metadata: authors: 0: author: Faini, Riccardo
1: author: Pritchett, Lant
2: author: Clavijo, Fernand
docna: 0: docna: Import demand in developing countries
docty: Policy Research Working Paper
subtopic: Trade Policy,International Trade and Trade Rules,Rules of Origin,Natural Disasters,Trade and Multilateral Issues
teratopic: Poverty Reduction
abstracts: cdata!: As a less restrictive trade regime is
            associated with greater responsiveness to economic
            incentives, econometric evidence that does not allow for the
            impact of import controls cannot be used reliably to assess
            the effect of a devaluation on the trade balance. Indeed,
            devaluation combined with trade liberalization ( a common
            feature of many adjustment programs) will have a more
            pronounced effect on import demand than available evidence
            would suggest. In this report, the authors compare three
            different approaches to modeling and estimating import demand.
repnme: repnme: Import demand in developing countries
display_title: Import demand in developing countries
listing_relative_url: /research/1988/11/700615/import-demand-developing-countries
topicv3: Trade m1326924 698,Non-Tariff Measures m1326926 778,Trade Policy and Integration m1327407 775,Trade Policy m1327640 776,Quantitative Restrictions m1504269 2564
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Poverty Reduction
origu: Policy Plan & Prog Review Dept
no_of_pages: 36
model_extractions: Polac,Pnning, and Romrwh

# Trade Policy

"Measured income elasticities in developing countries are generaUy higher than I -- and relative prices, although mostly inelastic, significantly affect demand for imports. When a lack of foreign exchange or, more generally, a restrictive trade regime effectively constrains import flows, the measured impact of price and activity variables becomes less pronounced. To recover structural elasticities in such a case, one can develop a direct modeling of quantitative restrictions (which is arduous) or use the experience of a structurally similar country (which is quicker). In gencrai, a less restrictive trade regime is associated with greater responsiveness to economic incentives.

Econometric evidence that does not allow for the impact of import controls cannot be used reliably to assess the effect of a devaluation on the trade balance. Indeed, devaluation combined with trade liberalizadon (a common feature of many adjustment programs) will have a more pronounced effect on import demand than available evidence would suggest.

The authors compare three approaches to modeling and estimating import demand--which is arduous when trade controls are pervasive: _Option 1:_ Trade import equations work well when import controls are relatively stable over time, but it is difficult to determine if this is the case. Without _a priori_ information, and short of using aU misspecification tests, ont: could perhaps rely on a comparison between estimated elasticity and the "norm" computed in this study. If the difference between the two values is deemed too high, consider.

_Option 2:_ This takes into account the impact of foreign exchange availability. If it seems clear that the country has foreign exchange constraints, the traditional specifications should be bypassed, but incorporating this constraint into the import demand equation is difficult for several reasons. At a minimum, the authors recommend using the broadest possible instrument list, including indicators of world demand, competitors' prices in export markets, exogenous capital flows, and international reserves.

Option 3: The direct incorporation of quantitative restrictions is the main method of recovering structural (notdonal) demand parameters and assessing, for example, the impact of removing import restrictions. Unfortunately, a good indicator of quantitative restrictions is not usually available and, even if it exists, interpreting its behavior may be difficult.

This paper is a product of theTrade Policy Division, Country Economics Department. Copies are available free from the World Bank, 1818 H Street NW, Washington DC 20433. Please contact Karla Cabana, room N8-065, extension 61539.

The PPR Working Paper Series disseminates the findings of work under way in the Bank's Policy, Planning, and Research Complex. An objective of the series is to get these fmdings out quickly, even if presentations are less than fully polished. The findings, interpretations, and conclusions in these papers do not necessarily represent official policy of the Bank.

