1 Chapter 18 Trade, Financial, and Exchange Market Reforms © Pierre-Richard Agénor and Peter J. Montiel.

1

Chapter 18Trade, Financial,

and Exchange Market Reforms

© Pierre-Richard Agénor and Peter J. Montiel

2

Reduction in trade barriers fosters adjustment in relative prices, and reallocation of resources toward the sector producing

exportables. In the long term, successful trade liberalization leads to

expansion of exports; contraction of activity in import-competing industries; transfer of resources from sectors producing

nontradables toward those producing tradables. More open trade regime may be associated with higher

long-term rates of economic growth.

3

Trade Reforms: Some Recent Evidence. Trade Liberalization, Wage Rigidity, and Employment. Monetary and Financial Liberalization. Unification of Foreign Exchange Markets.

Trade Reforms: Some Recent Evidence

5

Papageorgiou et al. (1990): trade liberalization in 19 countries, during 36 episodes of reform undertaken in developing countries between World War II and 1984.

Successful liberalization episodes have been characterized by their comprehensive nature; systematic elimination of quantitative restrictions on

imports; political stability; prudent macroeconomic policies; maintenance of restrictions on capital movements

until trade reforms were sufficiently advanced; significant initial depreciation of real exchange rate.

6

There is no strong evidence suggesting that liberalization was associated with sharp reductions in employment and short-run contraction in output.

Balance of payments improved significantly in most cases, as growth of exports outpaced growth of imports.

Since the mid-1980s, far-reaching trade reforms have been implemented in the developing world.

Prior to reform, extensive barriers to trade were in place in most of these nations.

Particularly interesting set of episodes took place in Latin America and the Caribbean.

In relation to different macroeconomic conditions, extent and timing of reforms differed across these countries.

7

Peru: Trade regime prior to reform was severely distorted. Import policy reform:

dismantling nontariff barriers such as quantitative restrictions and foreign exchange controls; and

eliminating widespread exemptions. Export policy reform:

reduction or elimination of price and quantitative barriers to exports; and

introduction or improvement of incentives for export promotion and diversification.

Table 18.1: Indicators of trade regime before and after most recent

reforms for 15 Latin American and Caribbean countries.

8

Average tariff rates were reduced dramatically. In Brazil, number of tariff rates was reduced from 18

prior to reform (in 1990) to 9 by the end of 1993. In Colombia, it fell from 22 in 1990 to 4 in 1992.

Dispersion of tariffs was also reduced, particularly in Colombia, Costa Rica and Ecuador.

Degree of openness increased significantly due to expansion of both exports and imports in real terms.

Many of reforms in Latin America were introduced in difficult macroeconomic context: high inflation; sluggish economic activity; balance-of-payments difficulties; scarce foreign exchange reserves.

9

Almost all the episodes of trade reform were preceded by, or associated with, significant depreciation of real exchange rate.

Figure 18.1: continuous real depreciation and expansion of export volumes in aftermath of recent trade liberalization in Chile.

10

Figure 18.1Chile: Trade Volumes and the Real Exchange Rate, 1980-96

1980 1982 1984 1986 1988 1990 1992 1994 1996

0

3000

6000

9000

12000

15000

18000

21000

0 20

40

60

80

100

120

140

Real exchange rate (right scale)

Source: International Monetary Fund.Notes: Real effective exchange rate, base 100=1990 (a rise is a depreciation). Real imports and exports are measured FOB, in millions of U.S. Dollars, at 1990 prices.

Real exports (left scale)

Real imports (left scale)

Trade Liberalization, Wage Rigidity, and Employment

12

There are potential channels through which trade reforms may lead to contractionary effects in the short run.

Such costs may have adverse effect on sustainability of adjustment process, leading to sudden policy reversals or complete abandonment of reform efforts.

Buffie’s (1984b) model is used to study output and employment effects of trade liberalization.

Key implication: trade reform raises relative price of imported inputs and, if wages are not perfectly flexible, can lead to a contraction in output.

13

The Analytical Framework. Fixed Nominal Wages. Flexible Wages.

14

The Analytical Framework Economy produces tradable and nontradable goods using

three factors of production: capital, labor, and intermediate input, which is not produced domestically.

Capital stock is sector-specific and fixed. Imported inputs are not subject to tariffs and their

domestic price PJ is equal to nominal exchange rate E. World price of traded goods is fixed on world markets,

and domestic price is

PT = (1+)E,

> 0 measures the extent to which import tariffs and export subsidies have raised domestic price of tradable good above its world market level.

