in inflation tax leads to a 0.3 percentage points appreciation of the real exchange rate. The estimated coefficient on the real money supply is also negative but statistically insignificant at the **_5_** percent level. The proxy for the real interest rate is statistically insignificant at the **_5_** percent level.

# B. Real Depreciations and Real Economic Growth

There is a general agreement about the extent of poor growth performance of most SSA countries. Data of sixteen out of twenty-two countries in the sample show a poor economic growth in the 1980s compared to that in the 1970s (see table A7). Fifteen countries have experienced negative growth rates during the period 1981-1991. There are both exogenous and endogenous explanatory factors for this poor performance. Among the endogenous factors are the distorted macroeconomic policies pursued by many countries. To improve the performance of their economies, many African countries embarked on policy reforms with the support of the Bank and the IMF. Most of the reform programs adopted included devaluations as a policy variable. The question addressed here is h3w do real devaluations have affected GDP growth? The next section focuses on deriving a theoretical model, where real depreciation of the exchange rate is an additional argument in the growth function.

# The Theoretical Approach.

Devaluations of domestic currency give a signal to producers about the authority's intention for openness. If devaluations induce real depreciations then producers have the incentive to produce more goods. Therefbre, we can think of real devaluations as a factor affecting productivity. On the other hand, real devaluations raise the price of importable goods (and their substitutes), which generates inflation and discourage imports. The increase in the price of importable goods generates inflation -and inflation expectations, which have negative impact on real output growth because it reduces the efficiency of the
43 price system. Thus, inflation distorts the allocation of resources decisions.35/ Bruno (1979) and Van Wijnbergen (1986) argue that in countries where factor inputs are imported, a currency devaluation results in an increase in production costs, hence, lowers output. Theoretically, it is not clear what would the effect of real devaluations be on real output. Edwards (1986) showed that real depreciations have neutral effect on real output.

The traditional neoclassical growth model (Solow, 1956) explains changes in the steady-state level of real income per capita as a function of changes in savings rates, population growth rates and total factor productivity (level of technology). Recent growth literature treats technology as an endogenous variable (Barro (1991) and Lucas (1988)). Capital is assumed of two parts, physical capital and human capital. Mankiw, Romer, and Weil (1990) introduced a model, where human capital accumulation enters as an additional argument in the Solow model. Using this model, we argue that real devaluations can affect total factor productivity. We test the null hypothesis Ho: real devaluations have zero effect on per capita real output growth against the alternative HI: real devaluations have non-zero effect -on per capita real output growth.

We follow Mankiw, Romer and Weil by assuming a Cobb-Douglas production function. Production at time t is given by: where Y is output, K is physical capital stock, H is human capital, L is labor, and Z is the level of technology. The parameters a and B are the shares of physical and human capitals in income respectively. Labor is assumed to grow exogenously at a rate n: The level of technology is assumed to grow exogenously at a rate g. In this paper we also assume that the level of technology is affected by the real exchange rates, R.

_Z,=zoeVtf (R)_ **i** (9) To simplify things, we assume a simple functional form for f(.): 35/ For further discussion about the negative impact of inflation on economic growth see for example, Cecchetti (1986), Leijonhufvud (1980), Friedman (1986), Carlton (1982), Parks (1987), and Fischer (1993).
44

