Economic Implications of Foreign
             Exchange Rationing
                  in Ethiopia
                           ...
Outline of Presentation
• Recent macro-economic developments
  – Current account
  – Nominal and real exchange rates
• Imp...
Ethiopia Trade and Current Account
      Transfers, 2004/05 – 2008/09*
                     12


                     10

...
Ethiopia: Nominal and Real Exchange
    Rate Indices, 2004/05 – 2008/09*
                                250




         ...
Figure 1a: Impacts of a Devaluation:
Unrestricted Market for Foreign Exchange
(Real)     Demand                      Suppl...
Figure 1b: Impacts of a Devaluation:
    Unrestricted Market for Foreign Exchange
(Real)     Demand            Exports    ...
Figure 2: Demand and Supply of Foreign Exchange
                  (Restricted Market)
(Real)      Demand            Export...
The Data Base
EDRI Social Accounting Matrix 2004/05
  – Constructed as part of a project with the
    University of Sussex...
Agro-ecological Zones
  “Three” Ethiopias
The CGE Model
• Production
  – Value added modeled using constant elasticity of
    substitution (CES) production function...
The CGE Model (2)
• Incomes and Consumption
  – Payments from each factor of production is
    allocated to households and...
The CGE Model (3)
• Macro-closure
  – Savings-investment closure with investment fixed in
    real terms, and with the mar...
Simulation 1: Increased Foreign
           Exchange Inflows
• Increased (exogenous) foreign savings inflows
  – An exogeno...
Simulation 1: Increased Foreign
 Exchange Inflows: Simulation Results
• Increased (exogenous) foreign savings inflows
  ad...
Simulation 1: Increased Foreign
Exchange Inflows: Simulation Results (2)
• Since prices of tradable goods are (somewhat
  ...
Simulation 1: Increased Total Investment
        and Foreign Capital Inflow
                                              ...
Simulation 1: Increased Total Investment and
  Foreign Capital Inflows: Sectoral Results

                                ...
Effects of a Decline in Foreign Savings with
       and without Import Rationing
                                         ...
Effects of a Decline in Foreign Savings with and
  without Import Rationing (Sectoral Results)

                          ...
Caveats
• The modeling results presented here are meant
  as indicators of the broad magnitudes of the
  effect of the pol...
Concluding Observations
• CGE simulations suggest that there are
  substantial efficiency and distributional effects of
  ...
Concluding Observations (2)
• There are substantial costs to both foreign exchange
  rationing and real exchange rate appr...
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Economic Implications of Foreign Exchange Rationing in Ethiopia

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Economic Implications of Foreign Exchange Rationing in Ethiopia