Produced at the PPR Dissemination Center
# Import Demand in Developing Countries

## by Riccardo Faini, Land Pritchett, and Fernando Clavijo

## Table of Contents

Introduction ...................................... 1 1. The Traditional Approach ....................... 3 2. Cross-Country Patterns ......................... 8 3. The Impact of Foreign Exchange Availability .... 10 4. Modeling Non-Tariff Barriers Directly .......... 17 5. Conclusions .................................... 20 Appendix .......................................... 22 References ........................................ 27 Footnotes ......................................... 29

> *** Thls** paper sumLres oUgong work at the Trade Policy Dilvision on import behavior In developing countries. hlUe providing new evidence, the paper draw on two main sourcesg Prltchett (1987) and Bertola and Faini (1987). We are very grateful to Bela **Saiassa,** Mario Blejer, Engo Grilli, Jaime de Kelo, Viod Thomas, and JiS Tybout for their very valuable camonts. Abdel Senhadii-Semlall provided skilled research **aslstance at** various stages and Karla Cabana skillfully typed the manuscript.
# Introduction

Understanding how import flows react to changing economic conditions is essential to the design of a successful structural adjustment program. There is widespread agreement that imports generally react more swiftly than exports to substantive trade liberalization, resulting in short-run current account imbalances and a need for temporary financing. This is, incidentally, one of the main justifications used by international organizations for supplementing structural adjustment packages with external loans. Being able to predict import flows more accurately can help policymakers assess more confidently the overall sustainability of an adjustment program, determine the appropriate speed of the trade liberalization process, and avoid the possibility of unexpected foreign exchange constraints jeopardizing the adjustment effort.

Unfortunately, several factors make predicting import flows in developing countries difficult. In particular, quantitative restrictions can be singled out because they drive a wedge between actual and desired imports, makin- the estimation of notional, i.e. unconstrained,l demand parameters problematic. Other complications include the pervasive presence of high and variable tariffs, which make observed border prices an unreliable indicator of import costs. Similarly, developing countries marked dependence on foreign capital goods makes aggregate estimation sometimes misleading (Khan 1975; de Helo and Vogt 1986 because the marginal propensity to import is highly dependent on the composition of income. These issues have been addressed to some extent in the empirical literature on trade focusing on developing countries. Also, the modeling of the
-2-

impact of quantitative restrictions has been given considerable attention. Khan (1974), by positing that import restrictions vary over time in a serially correlated way, models their effect by assuming an autoregresFive process in the error term. Others CDutta 1964, Turnovsky 1968 and more recently, Chu et al. 1983, Pritchett 1988 and Moran 1988] have used indicators of foreign exchange availability as a proxy for the government's inclination to impose import controls. An important shortcoming of this approach is that, with some noticeable exceptions (e.g. Chu et al. 1983), it does not allow for the recovery of the structural demand parameters. This paper presents new and relatively comprehensive evidence about import behavior in developing countries, updatin; and generalizing the evidence presented in Khan (1974). We focus on the impact of import controls and, because of data limitations, overlook the effect of tariffs and the aggregation problem (although in section 4 the issue is touched upon). Even in this more restricted framework, two tasks appear particularly worth pursuing: (1) the identification of *stable, parameters in the description of import behavior and (2) an analysis of the structural and policy determinants of the parameters themselves.

In pursuing these objectives, we have relied on three different but complementary approaches. First, traditional import demand functions relating import flows to relative price and domestic output were estimated for a set of 50 countries. The resulting parameters were then retained for a subsequent cross-country comparison of the pattern of income and price elasticities. This approach allows us to move closer to establishing a "standard' elasticity for countries with similar characteristics. The second approach relied on incorporating the foreign exchange constraint directly in the import demand equation. This approach was applied to
- 3 -

countries for which a statistically satisfactory import demand equation could not be identified using the first approach. Finally, the third line of attack relied on d'rect measures of import controls. The value of the structural impor't parameters was recovered from a behavioral equation relating the share of imports not subject to controls to price, output, and rationing measures (the latter to allow for any spillover effect). Given the large amount of data required to construct an adequate indicator of quar.itative restrictions, the equation was estimated for only one country. The first four sections of this paper discuss the three approaches outlined above in more detail. A finding that recurs throughout these sections is that import restrictions in general significantly diminish the responsiveness of import demand to price and income incentives. The last section offers some conclusions.