**ZCZeUZ RtD (10)**

where the elasticities ot technology with respect to the real exchange rate is 0. In the next section, we test Ho with respect to _0._ Let k be defined as the stock of capital per effective unit of labor (k= K/ZL). Let h be defined as the stock of human capital per effective unit of labor (h=H/ZL). Let y be defined as the level of real output per effective unit of labor (y=Y/ZL). The fraction of real income spent on physical capital is Sk and that spent on human capital is Sh. The physical and human capital stocks evolve according to: where it is assumed that both types of capital depreciate at a rate 6. The steady-state is defined when both types of capital are constant in efficiency units. Note that the retums on the two types of capital are not the same in die steady-state because the savings rates are assumed exogenous. The equilibrium values of physical and human capital stocks are k' and h' and given by:The equilibrium level of real output per effective unit of labor is y: The output per effective unit of labor is a function of investment in physical and human capital,. population growth, and technology. The natural logarithm of real output per capita (Y/L) is given by: where the level of technology is given by: The empirical equation is:
45 _ln{Y/L)_ **_C-constant+allnSk+a2InSh+a3ln(n+g+6)_** .a 4 1nR,. (16) Now let us assume that real output per capita grows at a speed X to the steady-state. This gives: where (Y/L) is the equilibrium (steady-state) path of real output per capita defined above, and X is the speed of convergence to the steady-state level of YIL. One solution to this differential equation is: In _YIL) c-lni(YIL) c-_ (1 (- eX _`9A+_ U **-e -1')** In **_(YIL)_** _1-n(Y/IL) c_ l, (B which describes the growth path of real output per capita between two points in time. This yields the following equation: Aln(Y/L) _t=cons. +b,JlnSk+_ blnS,+b 3<sup>1n(n+g+6)+b,ln(Y/L)</sup> 0 b5A1nR +eC. (19) The change of the real exchange is an endogenous variable. Modeling the real exchange for SSA countries is a difficult matter, therefore, we will not do so. Instead, we will treat the depreciation term AR, by decomposing the real exchange rate into the change of the real exchange rate measured at past prices and an inflationary part. The real exchange rate, R, is defined as (S.PW)L6. Totally differentiating yields: The first term is the change of real exchange rate at past prices, and the second term is inflation times the real exchange rate itself. Because we are measuring changes in the real exchange rate at past prices, we will assume that these changes are exogenous. Substituting equation (20) in equation (19) yields the following equation: 36/ The real exchange rate, R is defined as the ratio of the price of traded goods to the price of the nontraded goods. The spot exchange rat, S is defined as the domestic cunrency price of the U.S. dollar. P" is the price of traded goods approximated by the wholesale price index of the United States, WPII (1987 = 100). P is the domestic price of non-traded goods approximated by the GNP deflator (1987 =100). Real exchange rate = In [(S.WPIu)1GNP deflatore1<sup>) where i is a country index. The real devaluation</sup> variable is the first difference of the real exchange rate. R is A real exchange rate.
46 Aln(Y/L) _nb 11nSk+b 2_<sup>_1nS4+b)1n(n+g+8)_</sup> _+b4 1n(Y/L)+bs_ [Aln(ALp)J -be (x. 1n(- p)] +et. (21) **_PC-P- 1_**

# The restrictions implied by the model are given by:

**_ba-(14 )lnzo (ln)_** (e++)Pro. (22).

**_>0._** M (23) b2 _(1-e^_ 1 )O 24) .3<0 b3 2- (1-e «CO (') (25)

**_b-4- {-e 1 )_** c0. (26)

**_b5u_** (il-e t)l >o (27) **_16=_** (le-kc)O( 2<0,

The model implies that the growth rate of per capita real output depends positively on investment rates for physical and human capital, negatively on population growth, positively on changes in the real exchange rate at past prices and negatively on the inflation resulting from nominal devaluations.

# **Estimation and the Results.**

We estimated equation (21) via 2SLS using pooled time-series and cross-section annual data for the period 1971-1991 for 22 SSA countries. We assumed that investment/GDP and human capital are endogenous
47 Table 8: 2SLS Instrumental Variables Results for the Augmented Mankiw, Romer and Weil Model with Pooled Time-Series and Cross-Section Data for 1971-1991.