15

Each sector's output is produced by competitive firms operating with a constant-returns-to-scale technology.

Sectoral factor demands:

Lh = yh(Lh, Jh, Kh)Cw(w, h, E),

Kh = yh(Lh, Jh, Kh)C(w, h, E),

Jh = yh(Lh, Jh, Kh)CE(w, h, E),

h = N, T refers to production sectors;

Yh: sector h's output; Ch: sector h's unit cost function;

w: nominal wage; : rental rate on capital in sector h.

h

h

h (2)

(3)

(4)

16

Let Ph denote final prices in sector h. Zero-profit condition yields

Ph = wCw + hC + ECE.

Equations (2) to (5) can be solved for output and factor demand levels and rental rate of capital, as a function of the nominal wage, price of imported inputs and price of final goods.

Households consume both categories of goods and hold only domestic money in their portfolios.

Assume homothetic preferences and utility function separable in goods and money.

hhh (5)

17

Relative sectoral demand functions can be defined as homogeneous functions of degree zero in prices:

Dh/A = dh(PN, PT), 0 dh 1,

A: aggregate nominal expenditure. It is defined by

A = PNyN + PTyT – EJ - (M - Md),

J: total imports of intermediate goods. (7): A is equal to difference between net factor income

and hoarding, which depends on difference between actual (M) and desired (Md) money balances.

ss (7)

(6)

18

Desired balances depend on net factor income:

Md = PNyN + PTyT - EJ.

Nominal wages are indexed to the price level, which is defined as a geometrically weighted average of prices of traded and nontraded goods:

w = w(PNE1-), w > 0, 0 < , < 1.

s s

~~

(8)

(9)

19

Market-clearing condition for the nontraded goods market can be written as

yN = AdN(PN, PT),

which determines price of nontraded goods.

s (10)

20

Logarithmically differentiating Equations (6)-(8) and simplifying yields, in terms of rates of change,

Lh = hK(LK - KK) + J(LJ - KJ)

+ wL(LL - LK),

j: share of factor j in sector h's total production costs;

ij: partial elasticity of substitution between i and j;

: devaluation rate. Using (5) to substitute out for h in (11) and rearranging

yields:

Lh = Lh(h, , w), Jh = Jh(h, , w).

h h h h h h

hhh

h

^ ^

^(11)

^

^ ^ _+ _? ?+(12)

21

Sign of cross-price terms is indeterminate, due to possible divergence between output and substitution effects.

Since factor demand functions are homogeneous of degree zero, sum of all partial derivatives in each equation is equal to zero.

From (9), rate of change of nominal wages:

w = [N + (1-)T].

Equations (7)-(10), (12) and (13) can be solved simultaneously for Lh, Jh, w, and N as a function of T or .

^ (13)

^^^

22

Fixed Nominal Wages Assume: nominal wages are fixed ( = 0) and imported

inputs are used only in the tradables sector. Trade liberalization: lowering of import tariffs and export

subsidies coupled with nominal devaluation. Assume: reduction in tariffs is less than rate of

devaluation, implying increase in domestic price of tradables and thus of imported inputs.

If nominal wages are fixed, effect of the trade reform program on employment in traded goods sector is indeterminate: net devaluation leads to fall in product wage, which

stimulates demand for labor;

23

liberalization also leads to increase in relative price of imported inputs.

Whether net effect is positive or negative depends on pattern of substitution across factors, and effect on gross output.

If production function in traded goods sector is separable between primary factors and imported inputs, condition that determines whether employment in traded goods sector rises or falls is given by

T - JT 0,

JT: share of imported inputs in production costs in tradables sector.

><

24

If production function is not separable and capital and imported inputs are better substitutes than labor and imported inputs, condition (14) is not sufficient to guarantee increase in labor demand and employment.

Condition for employment to rise following trade liberalization is that expansionary, expenditure-switching effect dominates “hoarding effect” induced by relative price change; expenditure-reducing effect induced by negative

income effect; potential fall in employment in traded goods sector.

If cross-price elasticity of demand for nontraded goods is large enough, net effect of liberalization is expansion of employment in nontraded goods sector.

25

If cross-price elasticity of demand for nontraded goods is small, net effect of trade reform on employment is likely to be negative.

Result: overall effect of liberalization on employment is ambiguous in an economy with immobile capital in the short run and nominal wage rigidity.