# 1. The Traditional ALproach

A traditional import demand function relating real imports (M) to real income (Y) and the ratio of import prices (Pm) to domestic prices (PD) was estimated for 50 countriess ln M(t) - bo + bl ln Y(t) + b2 ln [Pm(t)/PD(t)] + V1(t) (l) where V1(t) is an error term with the standard properties. This function was then tested to determine whether it was historically stable, generated serially uncorrelated residuals, and had predictive power. The resulting estimates of income and price elasticities are reported only for countries that passed the tests of misspecification. The most striking feature of the specification testing is that although only a few tests were undertaken, and despite the inclusion of a general dynamic form and the potential lack of power of the tests, import regressions for almost half
- 4 -

(44 percent) of the countries could be rejected as misspecified. This does not bode well for ad hoc country-oriented estimation and highlights the importance of the kind of cross-country study undertaken in this paper. Some groups of countries appear more likely not to have a stable, well-behaved import relationship. Of the import regressions estim-ted for 14 Sub-Saharan African countries, only 4 could be accepted. Although most of the OPEC countries were not among the original 50 countries because of lack of data, there is a notable, and not surprising, tendency for oil exporters to have unstable import functions.2 In cases in which foreign exchange availability or, more generally, time-varying government controls cause unstable estimates, the model will need to be extended to account for these constraints. But, for countries for which a satisfactory import equation could be estimated, it can be argued that import controls were relatively constant over time; as a result, we were able to recover stable parameters describing import behavior. These are 'constrained, elasticities, however, measuring the responsiveness of imports that are, to some extent controlled. True (or notional) impor, elasticities, that is, elasticities that would prevail in the absence of c itrols, as we discuss later, are higher.

It is nonetheless of some interest to consider the pattern of estimated parameters (see Table 1). Income elasticities were usually precisely estimated and generally higher than one. The mean for the 28 country sample of income elasticities was 1.33. Only two countries had income elasticities significantly less than one, whereas 12 of the 28 countries (43 percent) had income elasticities significantly greater than one. We stress that these are 'secular' elasticities, i.e. they implicitly assume that changes in trend output have the same impact on imports as
Estimates for 28 Countries

# **Table 1.** Import Demand Elasticity

|Region/Country|Price E|lasticity|Income|Elasticity|
|---|---|---|---|---|
|Latin<br>Ainrican<br>sndCaribbean|||||
|Argentina|-2.1|(.67)a'|2.56|(.63)a/|
|Bolivia|-.44|(.21)r|1.11|(.1023W|
|Brazil|-1.1|(2 1)|.63|(.88)|
|Chile|-.32|(.12)3'|2.21|'.16)a'|
|Colombia|-.52|(.35)|1.25|(.08517|
|Paraguay|-.56|(.45)|1.42|(.36)lr|
|Peru|-.40|(.20aj|1.66|( 17)d|
|Uruguay|-.35|(17)Er|2.12|(.l5)1r|
|Honduras|1.2|(1.2)|1.08|( 29)1|
|Jamaica|-.18|(.16)|1.12|(.24)11|
|**Asia**|||||
|Bangladesh|-.36|(.12)!L|1.52|(.17)a/|
|India|.74|(.55)|1.05|(.39)57|
|Indonesia|-1.5|(1.1)|1.02|(.92)|
|Korea|-.22|(.54)|1.50|(.16)a3|
|Malaysia|-2.3|(1 7)|1.67|(.37)sr|
|<br>Pakistan|-.48|(.08)a'|.76|(.135)M|
|Philippines|-.56|( 34)b1|1.2|2)J|
|Thailand|-.67|(.23)1r|1.25|(.086)3'|
|Middle East**snd**North**Africa**|||||
|Israel|-.66|(.22)3'|1.43|(.05)a'|
|Morocco|-.42|(.43)|1.38|(.2451|
|Syria|.43|(.38)|1.44|( 07)11|
|Tunisia|-.25|(2.08)|1.43|(.39)!?|
|Sub-Saharan<br>Africa|||||
|C .A.<br>F.|-1.87|(.26)a3|.57|(.10)ai|
|Gabon|-1.33|(.5873w|1.53|(.0573w|
|Kenya|-1.48|(.34)ir|1.37|(.26)ir|
|<br>Zambia|-1.14|<br>(.1234w|.78|28)K|
|Southern<br>Europe|||||
|Greece|.013|(.34)|1.37|(.07)a'|
|Yugoslavia|-. 74|(.85)|.86|(.43)Ar|

_*I_ Significant at 5 percent level. _kL_ Significant at 10 percent level. Sources Pritchett (1987).
-6-

cyclical fluctuations of production do. The income elasticity of imports will be significantly higher in the short run; as the evidence in the studies by Khan and Ross (1975) and Clavijo and Faini (1988) indicates. Thus the assumptton of a unit income elasticity, which is often made in the context of short and medium-run projections, proves to be inadequate.