||Unrcstrcted Model|Rcstricted Model<br>Unrcstricted Modcl|Restricted Model|
|---|---|---|---|
|Indepcudcnt Vaibles|Depcndent Variabic R|aLe of Growth of Real CDP per Capita||
|InY0|0.0004|0.00003<br>-0.0006|0.00007|
||(0.560)|(0.957)<br>(-0.659)|(0.088)|
|In (U/GDP)<br>1|0.024|0.024<br>0.026|0.016|
||(3.729)*|(3.621)*<br>(2.885)*|(2.1298)|
|In (Lifecxp.),|0.015|0.010<br>0.028|0.007|
||(3.061)*|.295)"<br>(2.569)*|(1.062)|
||-0.88|-0.034<br>-1.75|-0.024|
|(n+g+6).|(-2.088)*|(-3.428)*<br>(-2.744)*|(-1.766)#|
|Aln[(SP)/Po1]||0.047|0.016|
|||(0.468)|(0.162)|
|-.ln[(SPY)/P,.||-0.035|-0.027|
|||(-2.315)*|(-2.541)*|
|i2|.0.0342|0.0329<br>0.0583|0.Q402|
|F|4.508|4.454<br>3.805|3.097|
|P-value|0.0014|0.0043<br>0.0011|0.0094|
|N|396|396<br>375|375|

An Asterisk denotes statistically significant at the 5 pernent levcl. The symbol V denotes statistically significalit at the ten percmt level. Numbers in parentheses are t-ratios. Instrumental variables are lagged values and all othcr exogenous variables in the model.
_48_ variables.aZ/ We used population growth instead of the variable (n+g+6) because we do not know the depreciation rates and the rate of growth of technological progress that satisfy the SSA countries3s8. All regressions are corrected for hetroskedasticity by scaling all variables and the instruments by the estimated standard deviations of country specific residuals.3i -The results are reported in table 8.

_The_ first regression is the growth model in the unrestricted form. All variables are found to be statistically significant at the 5 percent level and bear the expected signs except for initial income (1971 income measured in U.S. dollar). This estimated coefficient is found to be statistically not different from zero at the _5_ percent level.40/ The second regression is the basic Mankiw, Romer and Weil model with the restrictions that b, +b2+b,=O imposed. We tested the restriction and found it to hold on the 10 percent level only.

The third regression is the unrestricted augmented growth model. Again, most variables are found to be statistically significantly different from zero at the _5_ percent level. Initial income is fbund to be insignificant at the _5_ percent level. The estimated coefficient on AIn[(SP)/P1<sup>.</sup> 1<sup>J is found to be positive but statistically insignificant. The term that includes the</sup> domestic inflation rates _[r._ In (SP/Pt.)J] is found to be negative as expected and statistically significant. This is interpreted as a negative effect of inflation on per capita real GDP growth in the transition to the steady-state (Fischer, 1993). We testtd the restriction b5+b6=O and found it to hold at the 5 percent level. Thus, when we control for effect of inflation, real depreciations have neutral effect on real per capita growth rates in the transitional period. Note that the fiscal

**37/** We measure human capital by the variable life expectancy at birth. This measurement is not the best measurement but we use it because data are readily available in World Tables. A better measurement can be life expectancy for population 16-55 years of age. This latter variable is not available. For example, Barro and Lee (1993) use enrollment ratiDs at the primary and secondary school levels to measure human capital. Life expectancy at birth is usually assumed to be an endogenous variable and a function of education and health. We cannot find complete time series for 1971-1991 for these two variables. The instruments used in the regressioas are simply lagged values.

38/ Tha term (n+g+6) is traditionally treated in the literature by assuming some values for g and B such that (n+g+5) is equal to In (n+.05).

39/ Two tests for homoskedasticity are used. The Breush-Pagan test and the White test.

40/ We do not test for convergence. We follow Friedman (1992) argument that testing for convergence in growth model is in fact a regression fallacy.
49 and monetary policies variables are not controlled for by the model. This makes it very difficult to isolate the effects of real depreciations on the growth rate of per capita income.