26

Flexible Wages

Assume: wages are free to adjust to changes in prices, and only traded goods sector uses imported intermediate inputs.

Effects of trade liberalization become even more uncertain.

Product wage in traded goods sector may rise, thus further reducing demand for labor in that sector.

In the nontraded goods sector, employment may also fall to the extent that negative income effect associated with lower

employment in traded goods sector; possible increase in product wage compensate for

expenditure-switching effect of liberalization.

27

Result: overall decline in real consumer wage may be associated with increased unemployment.

Buffie (1984b): In a large number of cases, contractionary effects on

employment may be large enough to offset the expansionary effects.

Real wage rigidity increases short-run contraction in employment, unless there is very high degree of substitutability between labor and imported inputs.

Despite of short-run adjustment costs, trade liberalization may be beneficial in the long run, since elasticities of substitution between inputs are higher than in the short run.

Monetary and Fiscal Liberalization

29

Restrictions on competition in banking industry: barriers to entry into banking system and public ownership of banks.

Restriction on composition of bank portfolios: requirements that banks engage in certain forms of

lending; imposition of “liquidity ratios,” requiring banks to

invest specified share of their portfolios in government instruments;

directed lending to specific productive sectors; prohibitions from acquiring other types of assets.

Park (1991): Draws distinction between monetary reform and

financial liberalization.

30

Monetary reform: increase in controlled interest rates to near-equilibrium levels, with remaining set of restrictions on behavior of banks left in place.

Financial liberalization: more ambitious set of reforms, directed at removing at least some of remaining restrictions on bank behavior.

Full financial liberalization involves privatization of public financial institutions; removal of restrictions to entry into banking; measures aimed at spurring competition in

financial markets; reduction of legal reserve requirements; elimination of directed lending; freeing of official interest rates.

31

Monetary Reform. Financial Liberalization.

32

Monetary Reform Arguments for monetary reform as a structural policy

conducive to a higher growth path are due to McKinnon (1973) and Shaw (1973).

When saving instruments in formal financial system are limited to cash, demand and time deposits, raising interest rates to near-equilibrium levels may induce increase in saving rate; portfolio shift out of inventories, precious metals,

foreign exchange, and curb market lending into formal financial system.

High real interest rates resulting from the reform would increase investment either

33

because the need to accumulate funds to undertake lumpy investments makes money and capital complementary rather than substitute;

or because of “credit availability” effect. Many high-return projects not previously funded would

be undertaken after the reform. Reason: banks have scale economies relative to

informal market in collecting and processing information on borrowers.

Proposition: Raising controlled interest rates should raise demand

for domestic time and saving deposits. Rate of growth increases because

increase in saving raises investment; quality of investment improves.

34

Vogel and Buser (1976): Under financial repression, higher rate of inflation should

reduce private investment, since it would be associated with lower real interest rates.

But, they found little evidence of this effect. Inflation significantly affected demand for time and

saving deposits. Investment level depended positively on rate of

accumulation of time and saving deposits : supportive of complementarity and credit availability hypotheses.

Galbis (1979): Tested McKinnon's direct complementarity hypothesis. Found little support for the proposition.

35

Unable to find negative effects of inflation on investment levels.

Lanyi and Saracoglu (1983): increases in real deposit interest rate increased national

saving rates; real deposit interest rate had positive and significant

coefficient in a regression of growth rate on deposit rate.

Fry (1996): Used pooled cross-section-time series regressions for

several samples of Asian countries. Found weak positive effect of real deposit rates on

national saving, but strong positive effect on demand for money and on supply of credit.

Thus, credit supply was found to have strong positive effect on investment.

36

No evidence was found for McKinnon's “complementarity” effect.

Found two types of evidence in support of improved quality of investment: Real deposit rates were positively correlated with

ICOR (proxy for efficiency of investment). Real deposit interest rate had positive effect on

growth.

Gelb (1989): Investigates whether positive correlation between real

deposit rates and growth is consistent with causation from growth to interest rates, or from common third factor.

Sample of 34 developing countries during 1965-85.

37

Real deposit rates had strong positive effects on both growth and ICOR, but weaker positive effects on investment ratio.

Inclusion of additional variables weakened effects of interest rates on investment, but not on ICOR.

Thus, efficiency effect on investment, and not effect on overall volume of investment, accounted for positive relationship between real interest rates and growth.

Inclusion of other measures of distortion weakened relationship between real interest rates and growth, although it remained positive.