The income elasticity estimates for developing countries reported here are quite close to estimates for developed countries. In their survey Goldstein and Khan (1985) report the results of a number of studies that estimate import activity elasticit!.es for 14 developed countries. The cross-country averages of the estimates from the four studies with broadest coverage ranged from 1.22 to 1.63. The central tendency of the previous estimates for developing countries is also above one. The modal value of Bahmani-Oskooee's3 (1986) six-country estimates is 1.16.

Price elasticities were generally less precisely estimated. The average price elasticity of -.57, while a non-negligible price responsiveness, is less than one. Only 14 of the 28 countries had long-run price elasticities significantly different than zero (even at the 10 percent significance level). Only 2 countries had estimated price elasticities significantly greater than one, whereas 9 of the 28 countries have price elasticities significantly less than one. Hcst countries had price elasticities in the zero to one range, indicating that although price responsiveness is not entirely absent, it is not large, perhaps, as noticed earlier, because of the existence of controls. Some regional patterns of price elasticity are striking. For example, six of the eight South American countries in this study are reported to have price elasticities in the narrow range of 0.3 to 0.6. All of the four Sub-Saharan African
- 7 -

countries have price elasticities greater than one. The pervasive controls on imports that were imposed in Latin American countries to foster industrialization may explain the low estimated elasticity for those countries. Conversely, in the Sub-Saharan countries a pure foreign exchange constraint may be binding as quantities adjust to price changes in order to keep constant the total expenditure in foreign currency.

A comparison of the literature on price elasticities reveals much less consensus on price than on income elasticities. In their 1985 review article, Goldstein and Rhan suumarize several studies of aggregate import price elasticities.4 The reported cross-country average elasticity varies widely across studies. In Goldstein, et al., (1980), the average price elasticity for the eight countries reported is .57.5 A paper by Geraci and Prewo (1980) on five developed countries finds an average import price elasticity of .734. Other studies find average price elasticities around one.<sup>6</sup> Although this paper's price elasticity estimates for developed countries are lower than the average,7 they are well within the bounds of prior estimates. Evidence for developing countries is more limited. Khan (1974) reports price elasticity estimates for 15 developing countries8 that average (excluding Turkey) .948.9 Bahmani-Oskooee (1986) uses quarterly data to estimate long-run price elasticities for seven developing countries with an average (excluding South Africa) of .395. This study confirms the consensus that the estimated historical long-run price responsiveness in developing countries is less than one.<sup>10</sup>
-8-

# 2. Cross-Country Patterns

Previous studies have shown that countries of similar size and income levels also display other economic similarities. Both the sectoral composition of production (Chenery and Syrquin, 1975) and trade patterns (McCarthy, Taylor, and Alikhani 1984) have been shown to be systematically related to per capita income and population. The estimates of import demand elasticities for 28 countries developed in this study are used to investigate import responsiveness and its relation to three col.-try characteristics: per capita income,<sup>11</sup> population, and openness of trade as measured by the share of imports plus exports in gross national product (GNP).

This type of study has two purposes: (1) to establish a standard elasticity for countries with similar characteristics; and (2) to give an indication, using the openness variable, of the direction and magnitude of changes in import responsiveness as a country becomes more open at given income and population.