  1. 1. Economic Implications of Foreign Exchange Rationing in Ethiopia Paul Dorosh International Food Policy Research Institute (IFPRI) (Ethiopia Strategy Support Program, ESSP-2) Sherman Robinson University of Sussex / IDS Hashim Ahmed Ethiopian Development Research Institute (EDRI) EDRI – IFPRI ESSP2 Conference Addis Ababa, Ethiopia 22-24 October, 2009 The views expressed in this paper are those of the authors and do not represent the official positions of their respective institutions.
  2. 2. Outline of Presentation • Recent macro-economic developments – Current account – Nominal and real exchange rates • Implications of rationing of foreign exchange • Structure of the SAM and CGE • CGE Model Results – Implications of Foreign Exchange Inflows – Implications of Foreign Exchange Rationing • Concluding observations
  3. 3. Ethiopia Trade and Current Account Transfers, 2004/05 – 2008/09* 12 10 8 billion US$ 6 4 2 0 2004/05 2005/06 2006/07 2007/08 2008/09* Imports Exports + All Transfers Exports + Net Servs + Priv Transfers Exports •2008/09 data are projections based on data for part of the fiscal year. Source: EDRI and authors’ calculations.
  4. 4. Ethiopia: Nominal and Real Exchange Rate Indices, 2004/05 – 2008/09* 250 200 (Index, July 2004 = 100) 150 100 50 0 Jul-04 Dec-04 May-05 Oct-05 Mar-06 Aug-06 Jan-07 Jun-07 Nov-07 Apr-08 Sep-08 Feb-09 Jul-09 Real Exchange Rate Nominal Ex Rate CPI World Price Index (Birr) Source: EDRI and authors’ calculations.
  5. 5. Figure 1a: Impacts of a Devaluation: Unrestricted Market for Foreign Exchange (Real) Demand Supply Exchange (Imports) Rate (Exports) (Birr/$) Trade Deficit 1 ER1 ER0 Trade Deficit 0 X0 M0 Foreign Currency ($)
  6. 6. Figure 1b: Impacts of a Devaluation: Unrestricted Market for Foreign Exchange (Real) Demand Exports Exports plus Net Exchange (Imports) Rate Capital Inflows (Birr/$) Trade Deficit 1 ER1 ER0 Trade Deficit 0 X0 M0 Foreign Currency ($)
  7. 7. Figure 2: Demand and Supply of Foreign Exchange (Restricted Market) (Real) Demand Exports Exchange Exports plus (Imports) Rate Net Capital (Birr/$) Inflows Excess Demand Trade Deficit at for Foreign ERpar: (M2-X2) Exchange at ERpar ER0: (M0-X0’) ER0 X0 X2 X0’ M2 M0 Foreign Currency ($)
  8. 8. The Data Base EDRI Social Accounting Matrix 2004/05 – Constructed as part of a project with the University of Sussex (w/support of IFPRI-ESSP2) – 65 production sectors (24 agricultural, 10 agricultural processing, 20 other industry, 11 services) – Regional SAM based on the “3 Ethiopias” • Rainfall sufficient, drought prone, pastoralist • Rainfall sufficient AEZ disaggregated to humid lowlands, enset-based systems, and other (highland) rainfall sufficient areas – Poor and non-poor groups in rural and urban areas
  9. 9. Agro-ecological Zones “Three” Ethiopias
  10. 10. The CGE Model • Production – Value added modeled using constant elasticity of substitution (CES) production functions of factor inputs (land, livestock capital, various types of labor and non-agricultural capital) – Intermediate inputs into production are determined as fixed shares of the quantity of output. • Trade – Imported goods are assumed to be imperfect substitutes for domestically produced goods; – Likewise, exported goods are imperfect substitutes for domestically produced and consumed goods.
  11. 11. The CGE Model (2) • Incomes and Consumption – Payments from each factor of production is allocated to households and other institutions using fixed shares derived from the base SAM. – Household consumption is modeled using a Linear Expenditure System (LES) specification. • Factors of production – Non-agricultural capital is fixed by sector, as is agricultural land. – Labor is free to move across sectors, but total labor supply is exogenous and the wage rate adjusts to balance supply and demand for labor.
  12. 12. The CGE Model (3) • Macro-closure – Savings-investment closure with investment fixed in real terms, and with the marginal propensity to save of urban households adjusting so that total savings in the economy is equal to total investment. – The consumer price index is fixed at its base level (and so serves as the numeraire) – Foreign savings is also fixed, and the exchange rate adjusts to help bring about equilibrium in the market for foreign exchange. – In the simulations with foreign exchange rationing, rents are modeled using an implicit tariff for all imports that adds to the cost of the foreign exchange. – Rents are distributed to institutions in fixed shares.
  13. 13. Simulation 1: Increased Foreign Exchange Inflows • Increased (exogenous) foreign savings inflows – An exogenous increase in foreign savings approximates the case of “Dutch Disease” effects arising from a surge in exports (typically natural resource exports that use very little domestic factor inputs) – The surge in foreign capital inflows in Ethiopia from 2005/06 to 2007/08 was not driven by a surge in export earnings or exogenous increase in capital inflows. Rather, a policy of promoting domestic investment led to an increase in import demand that was accomodated by permitting foreign borrowing.