Causal chain between real deposit rates and growth through more effective intermediation into higher-productivity investment:

38

increase in real deposit rate increased share of domestic saving intermediated through formal financial system;

this share had stronger effect on growth than level of saving itself.

Dornbusch and Reynoso (1993): Alternative interpretation of such results. In neoclassical growth models, growth of output per

capita can be written as

y – n = [(I/y)(K-1/y)-1 – n],

y: real output; K: capital stock; I: net investment;

n: rate of growth of the labor force; : share of capital.

^

39

What matters for contemporaneous growth is average, not marginal, efficiency of capital, and this is improved slowly through improved efficiency of investment.

Their interpretation of correlation between real deposit interest rates and growth is that high inflation impedes growth through distortions induced by uncertainty.

Evidence on effects of monetary reform on growth is inconclusive.

Higher real deposit interest rates are unlikely to have strong effects on saving rate.

Even though portfolio shifts toward domestic financial instruments are induced by monetary reform, this may not have large effect on volume of investment.

40

While there is little evidence in favor of “complementarity” effect, “credit availability” effect is more strongly supported by data.

Interpretation of positive correlation between real deposit rates and growth is problematic beacuse it may reflect some contribution of efficiency effect; real deposit rate may be serving as a proxy for more

general distortions. Episodic evidence associated with specific-country

cases of monetary reform does not provide clearer verdict because ceteris paribus conditions do not hold.

Consider Korean monetary reform of 1965.

41

McKinnon (1976): Nominal deposit and lending rates had been pegged at

low levels in Korea prior to the reform, yielding negative real rates in 1963-64.

Nominal rates were revised upward, in September 1965, and directed credit restrictions were reduced, thus qualifying this episode as monetary reform.

Real rates of return rose subsequent to the reform. Ratio of broad money to GDP increased by factor of 7

between 1964 and 1969. Private saving increased, and growth experienced

strong acceleration. McKinnon interpreted this as supporting positive effect of

monetary reform on growth.

42

Giovannini (1985): Reached different conclusions. Most of the increase in national saving in Korea arose in

public sector due to fiscal correction. Measured increase in households' surplus after the

reform was one-shot event concentrated in 1966. Correlation between surplus and real interest rate was

negative after that year. Measured increase in saving may have been due to

recording of portfolio shift out of informal market as a change in saving.

43

Financial Liberalization Evidence on effects of financial liberalization is episodic.

Villanueva and Mirakhor (1990): Success in financial liberalization requires

macroeconomic stability and strong and effective system of bank supervision as preconditions.

Success is more likely if controls on interest rates are removed gradually.

Sri Lanka and Korea moved to financial liberalization gradually, while requisite preconditions were put in place.

Without these conditions, full financial liberalization is apt to be associated with sharp increases in real interest rates;

44

bankruptcy of financial institutions; loss of monetary control.

Early examples of these outcomes are Southern Cone liberalizations, Philippines and Turkey.

Argument is as follows: Macroeconomic instability increases variance of and

covariance among projects funded by banks. This increases riskiness of bank portfolios. If deposit insurance is absent or correctly priced, banks

would reduce interest rates and ration credit more severely.

But with inadequately priced deposit insurance, moral hazard will induce banks to raise interest rates to attract deposits and fund high-risk projects.

45

Reason is that they face one-way bet: if the projects pay off, bank owners reap the profits, if they do not, government pays off depositors, with

bank owners risking only their limited capital. This can be avoided when deposit insurance is priced

correctly, because this forces banks to pay for higher risk that their

portfolio choices impose on the government; So they internalize consequences of their actions.

Same result could be ensured by adequate bank supervision.

Villanueva and Mirakhor (1990): Contrasting experiences of Southern Cone countries,

Philippines, and Turkey versus that of Malaysia.

46

All of these countries moved to full liberalization of interest rates in very short period.

Southern Cone countries: In Argentina, Chile, and Uruguay, removal of interest

rate ceilings and credit controls was accompanied by relaxation of bank supervision; extension of either explicit or implicit deposit

insurance; all in high inflation and unsatisfactory economic

performance. Financial liberalization measures were accompanied by

innovative macroeconomic stabilization programs in all three countries.