The empirical relationships are established by cross-country regressions of income and price elasticities on per capita income in thousand USS (Y), its square (YSQ), share of trade in output (TRD), and population (POP). The results for price elasticities (Ep) are as follows:12 IFpi - .65 - .54 Y + 8.54x10-5 YSQ + .79 TRD - .w002 POP (2) (3.32) (2.74) (1.9) (2.58) (1.61) R2 . .79 SER 5 1.49
- 4 -

Perhaps not surprisingly, we find that the price elasticity of import demand increases significantly with a higher trade share for a given per capita income and population size. Although it is not clear to what extent trade openness is a policy variable rather than a structural characteristic, this result suggests that liberalization may raise price elasticities as the share of trade increases for a given population size and relatively stable per capita income. The estimated quadratic pattern of price elasticities with respect to per capita income is primarily due to the extraordinary high estimated price elasticities of the Sub-Saharan African countries (see Table 1) at the low end and to a gradual increase of elasticities through the test of the range of incomes. With respect to income elasticities (Ey), we find that: Ey - .72 + 7.5 Y - 1.33x10-4 YSQ + .004 POP - .0004 TRD (3) (3.09) (3.47) (3.16) (.31) (.018) Income elasticities of imports increase with income up to about $2,800 per capita and then decrease. To explain this pattern, we can refer to a modified Engel's laws at very low income levels, imports may consist of food and necessary intermediates, which have less than unity elasticity, whereas at higher income levels more sophisticated investment goods and intermediate inputs are imported, that is, goods with higher income elasticities. Alternatively, it may be argued that at low levels of per capita income, high income-elasticity goods are neither produced nor consumed. At middle levels of per capita income, hi%h income-elasticity goods are imported, that is they are consumed, but are not produced domestically. Finally, as an economy matures, the match between the production structure and the consumption structure improves. With the
- 10 -

increasing production of high income-elasticity goods, the overall income elasticity of import demand declines. More research on the sectoral composition of imports is needed to test these tentative hypotheses.13 This cross-country type of study allows us to move closer to establishing a standard elasticity for countries with similar economic characteristics. At the same time, the openness variable gives an indication of the direction and magnitude of changes in import responsiveness as a country becomes more open at a given per capita income and population, as might be brought about by a more liberal trade policy. Although we cannot directly observe the impact of government policy on import responsiveness for any given country, we should be able, by looking at values across countries, to observe the impact of different policies on observed elasticities.

# 3. The Impact of Foreign Exchange Availabilita

The finding that in about 40 percent of developing countries the relationship between income and relative prices is unstable strongly suggests that there are other factors influencing import determination in such countries. Quantitative restrictions can be singled out as one of these factors. Whereas the pervasive presence of quantitative restrictions in developing countries is often motivated by the desire to foster domestic industrialization, the considerable variability of quantitative restrictions can be attributed mostly to balance of payment considerations. The latter, following Hemphill (1974) and Winters (1985), can in turn be related to the availability of foreign exchange. Thus, for example, a decrease in foreign exchange receipts may lead the government to tighten import controls and reduce import flows.<sup>14</sup>
> - 11 -

As a cursory review of the literature suggests, there are basically two ways to allow for this factor. Both approaches recognize that the government in most developing countries largely controls the allocation of foreign exchange and that the supply of imports is really the supply of foreign exchange made available to purchase imports. In the first approac-h (Hemphill 1974; Chu et al. 1983; and Moran 1988), it is assumed that the policymaker fully controls the supply of foreign exchange and ateempts to optimize a cost function that includes among its arguments the deviation of imports and reserves from their long-run equilibrium levels and the discrepancy between actual and notional imports, tha.t is, the amount of rationing. Based on these assumptions, it is possible to relate the actual flow of imports to foreign exchange receipts, reserve levels, relative prices, and activity levels. Empirically, it is found that the inclusion of these foreign exchange indicators leads to much less precise estimates of both activity and price elasticities whose coefficienta are often not statistically different from zero. This finding can be taken either as an indication that the inclusion of "irrelevant" variables (i.e., the foreign exchange availability indicators) leads to a los of efficiency in the estimates and precludes precise estimation of price and activity parameters or that import responsiveness is much more limited for foreign exchange constrained countries.

This approach has both strengths and shortcomings. From a practical point of view, it allows us to assess, albeit indirectly, the impact of import controle based on a wide variety of indicators. However, with this approach, it is not possible to easily recover the true elasticities of demand and to assess the impact of changes in the trade
- 12 -

regime. More important, the whole approach relies on the possibility of specifying a stable government objective function--which is not a practicable hypothesis when faced with the need to make judgements concerning a major structural adjustment programs. Finally, as Moran (1988) and Chu et al. (1983) point out, there are some econometric problems within this approach. Because foreign exchange receipts are in general not exogenous, the resulting estimates may be inconsistent.