  14. 14. Simulation 1: Increased Foreign Exchange Inflows: Simulation Results • Increased (exogenous) foreign savings inflows adds to pool of total savings, enabling additional investment – Using an alternative closure for savings and investment would shift the composition of savings between consumption and investment, but would not affect the main results regarding the real exchange rate appreciation. • This increased domestic spending (demand) leads to an increase in domestic prices – With a fixed nominal exchange rate, this implies a real exchange rate appreciation
  15. 15. Simulation 1: Increased Foreign Exchange Inflows: Simulation Results (2) • Since prices of tradable goods are (somewhat loosely) tied to world prices and the nominal exchange rate, prices of tradable goods relative to average domestic prices (and especially relative to prices of non-tradables) falls. – Incentives for production of exportables falls as do exports • Since many agricultural products are tradable (especially coffee and other export crops), farm incomes do not rise as fast as urban incomes
  16. 16. Simulation 1: Increased Total Investment and Foreign Capital Inflow Increase in Base Foreign Savings (bn 2005/06 Birr) (% change) Real GDP 128.6 0.0% Absorption 158.8 5.9% Consumption 114.8 6.1% Investment 28.2 8.5% Government 15.9 0.0% Exports 16.8 -32.6% Imports 47.0 8.4% Real Exchange Rate 1.0 -21.5% Nominal Exchange Rate 100.0 -21.5% CPI 100.0 -4.4% Real HH Incomes Rural Poor 21.1 4.8% Rural Non-Poor 66.0 6.1% Urban Poor 4.3 4.9% Urban Non-Poor 23.4 7.5% Total 114.8 6.1%
  17. 17. Simulation 1: Increased Total Investment and Foreign Capital Inflows: Sectoral Results Increase in Base Foreign Savings (bn 2005/06 Birr) (% change) Agriculture 53.0 -0.3% Cereals 16.9 1.8% Export Crops 9.0 -7.4% Other Crops 9.5 1.0% Livestock 17.6 0.6% Industry 14.5 0.8% Services 54.8 -0.2% Total Value Added 122.2 -0.1%
  18. 18. Effects of a Decline in Foreign Savings with and without Import Rationing Simulation 2 Simulation 3 Reduced Foreign Reduced Foreign Simulation 3 Savings with Import Savings with no relative to Base Rationing Import Rationing Simulation 2 (bn 2005/06 Birr) (% change) (% change) (% change) Real GDP 128.6 -1.2% -0.5% 0.7% Absorption 158.8 -3.9% -3.3% 0.6% Consumption 114.8 -2.6% -3.2% -0.6% Investment 28.2 -12.9% -5.6% 8.4% Government 15.9 2.6% -0.5% -3.0% Exports 16.8 -0.2% 16.7% 16.9% Imports 47.0 -10.1% -4.1% 6.7% Real Exchange Rate 1.0 0.0% 11.8% 11.8% Nominal Exchange Rate 100.0 0.0% 11.8% 11.8% CPI 100.0 0.0% 2.1% 2.1% Real HH Incomes Rural Poor 21.1 -5.3% -3.2% 2.2% Rural Non-Poor 66.0 -8.4% -3.2% 5.7% Urban Poor 4.3 -5.9% -2.1% 4.0% Urban Non-Poor 23.4 16.9% -3.4% -17.4% Total 114.8 -2.6% -3.2% -0.6%
  19. 19. Effects of a Decline in Foreign Savings with and without Import Rationing (Sectoral Results) Simulation 2 Simulation 3 Reduced Foreign Reduced Foreign Simulation 3 Savings with Import Savings with no relative to Base Rationing Import Rationing Simulation 2 (bn 2005/06 Birr) (% change) (% change) (% change) Agriculture 53.0 0.0% 0.1% 0.1% Cereals 16.9 -0.9% -1.1% -0.2% Export Crops 9.0 0.5% 3.2% 2.7% Other Crops 9.5 -1.3% -0.5% 0.8% Livestock 17.6 1.2% -0.1% -1.4% Industry 14.5 -1.4% -0.4% 0.9% Services 54.8 0.1% 0.0% -0.1% Total Value Added 122.2 -0.1% 0.0% 0.1%
  20. 20. Caveats • The modeling results presented here are meant as indicators of the broad magnitudes of the effect of the policies simulated – Annual model (no seasonality or within-year effects) – No financial sector (real-side only) – Need to include changes in exogenous world prices • Sensitivity analysis needed: – Substitution parameters that determine largely determine elasticities of export supply and import demand – Alternative distributions of foreign exchange rents
  21. 21. Concluding Observations • CGE simulations suggest that there are substantial efficiency and distributional effects of foreign exchange rationing. • Foreign exchange controls: – Result in the creation of large rents that likely accrue mainly to non-poor households. – Reduce economic efficiency so that real incomes from factors of production (land, capital and labor) decline, as do overall household incomes (except for those who gain large rents). – Inhibit depreciation of the real exchange rate, and thus slow or prevent reversal of the real exchange rate appreciation between 2004/05 and 2007/08 that reduced price incentives for exports.
  22. 22. Concluding Observations (2) • There are substantial costs to both foreign exchange rationing and real exchange rate appreciation in terms of growth (reduced incentives for production of tradables) and income distribution (large rents accruing to the non-poor). • Policy reforms need not involve full liberalization of the foreign exchange market, however. – Various versions of managed floats and controls in foreign capital markets exist that can gradually reduce economic rents, improve incentives for exports and increase overall economy efficiency. – Indeed, policies since late 2008 have effectively reduced the earlier appreciation of the real exchange rate.

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