47

Bank portfolios included unusual number of bad loans, impairing bank capital, and increasing moral hazard problems created by deposit

insurance. Lending rates rose to high real levels, distress borrowing

by firms ensued, and bankruptcies became common. Liberalization and stabilization programs collapsed in

midst of a financial crisis. Philippines and Turkey: Liberalizations in the 1980s

were carried out under similar circumstances and in similar fashion and they produced similar results.

Malaysia: Although financial liberalization was carried out rapidly,

there were macroeconomic stability and banking supervision.

48

Transition to liberalized financial system was smoother, with mild increase in real interest rates and no widespread bankruptcies.

Sri Lanka and Korea: Both undertook liberalization from initially unsatisfactory

macroeconomic performance. But Asian countries removed restrictions on interest

rates gradually while pursuing macroeconomic stability and stronger prudential regulation over banks.

Greater flexibility was permitted only after supervisory mechanism strengthened and macroeconomic stability was achieved.

Unification of Foreign Exchange Market

50

Attempts at imposing exchange and trade restrictions in developing countries have led to emergence of illegal markets for foreign exchange.

Costs of this: high volatility of exchange rates and prices; creation of incentives to engage in rent-seeking

activities or divert export remittances from official to parallel market;

loss in tax revenue. These costs have led policymakers to seek ways to unify

official and parallel markets for foreign exchange. Exchange-rate unification has objectives as

absorption and legalization of parallel market;

51

elimination of inefficiencies and market fragmentation associated with quasi-illegal activity;

thus permitting efficient allocation of foreign-currency earnings.

Unification attempts have often taken form of adopting uniform floating exchange rate.

Impact of such a policy shift on short- and long-run behavior of exchange rate and inflation is ambiguous.

52

Short-Run Dynamics of Unification. The Pre-Reform Dual Rate Regime. The Post-Reform Flexible Rate Regime. Dynamics in Anticipation of Reform.

Longer-Run effects of Unification. Evidence on Unification Attempts.

53

Short-Run Dynamics of Unification

Lizondo (1987), Kiguel and Lizondo (1990), and Agénor and Flood (1992): short-run effects of preannounced future adoption of unified flexible-exchange-rate.

54

The Pre-Reform Dual Rate Regime

Small open economy operating informal dual exchange-rate regime: official, pegged exchange rate coexists with freely determined parallel rate.

Official rate applies to current account transactions authorized by the authorities.

Parallel rate is used for capital account transactions and remainder of current account items.

Agents are endowed with perfect foresight and hold domestic- and foreign- currency balances.

Domestic output is exogenous single exportable good. In each period, exporters

surrender given proportion of their foreign exchange earnings at official exchange rate, and

55

repatriate remaining proceeds via parallel market.

56

Model is described by the following log-linear equations:

m – p = -s,

m = R + (1-)d, 0 < < 1,

p = s + (1-)e, 0 < < 1,

R = -(s-e), d = 0,

m: nominal money stock; d: domestic credit;

R: stock of net foreign assets held by central bank;

p: domestic price level; e: official exchange rate;

s: parallel exchange rate.

.

. .

(15)

(16)

(17)

(19)(18)

57

(15): money market equilibrium. (16): log-linear approximation that defines domestic

money stock as a weighted average of domestic credit and foreign reserves.

(17): price level depends on official and parallel exchange rates.

(18): behavior of net foreign assets. Negative effect of premium on behavior of reserves

results from its impact on under-invoicing of exports. The higher the parallel exchange rate is, the greater

will be the incentive to falsify export invoices and to divert export proceeds to the unofficial market.

(19): stock of credit is constant over time.

58

In pre-reform dual exchange-rate system: forward-looking parallel rate s and predetermined

level of official reserves R are endogenous variables; official exchange rate e is set by the authorities.

In post-reform, unified flexible-rate regime s = e = and reserves remain constant.

With d constant, solving (15)-(19) yields

where = -(1-)d/ + (1-)e/.

.s

R=

/

R

s.

e

+

-/0-

(20)

59

Because determinant of the matrix of coefficients is -/ < 0, system (20) is saddlepoint stable, with one negative root (denoted by 1) and one positive root, 2.

Solving for the particular solutions yields

s = s + C1e- t + C2e- t,

R = R + 1C1e- t + 2C2e- t, 1 > 0, 2 < 0,

C1 and C2: yet undetermined coefficients;

s = e and R = [e - (1-)d]/ > 0: steady-state values of parallel rate and foreign exchange reserves.

~

~

~ ~

1

1 2

2

(21)

(22)

60

If existing dual-rate system is expected to last forever: Stability would require setting C2 = 0 in (21) and (22).