The fourth regression is the restricted augmented growth model. The restriction are found to be statistically insignificant at the **_5_** percent level. However, we cannot reject the restriction that b,+b 6=0. We estimate the implied shares of physical and human capital a and £ **iht** the restricted regressions (the second and the fourth) to be 0.023, and 0.0096 and 0.015 and 0.0068 respectively. These estimates suggest that there are variables other than physical and human capital that could be important in determining the growth rate in SSA.41/

# C. Inflation, Money Growth, Output Growth, and Devaluations: A Causality Test

## **_NTe_** _Granger-Causaliy Model_

The relationship between inflation, money growth, and income can be derived from the following exchange equation: where P is the natural logarithm of the price level, Y is the natural logarithm of real output, M is the natural logarithm of money stock, and V is the natural logarithm of the velocity of money. This identity can be rearranged such that which is an inflation equation, where money growth is positively correlated with inflation, income growth is countercyclical for a given rate of money growth, and the interest rate is positively

**41/** We also estimated a regression equation with additional lagged changes of real exchange rates. We tested the restriction that the sum of the lagged terms is equal to zero. We cannot reject the restriction that all lagged changes of the real exchange rate sum to zero at the **_5_** percent level. Therefore, real depreciations have neutral effect on growth. The estimated coefficients an not reported.
_50_ correlated with inflation. The coefficients ot, **et.,** and **_a 3_** can be estimated and the hypothesis that these coefficients are significantly not different from one can be tested empirically.4z/ Instead of estimating the model above, we will focus on the causal relationships between these variables and nominal devaluations. The idea is to determine the direction of causality and what are the policy implications of such findings. For example, if money growth causes inflation then the policy lesson is clear; a tighter monetary policy may be required. The interesting question is about the causality direction between devaluations-inflation and devaluations-money growth.

Mhe analysis is based on Granger's (1969) causal model and Alvi and Islam (1989) who implement the test for time series-cross sectional data.

**_k k k k AFr=ui.2; a1 4Pe.1_**<sup>**_+._**</sup><sup>_b_</sup> _1_<sup>_AM_.L+ 2c_</sup> _4_<sup>_A. .Y_</sup> _1_<sup>_+f2 d_</sup> _1_<sup>_ANS_</sup> **+**<sup>**6**</sup> **,** Y **-i f-i i** 1-i **I-1 i** **_"v,_** . **_k k k k_** AMwhee **_aE_** al **_-jAMtbl_** a _fAP,nau+_ **_glA_** _Ythrbte_ o **_-AN, ite_** _k k_ ~~~k **kIu."(0 i-I J-a - i-a** It **_k kr_** _k_ **_A&NDWf=yo+_** S **_n1 &Nv,,,. + So 1AP,-1 + Sp 1 AMt.1+ESqA&Yc.-ite- 4_** - **_i-2 J-a._ J-3. i-a.**

where all variables are in natural logarithms, therefore, rate of growth of pric es (inflation), rate of growth of money stock, rate of growth of output, and rate of growth of nominal exchange rate (devaluations), which is defined as the percentage change of the nominal exchange rate. All variables in the system are stationary time series. The error terms are uncorrelated. The idea is to conduct a series of F tests on all the coefficients in the Vector Auto-Regressive (VAR) system to test the nuill hypotheses that the sum of each of the coefficients is equal to zero. For example, if the sum of the coefficients b is statistically different from zero, then we say money growth Granger-causes inflation. It is important to carefully determine the number of lags, k.43/ The number of lags here is set equal to four.

**42/** The other model for inflation is the structurlist model. This model emerged in **Latin** America in the 1950s as an alternative to the monetary model above. The model emphasizes bottlenecks that accompany development processes as determinants of inflation. Thus, inflation is a finiction of sectoral impasses or constraints.

43/ We **use** the Akaike (1974) Information Criterion (AIC) and Hall's (1992) general-to-specific method to determine the optimal lag length. We fit a general lag structure (4 lags) and use an F-test to test **backward** and eliminate all unnecessary lags.
_51_

**_Estiation_** _and Results_

The results are reported in table 9. We find a statistically significant causal relationships between money growth and inflation that run in both directions. Thus, Money growth Granger-causes inflation and inflation Granger-causes money growth. This result needs no further explanations.We also find that output growth Granger-causes inflation and that inflation Granger-causes devaluations. No causality is detected between money growth and real output, money growth and devaluations, and output and devaluations.