The second approach (Pritchett 1988; Moran 1988) aims at providing a simple way to recover the structural demand parameters. It relies on the specification of an import supply equation (describing the availability of foreign exchange) as well as on a standard demand equation (see equation 1).

ln **M(t)-** aO + al ln F(t) + a2 ln R(t-l) + a3 tln Pit)-ln Pv(t)] + V2 (t) (4) where M denotes imports, F and R denote real foreign exchange receipts and reserve levels respectively, and Pm and Pm denote the domestic and the border prines of imports, respectively. A higher value of the import premium (PM/Pm) may induce the government to supply more foreign exchange. Otherwise a3 - 0.

In this model the domestic price of imports, Pm. will shift to equate supply and demand for foreign exchange. Prices will then be endogenous. To recover consistent estimates of the demand parameters, a two-stage least-squares procedure can be used with foreign exchange indicators P(t) and R(t-l) and other exogenous variables (PD,Y) as instruments. This approach is at first blush more promising. It allows for the recovery of all structural parameters, while taking into account the impact of foreign exchange availability. Empirically, both price and
- 13 -

income elasticities turn out to be considerably higher than the corresponding price and income elasticities obtained by ordinary leestsquares estimation. There are, however, some important flaws. First, where foreign exchange is scarce and imports are to some extent rationed, economic agents will react to price, income, and controls. It is not reasonable under these circumstances to suppose that consumers will act according to their notional demand. More crucially, as noted earlier, in this set-up the domestic price of imports is endogenous and generally differs from the border price. If, as is generally the case, we observe only the border price variable, we will be faced with the problem of an error on the variable. Moreover, this error will be correlated with all the exogenous variables which are therefore no longer appropriate instruments.15 To address these issues, we considered the set of countries discussed in Section 1 for which it was not possible to identify a statistically satisfactory equation.<sup>16</sup> We then estimated an import demand equation using the second approach described above (i.e., taking indicators of foreign exchange availability as instruments) and tested throughout for the adequacy of the instrument set by means of a Sargan (1964) test.<sup>17</sup> The results of the test (see Table A-1 in the appendix) highlight the dangers of relying on a single approach without testing for its possible limitations. For 8 out of 12 countries the test is highly significant, indicating a correlation between instruments and errors and showing coefficient estimates to be unreliable. At least two possibilities, both mertioned earlier, can account for this result. One possibility is simply that foreign exchange receipts are not exogenous.18 The other possibility is that we do not observe the correct price variable (i.e., the domestic
- 14 -

Table 2. Long-run Import Demand ElasticitlesAl (Two-stage, Least-squares estimates)

|Countr,|Income Blasticity|Price Elasticity|
|---|---|---|
|Mexico|1.29<br>(.09)|-1.12<br>(.15)|
|Libya|.64|-1.21|
||'.24)|(.05)|
|Nigeria|5.10<br>(4.67)|3.71<br>(5.40)|
|Senegal|2.43|-.35|
||(.36)|(.43)|
|Portugal|2.24|-1.58|
||(1.10)|(.94)|
|Ivory Coast|1.6|-1.58|
||(.19)|(.42)|
|Venezuela|3.34|2.23|
||_(.59)_|(1.03)|

a/ Standard errors in parenthesis
- 15 -

price of imports), but only the border price. To address the first possibility we consider an enlarged model in vhich foreign exchange receipts are endogencus and depend on the performance of exports. The exogenous factors underlying export behavior can then be used as (possibly appropriate) instruments for estimating equation 1. Finally, the Sargan test can be used again to check whether this new set of instruments still correlates with the error term. We then find that of 12 countries, only 8 show no misspecification problems. The estimation results for these countries are summarized in Table 2 and presented in more detail in Table A-2 in the appendix. Overall results are not at variance with what was found in section 1. Income elasticities are well determined and generally higher than one, and prices play a significant though less important role. Although we have used a fairly broad set of instruments, there are still five countries for which the Sargan test shows significant value. Therefore, a case can be made that at the root of the econometric troubles is the fact that instead of observing the domestic price of imports, we only observe their border values. Under such circumstances, it is easily shown that the reduced-form estimation of the demand for imports, while precluding the recovery of the structural parameters, is the only viable option. (See Table A-3 for full estimation results.) Some care is now necessary in interpreting the coefficients. For instance, once again we find that income plays a major role in determining imports. However, we must allow for the fact that now income affects imports both directly (by raising import demand) and indirectly (by increasing export supply and foreign exchange availability). The reducedform coefficient in Table A-3 captures both these effects and will not
- 16 -