Using initial condition on reserves R0 allows determination of C1.

Economy's equilibrium path is unique nonexplosive path SS depicted in Figure 18.2.

For positive (negative) premium, reserves are falling (increasing), as indicated by the arrows pointing west (east) in the figure.

Saddlepath SS has positive slope (-1) and is flatter than the curve [s = 0].

Increase in rotates [s = 0] and SS clockwise. Increase in d shifts both [s = 0] and equilibrium point E to

the left.

..

.

61

Figure 18.2Steady-State Equilibrium Prior to Reform

E

s = 0.

S

S

s

Source: Agénor and Flood (1992, p. 930).

_s* = e

R*

R = 0.

R

62

Rise in translates into clockwise rotation of SS. Devaluation of official exchange rate leads to upward

shift of [R = 0] and rightward shift of [s = 0]. In the long run, devaluation leads to equiproportional

depreciation of parallel exchange rate and increase in reserves.

If policymakers announce their intention to switch to floating-rate arrangement at a well-defined date in the future:

Forward-looking agents will anticipate abandonment of dual-rate system.

Coefficient C2 will not be zero.

C1 and C2 will be determined satisfy constraints imposed by perfectly anticipated transition to post reform regime.

. .

63

The Post-Reform Flexible Rate Regime

T > 0: future transition date announced at period t = 0. In post-reform flexible-rate system = e = s, condition

that yields, from (18), R = 0. Therefore, reserves remain constant beyond t T at

level RT. Under these assumptions, unified flexible exchange rate

is determined by

- = -mT, t T,

where

mT = RT + (1-)d, t T.

.

+

(23)+

++

.

64

(23): linear differential equation in , whose solution is

= Cet/ + mT, t T.

Ruling out speculative bubbles requires setting C = 0. Exchange rate in effect at the instant the economy

switches to unified floating-rate regime is

T = mT, t T,

which depends on reform date, since it is linearly related to terminal stock of reserves at T.

Relationship between reserves and unified exchange rate at T defines “terminal curve,” (denoted CC), whose slope is equal to .

+

++ (26)

65

Dynamics in Anticipation of Reforms

How will reserves and premium evolve when agents perfectly anticipate transition from dual-rate regime to flexible system?

Two requirements to “connect” two regimes: initial condition on reserves R0; price continuity condition to prevent a jump in parallel

exchange rate at the moment reform is implemented.

R0 = R0, sT = T, t T.

(27) allow us to determine C1 and C2 in solutions for reserves and parallel exchange rate obtained for dual-rate regime.

+~

(27)

66

Setting t = 0 in (22), t = T in (21) and (22) and using (26) and (27) yields

1C1 + 2C2 = R0 – R,

R + 1C1e- T + 2C2e- T = s + C1e- T + C2e- T.

Solving this system yields

C1 = [(1-2)e T(R0 - R) - 2(R - e)]/,

C2 = [1(R - e) - (1-1)e T(R0 - R)]/,

where = 1(1-2)e T - 2(1-1)e T.

~ ~

~ ~11 22

~ ~ ~2

~ ~ ~1

12

(28)

(29)

(30)

(31)

67

Substituting (30) and (31) in (21) and (22) yields solutions for parallel exchange rate and foreign reserves prior to reform.

These solutions depend on relation between initial value of reserves R0 and its

steady-state value in dual rate regime R, and initial level of domestic credit,

since –R – e = -(1-)(d-e)/ . Realistic case for developing countries: initial situation in

which positive premium exists up to an instant before future reform is announced (s0 > e = s).

Such a condition is satisfied for R0 > R. Assuming that this condition holds, two cases must be

considered, depending on initial positions of saddlepath SS and terminal curve CC.