# D. Real Exports Growth, Output Growth, and Real Devaluations: A Causality Test

The objective of this section is to examine the causal relationship between real exports and-real devaluations in Sub-Saharan Africa. Real devaluations are defined here as the percentage changes of the real exchange rate that are equal to or greater than 15 percent. This cutoff point was used by Edwards.44; We apply the Granger-Causality (1969) test to pooled time-series and cross-section data for 19 Sub-Saharan African countries45/ for the period 1971-1991. Among these countries, there are i3 that have gone through major devaluation episodes during the 1980s as defined above.46!

# **_44_** We have also tested the model without any cutoff point and found similar results.

_45/_ The countries are chosen because we have complete time-series for all variables. These countries are Benin, Cote d'Ivoire, Cameroon, Congo, Gabon, Ghana, Gambia, Kenya, Madagascar, Mali, Mauritania, Mauritius, Malawi, Niger, Nigeria, Senegal, Togo, Zaire, and Zambia.

**46/** Countries that implemented devaluation policies are Botswana, Ghana, Gambia, Kenya, Lesotho, Madagascar, Mauritania, Mauritius, Malawi, Nigeria, Rwanda, Zaire, and Zambia.
52 Table 9. Summary of Causal inferences for Twenty SSA countries, 1971-1991.

|Null Hypothesis|Devaluation=N_D<br>EV|Causal inference|
|---|---|---|
|1. AM does not cause AP|F=7.2073<br>(0.0077)*:|Inflation<br>Money Growth|
|2. AP does not cause AM|F=21. 1425<br>(0.0001)*|Money Growth-*Inflation|
|3.AY does not cause AP|F=8.2025<br>(0.0045)*|Income Growth<br>Inflation|
|4.AP does not cause AY|F=0.7295<br>(0.3937)|No causality|
|5.Devaluation does not cause AP|F=0.4888<br>(0.4850)|No causality|
|6.AP does not cause devaluations|F= 16.3632<br>(0.0001)*|Inflation<br>Devaluation|
|7.AM does not cause AY|F= 1.0408<br>(0.3084)|No causality|
|8.AY does not cause AM|F=0.0400<br>(0.8416)|No causality|
|9.AY does not cause devaluations|F=2.6637<br>(0.1037)|No causality|
|10.Devaluation does not cause<br>AY|F=0.0031<br>(0.9557)|No causality|
|1L1AM does not cause<br>devaluations|IF=0.1293<br>(0.7195)|No causality|
|12.Devaluation does not cause<br>AM|F=0.2077<br>(0.6489)|No causality|

Statistically significant at the _5%_ level.

# Statistically significant at the 10% level.

P-values in parentheses.

Number of observations is 302. All variables are in natural logarithms; so Ain is the rate of growth.
53

**Methodology** and the data

Nelson and Schwert (1982), and Geweke, Meese and Dent (1983) argue that the OLS version of the Granger test is more powerful than most of the other procedures, for example, Sims (1972). The Granger procedure can be described by the following system, Where, X is the real export growth defined as the first difference of the natural logarithm of the real exports measured in domestic currency. Inflation, P is defined as the first difference of the natural logarithm of the GNP deflator. R is the real exhange rate which is the ratio of traded goods price level to non-traded goods price level. This variable is measured by S.Pf/P as defined earlier. And AX,, A&, and AP, are stationary time series and e1, v,, and ut are uncorrelated error terms that retain the classical regression assumptions. Unidirectional causality from AR to AX or from AX to AR requires that at least some bj's and gi's to be significandy different from zero. The same condition is required for causality from AP to AX (some c1's •0) or from AX to AP (some l,'s• O), from AP to AR (some Ig's•0 0) and from AR to AP (some rn;'s•; O). Bidirectional causality in the order above implies that b 1•0, _g 1 0, X4•0,_ I;•0, h;•0, and mn;dO for at least some i's. Of course, if AR, AX, and AP are causally independent, all the coefficients of AR in equations (31) and (33) and of AX in equations (32) and (33) and of AP in equations (31) and (32) should be statistically insignificant.