provide an estimate of the notional income elasticity of demand. Similarly, an increase in the price of domestic substitutes (PD) has two contrasting effects insofar as it leads directly to higher imports (the demand curve for imports shifts to the right) but also discourages exports, reduces foreign exchange receipts, and shifts the supply schedule for imports to the left. The net effect on import quantities is ambiguous and is reflected empirically in the shifting sign and low significance of the reduced-form coefficient associated with PD (Table A-3). Regarding other prices, import and export prices have almost without exception the expected negative ahd positive impact on imports. Finally, lagged reserves appear to positively affect import quantities. The effect, however, is statistically weak. The statistical properties of the equation are satisfactory, and indications of misspecification are much weaker here than when we applied ordinary least squared to equation 1.

In summary, considerable specification testing and common sense are required in order to find the most appropriate framework for determining import flow in a given country. Traditional import demand equations can provide the policymaker with valuable information on the price and activity responses of import flows. However, when considerations about the availability of foreign exchange become paramount, one of the approaches described above becomes more appropriate. However, limitations of these approaches and the resulting need for careful econometric practice should not be overlooked. Also, if the need arises to recover the structural elasticities (for instance when predicting the impact of import liberalization), the experience of similar countries is useful--perhaps the cross-country analysis described in section 2.
- 17 _-_

# 4. Modelirs Non-Tariff Barriers Directla

The demand for imports comes mostly from private consumers and producers. Under a stringent balv'ce of payments constraint, however, the government will restrict the availability of foreign exchange through price and especially nonprice mechanisms, moving demand for imported goods away from notional demand curves. Sometimes a direct measure of import controls is available, which can be incorporated in a model of rationed import demand. The key here is the recognition that in most developing countries not all imports are subject to controls, but even at the subcategory level, several foreign goods are freely importable into the country. By focusing the analysis on this subset of imports it is possible, with some additional assumptions, to recover estimates of structural parameters that can then be used to assess the impact of trade liberalization. More specifically, it is assumed that consumers and producers determine their optimal choice among three kinds of goods: free imports, restricted imports, and domestically produced commodities.

Border-relative import prices are constant. The crucial assumption is that the ratio of the marginal propensity to import rationed goods to the overall marginal propensity to import can be approximated by the import coverage ratio of non-tariff barriers (i.e., by the ratio of restricted imports to total imports). Higher values of this indicator signal a tightening of the import constraint.19 Although this is not necessarily always the case, it appears to be true in the context of our empirical application to Morocco. This model permits us to recover the total marginal propensity to import and, as a result, to simulate the impact of lifting non-tariff barriers. The model was applied to the demand for consumption, intermediate, and investment goods in Morocco from 1966 to
- 18 -

1985, using, respectively, a linear expenditure system, a Cobb-Douglas production function and a Cobb-Douglas allocation function. It was found that, for consumer goods, the marginal notional propensity to import was 9 percent versus a restricted value of 4.2 percent. For investment goods the activity elasticities were equal to one in the unrestricted case and .87 in the restricted case. For intermediate goods quantitative controls had no major impact. Notional price elasticities were also fairly well determined, ranging from around one for consumer goods, .68 for investment imports, and .31 for imported intermediate goods (see Table 3). Also, by using these notional parameters, it was possible to estimate the impact of a full repeal of import controls. Not surprisingly, the biggest impact was on consumer goods, for which steady state value of impoLts would have increased in 1985 by 66 percent had quantitative restrictions been abolished. The impact on investment imports would have been significant as well, increasing by 5 percent in the long-run. No sizeable effect was detected for intermediate imports because imports controls for this category were fairly loose.