~

~

~

~~~

68

Figure 18.3: case where CC is steeper than SS. In such a situation, e < s0 < T. Announcement at t = 0+ of future reform at T leads to

immediate depreciation of parallel exchange rate and gradual fall in reserves.

Dynamic behavior in anticipation of reform is illustrated in Figure 18.3.

Economy before reform announcement is such that R0 > R and is located on a point such as A on saddlepath SS.

Position of steady-state equilibrium in post-unification regime depends on length of T.

If reform occurs where T 0+: Upon announcement, economy moves immediately to its

post-reform steady state.

+

~

~

69

Figure 18.3Dynamics upon Unification: Case I

E

S

S

_A

D

B

s

C

C

'

s

B'

R* RR

0

0

0

+

s* = e

s = 0.

R = 0.

70

Parallel exchange rate jumps from A to B, with no change in the initial stock of reserves, and unified exchange rate equal to 0 .

If T is positive: At the moment future reform is announced, parallel

exchange rate depreciates instantaneously. It appreciates continuously during transition period

toward B’ on curve CC, which is reached at T. Unified exchange rate is equal to ’, which is more

appreciated than 0.

If T : Announcement will have no effect on parallel exchange

rate and reserves.

+

+

71

Economy will remain at initial position A upon announcement, and then move along original saddlepath SS toward E.

There are therefore three possible paths associated with unification when terminal curve CC is steeper than SS.

While reserves fall continuously, parallel market exchange can either jump instantaneously to more depreciated equilibrium

level, appreciate continuously after initial depreciation

or appreciate continuously with no initial jump toward unified exchange rate, which may be

above initial parallel exchange rate, or below it,

depending on T and parameter values.

72

Figure 18.4: CC is flatter than SS. This case corresponds to s0 > T > e. If the reform occurs overnight: parallel exchange rate will

appreciate immediately and jump from A to B. If reform is preannounced: initial downward jump is from

A to D, followed by movement along unstable trajectory DB’ during transition period, which is characterized by falling reserves; continuous appreciation of parallel exchange rate with

or without initial downward jump.

Summary: Short-run behavior of parallel exchange rate in

anticipation of reform depends on state of expectations about timing of reform;

+

73

Figure 18.4Dynamics upon Unification: Case II

E

S

S

B

A

Ds

C

C

B'

R* RR

s* = e__

0

0

0+

s = 0.

R = 0.

s

74

initial position of the economy; length of transition period between announcement

and implementation of reform; macroeconomic policy stance that agents expect

policymakers to adopt in post-reform regime. If unification attempt is fully anticipated, agents will

adjust their portfolios toward foreign-currency-denominated assets if uniform

floating exchange rate is expected to be more depreciated than existing parallel rate; or

domestic-currency-denominated assets if floating exchange rate is expected to be more appreciated.

Due to this adjustment, parallel market rate will depreciate or appreciate immediately.

75

After initial jump, and if the reform is known to take place in the near future, parallel market rate will steadily depreciate or appreciate toward unified exchange rate.

Reason for jump in parallel exchange rate upon announcement of the reform:

If unified exchange rate is more depreciated than initial level of parallel exchange rate and official exchange rate, agents realize that future reform may imply depreciation of official exchange rate; rise in prices; and thus reduction in real money balances.

Under perfect foresight, these effects are reflected immediately in the expected and actual rate of depreciation of parallel rate.

76

This leads agents to reduce their demand for domestic currency.

But since the initial money stock is constant, equilibrium in money market can be maintained only if parallel exchange rate depreciates.

Uncertainty about reform date or nature of post-transition regime:

Expectations of reform would cause jump in parallel exchange rate at the moment the

reform is implemented; volatile exchange-rate movements prior to transition if

this type of uncertainty varies over time. It may be difficult to interpret short-run movements in

parallel exchange rate.

77

Erratic fluctuations in exchange rates induced by this uncertainty may distort portfolio decisions; and have adverse inflationary effect.

78

Longer-Run Effects of UnificationPinto (1989, 1991a): These effects depend on fiscal implications of exchange-

rate reform. He models government behavior and assumes that

rationing occurs in official market for foreign exchange. Government buys imported goods and uses foreign

exchange surrendered by exporters to pay for them. Excess foreign exchange is resold to private sector at

official exchange rate. Thus, reserves remain constant over time and dynamics

of money supply are determined by credit policy. Production for exports is partly smuggled out and partly

sold through official market.

79

Thus, parallel market premium acts as implicit tax on exports taking place through official channels.

Since exporters face rising marginal costs to smuggling, allocation of output between official and parallel markets is determined by equating marginal returns.

In equilibrium proportion of smuggled exports is positively related to the parallel market premium.