The time series X, R, and P are nonstationary. These series are tested by the Augmented Dickey-Fuller test (1984).47/ All series are first differenced and checked for unit _47/_ Test statistics are not reported. For all variables, we tested the null hypothesis that p=O in the following regression equation: A R1, = Bo + **pR,. 1**<sup>+Di-jai A RF; + A* R is X, R, and P respectively. Critical values are in Dickey-</sup> Fuller (1979).
54 root again. Tle optimal number of lags, k in equations (31), (32), and (33) is determined by two methods: the Akaike (1974) Information Criterion (AIC) and by fitting a general lag structure and test backward using F-test.4st The standard F-Statistics are used to test the joint significance of the corresponding lag coefficients.

The exports supply relationship captures the relationships between real exports, the real price of exportable goods measured by the real exchange rate, and the cost of production at the home country measured by the home inflation rates. All regressions are corrected for hetroskedasticity using the estimated standard deviations for each country to scale the variables in the regressions including the constants.

# Empirical Results

We test the following six hypotheses:

- real devaluations (AR) does not Granger-Causes real export Growth (AX);

- real export Growth (AX) does not Granger-Causes real devaluations (AR);

- inflation (AP) does not Granger-Causes real export growth (AX);

- real export (AX) does not Granger-Causes Inflation (AP);

- real devaluations (AR) does not Granger-Causes inflation (AP); and

- inflation (AP) does not Granger-Causes real devaluations (AR).

Table 10 presents summary results of the above causality tests. Estimates of F-statistics and their P-values are reported in column 2. A causal inference is reported in column 3 where an arrow indicates the direction of significant causality. On the basis of these statistics, it is clear that there is no support for any causal link between real export growth and real devaluations. Statistical inferences indicate that real devaluations do not cause real exports growth. The absence of any significant causal relationships between real devaluations and real exports growth can be due to the omission of an independent factor that jointly influences real exports growti and real devaluations.

4SI Sephton (1989) suggests that inappropriate lag structure could result in misleading causal relationship. The General-to-Specific method is described in Hall (1992).
_55_ Table 10. Summary of Causal inferences for 19 SSA countries, 1971-1991. Real devaluations= %A Real exchange rate Greater than 15%

|Null Hypothesis|(1)|(2)<br>Causal inference|
|---|---|---|
|1. Real Devaluation does not cause Real export Growth|F=0.7540<br>(0.3861)|No Causality|
|2. Real Export Growth does not cause Real evaluations|F=0.3795<br>(0.5384)|No Causality|
|3. Inflation does not cause Real Export Growth|F=0.5373<br>(0.4643)|No Causality|
|4. Real Export Growth does not cause Inflation|F=0.0217<br>(0.8831)|No Causality|
|5. Real Devaluation does not cause Inflation|F=2.3995<br>(0. 1227)|No Causality|
|6. Inflation does not cause Real Devaluations|F= 1.0202<br>(0.3135)|No Causality|

P-values in parentheses. Number of observations is 286.

# E. Condusions

Pooled time-series and cross-section data for 22 African countries covering the period 1971-1991 are used to test a number of hypotheses.

First, we find that nominal devaluations have a long-mn impact on real devaluations; that nominal devaluations have significant contemporaneous relationship with real exchange rate devaluations; and that there is a significant long-run relationship between the two forms of devaluations. A 10 percent nominal devaluation at time t gives a 7.7 percent real depreciation. in the long run. We also show that expansionary monetary policy leads to appreciation of the real exchange rate for this group of SSA countries. The data confirm that devaluations can indeed be an effective policy tool to correct an overvalued currency if accompanied by restrictive monetary and fiscal policies.
_56_ Second, the same data are used to estimate an augmented Mankiw, Romer and Weil model. We augmented the model with real exchange rate depreciations as factor affecting total output productivity. We find that depreciations have neutral effect on real output per capita growth rate in the transition to steady-state.

Third, we investigated the causal relationship between, inflation, money growth, output growth, and devaluations. We find that money growth and real output growth cause inflation; that inflation causes money growth and devaluations; and that there is no significant causal relationship that runs from real exchange rate depreciations to real export growth. The above results, particularly the effects of real exchange rate depreciations on growth and exports, should be interpreted with caution as fiscal policies are not controlled for in the models.