These results suggest a few policy implications. First, the results show that lifting quantitative restrictions will not only affect the level of imports but may also lead to a significant increase in the sensitivity of imports to activity levels. Under the plausible condition that controlled imports and domestic goods are net substitutes, the elimination of controls will increase the price responsiveness of imports as well. Second, our empirical results suggest that for Morocco the reduction of tariff barriers has only limited effect on import demand, while the elimination of quantitative restrictions, especially on consumption goods, will lead to an upsurge of imports. Whether this can be
X _.4_

# Table 3: DEPORT DUWID FUNCTIONS UNDER RATIONING Estimates for Morocco

<!-- Start of picture text --> Comitted Quantities ofs<br>Notional Marginal<br>Propensity to Imports Domestic Goods Imported Goods<br>Consumption Goods .0897 9213 333.1<br>[Linear Expenditure (.030) (1985.1) (94.27)<br>System]<br>Investment Share<br>of Domestically Produced Capital Goods (p)lI<br>Investment Goods .32<br>(Cobb-Douglas Allocation (.10)<br>Function)<br>Labor Share in Share of Imported Inputs Rate of<br>Gross Output (M)2I in Gross Output (6)21 Technical Progress<br>Intermediate Goods .31 .08 .03<br>(Cobb-Douglas Allocation (.21) (n.a.) (.008)<br>Function)<br><!-- End of picture text --> Standard Errors in Parenthesis Source: Bertola and Faini (1987) IJ Notional Price Elasticity: 1-P

- 21 Notional Price Elasticitys a
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generalized to other countries remains to be seen. Common sense and the experience of some countries (like Turkey) would suggest that consumption good imports may indeed react swiftly to trade liberalization.

# 5. Conclusions

The modeling and estimation of imoort demand in a context in which trade controls are pervasive is arduous. Yet for the purpose of policy simulation and a firm understanding of how imports react to changing economic conditions, solid empirical work is indispensable to this effect. We have pursued three approaches, all of which have strengths and shortcomings. Traditional import equations work well when import controls are relatively stable over time (first option). But it is fairly difficult to determine a priori whether this is indeed the case. In the absence of a priori information and short of using the full set of misspecification tests, one could perhaps rely on a comparison between the estimated elasticity and the 'norm' computed in this study.

If the difference between the two values is deemed to be too high, an approach that allows for the impact of foreign exchange availability should be used (second option). Of course, if there are strong a priori reasons to believe that the country has foreign exchange constraints, the traditional specification should be immediately bypassed. Still, it must not be forgotten that the incorporation of the foreign exchange constraint in the import demand equation is beset by several difficulties. In fact, both endogeneity and error-in-variable problems make instrumental variable estimation of the structural import demand equation problematic. At a minimum, we recommend the use of the broadest possible instrument list, including indicators of world demand, competitors' prices in export markets 20 as well as exogeneous capital flows and international reserves.
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Finally (the third option), the direct incorporation of quantitative restrictions is the main method of recovering structural (i.e., notional) demand parameters and assessing, for example, the impact of removing import restrictions. However, this approach also suffers from many shortcomings. A good indicator of quantitative restrictions is not usually available, and even if this indicator exists, interpreting its behavior may be difficult.2 1 Although these caveats should be borne in mind when analyzing our results, our study has been able to convey some useful facts on both the modeling and the behavior of import flows in developing countries. In sum, we have shown that "measured" income elasticities in developing countries are generally higher than one and relative prices, although they are mostly inelastic, significantly affect demand for imports. When the lack of foreign exchange or, more generally, a restrictive trade regime effectively constrains import flows, the measured impact of price and activity variables becomes less pronounced. To recover structural elasticities in such a case, one can develop a direct modeling of quantitative restrictions which is arduous, or one can use the experience of a structurally similar country which is quicker. In general, a less restrictive trade regime is associated with higher responsiveness of imports to economic incentives. We conclude that the econometric evidence that does not allow for the impact of import controls cannot be used reliably to assess the effect of a devaluation on the trade balance. Indeed, if devaluation is combined with a liberalization of the trade regime (a common feature of many adjustment programs), its effect on import demand will be more pronounced than the available evidence would suggest.