Private agents spend a fixed fraction of their wealth on imported consumption goods.

80

Government finances its deficit by credit from central bank:

D = E(G - ),

E: official exchange rate; G: government imports;

: revenue from conventional, explicit taxes. (32) implies that

m = G - - m,

m: real money stock in terms of official exchange rate;

: constant rate of official depreciation. (33): in steady state (m = 0) budget deficit is financed by

inflation tax m.

(32)

.

.~

(33)

81

To identify steady-state revenue from implicit tax on exports requires moving from “recorded” deficit measured in terms of official

exchange rate (33) to “true” deficit measured in terms of parallel exchange

rate. Let denote 1 plus parallel market premium. “True” long-run capital loss incurred by private sector

due to inflation tax is m/. Officially recorded taxes are equal to E. Real tax burden is equal to /. If > 1, “true” fiscal burden imposed by inflation tax and

conventional taxes is lower than “recorded” one.

~ ~

~

~

82

But since real government spending does not depend on premium, difference between “recorded” and “true” tax burdens is implicit tax on exports: G - / - m/.

Since G - = m, this tax is equal to G(1-1/). Steady-state government budget constraint:

G = + m = ( + ) = G(1 - ) + + ,

This shows how implicit tax on exports serves to finance government expenditure.

If elasticity of demand for domestic money is less than unity, there is trade-off between inflation tax rate and premium for given level of fiscal deficit.

~ ~ ~

~

~

1~

m~~ m

~~

~

~ ~

83

By unifying, government loses tax revenue implicit in premium, G(1 - 1/).

The larger implicit tax on exports prior to reform, the larger the jump in inflation upon unification.

Pinto's analysis neglects another important source of implicit tax or subsidy associated with informal dual exchange-rate regimes.

Agénor and Ucer (1998): Taxes on imports are important source of revenue for

developing countries. In many countries, official rather than parallel market

exchange rate is used for customs valuation purposes. Use of official exchange rate for valuation of imports for

duty purposes provides implicit subsidy to importers.

~

84

If subsidies are large relative to revenue generated from implicit tax on exports, net long-run effect of exchange market unification may be a fall in domestic inflation rate.

Evidence: prior to unification significant net quasi-fiscal losses were registered in many countries operating informal currency markets.

85

Evidence on Unification AttemptsExperience of sub-Saharan African countries in the

mid-1980s. While some of them chose to follow gradual path to

unification, most of them opted for “overnight” approach. Indications:

In some countries exchange-rate unification led to a surge in inflation.

Parallel market premium rose substantially in the months preceding unification attempt and fell sharply upon implementation of reform.

Unified floating exchange rate was in some cases very close to pre-reform parallel rate.

86

This implies that drop in premium resulted from sharp depreciation of official exchange rate.

Case most notably in Nigeria. Despite sharp drop on impact, significant premium

reemerged in some countries.

Other countries: Unified their foreign exchange markets by adopting a floating

exchange-rate arrangement: Egypt (early 1991), Guyana (March 1990), India (March 1993), Iran (March 1993), Jamaica (September 1991), Madagascar (May 1994), Peru (August 1990), Sri Lanka (August 1990), Trinidad and Tobago (April 1993), and Venezuela (March 1989).

Prior to floating, these countries had widespread trade and exchange restrictions.

87

These restrictions led to substantial diversion of foreign exchange to parallel market, creating in some cases severe balance-of-payments problems.

Experience of Jamaica, Guyana, and Sri Lanka: In addition to balance-of-payments difficulties, pre

reform period was marked by rising inflation. Parallel market premium also displayed a rising trend. Adoption of floating exchange-rate system was

accompanied by relaxation of trade and capital account restrictions.

After the reform was implemented, parallel market premium dropped considerably, but, import/reserves ratio recovered sharply only in Guyana.

Overall balance of payments deteriorated.

88

Inflation is accelerated in Guyana and Jamaica, but fell in Sri Lanka.

Sharp acceleration of money growth occurred in Guyana and Jamaica.

Possible reason for inflationary burst: inability of policymakers to control primary budget deficit and rate of expansion of money supply (Agénor and Ucer, 1998).

This may be the case in several unification experiments attempted in sub-Saharan African countries.

Increase in premium prior to reform can be a result of expectations about timing of reform process, and size and direction of movements in official and

parallel exchange rates upon implementation.

89

Parallel market exchange rate in some cases did not undergo large “jump” when reform was implemented.

Reason: prediction of the reform with high degree of accuracy by private agents.

At the time of implementation, only official exchange rate adjusts in a discrete fashion.

Reason: most of the effects of the change in exchange-rate regime have already been discounted through parallel market by forward-looking agents.

Reemergence of significant premium subsequent to reform occurred in countries where money growth was not kept under control; foreign exchange controls were retained or

reintroduced; inflation rose substantially.