Nafziger Economic Development (4th ed)

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production and employment (Chapter 9), improve investment choice (Chapter 11), and reduce structural inflation but probably reduce real wages (Chapter 15).

The Real Exchange Rate (RER)

We cannot calculate LDC currency depreciation or appreciation vis-a`-vis the dollar over time by looking at changes in the nominal exchange rates. To illustrate, in 1968 (the base year), —N 1 = $1.40, whereas the United States wholesale price index and Nigeria’s consumer price index were both 100. By 1979, —N 1 = $1.78 (a 27 percent increase for the naira compared to 1968), whereas the U.S. wholesale price index was 237.6 and Nigeria’s was 498.0. The real exchange rate (the nominal exchange rate adjusted for relative inflation rates at home and abroad), calculated as

dollar price of naira in base year X percentage change in dollar price of naira from base year to terminal year X (Nigerian consumer price index/U.S. wholesale price index)

was —N 1 = $1.40 in 1968, and —N 1 = $3.73 (1.40 × 1.27 × 2.10) in 1979, which was an increase of 2.66, meaning the value of the naira vis-a`-vis the dollar more than doubled over the 11-year period. With further real appreciation, as Nigerian nonoil exports became less competitive and imports more competitive, Nigeria depreciated the naira in 1986 under World Bank adjustment to bring it closer to the 1969 real exchange rate. However, with rapid inflation in the late 1980s and early 1990s, the Abuja government stubbornly resisted the more rapid naira devaluation necessary to maintain a stable real exchange rate.

Although we would prefer RER as PT (the domestic price index of tradables) over PN (the domestic price index of nontradables), this is difficult to calculate in practice. Thus, the most readily available proxies are, as indicated earlier, the domestic country’s CPI or consumer price index (instead of the price index of nontradables) and the United States’ WPI or wholesale price index (instead of the price index of tradables).

What is the significance of the real exchange rate? The RER is a good proxy for a country’s degree of competitiveness in international markets? An increase in the RER represents a real exchange appreciation or a rise in the domestic cost of producing tradable goods. A decline, by contrast, reflects a real exchange rate depreciation or an improvement in the country’s international competitiveness (Domac and Shabsigh 1999:4).13

The link between RER and economic performance in Latin America, Asia, and Africa is strong. Figure 17-10 shows that the real exchange rate of the Egyptian pound relative to the U.S. dollar is highly correlated with Egypt’s trade deficit (Alawin 2003). RER misalignment undermines external competitiveness (by overpricing exports) and allocation of resources (by distorting prices of domestic relative to international

13If the exchange rate was expressed in U.S. dollar terms, as $1 = ––N 0.71 (rather than ––N 1 = $1.40), a decrease in the United States’ RER to $1 = ––N 0.28 (rather than ––N 1 = $3.73) reflects a real exchange depreciation for the United States or an improvement in its competitiveness relative to the Nigerian naira.

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However, dual rates maintain some price distortions, postpone resource adjustments, and spur people to acquire foreign currency cheaply in one market and sell it expensively in the other.

Still, dual exchange rates can support the consumption of the state elite. In Angola, elites imported luxury cars at the official exchange rate (a cheap kwanza price of both the U.S. dollar and thus foreign-made automobiles), whereas food was imported using foreign currency at the more expensive parallel market rate (Agular 2003:132).

Exchange-Rate Adjustment and Other Prices

Let the student be warned: Market-clearing exchange rates may not provide enough signals for improving the efficiency of resources use if domestic prices of goods and services, wages, interest rates, and other prices are not flexible (Srinivasan 1987:427– 443). The theory of the second best states that if economic policy cannot satisfy all the conditions necessary for maximizing welfare, then satisfying one or several conditions may not increase welfare (that is, may not lead to a second-best position). This theory indicates that liberalizing one price (for example, the exchange rate) while other prices are still repressed may be worse than having all prices distorted.

The Impossible Trinity: Exchange-Rate Stability, Free Capital Movement, and Monetary Autonomy

From 1979 to 1999, with the birth of the euro currency, the European Monetary System (EMS) aimed to maintain stable exchange rates, free capital mobility, and national control over monetary policy among members, labeled an impossible trinity by OECD economist Helmut Reisen (1993:21–23, supported by Higgins 1993:27– 40). On the average of once per year, however, weak-currency countries could no longer maintain the tight coordination of their currencies with the German mark, contributing to a crisis in the foreign-exchange or capital markets. The French or Italian treasury then have confronted the prospect of capital controls, increased interest rates in the face of high unemployment, or devaluing the currency or widening currency spreads (as in mid-1993, when European finance ministers pretended that the increase from 2.5 percent to 15 percent in the range allowed around parity did not mean abandoning a fixed exchange-rate system).

Since 1999 for bank deposits and 2002 for notes and coins, 12 inner Western European members of the 25 (then 15) members of the European Union adopted a common currency, the euro. In 1992, the European Union adopted the stability and growth pact of the Treaty of Maastricht (Netherlands). This treaty set a deficit ceiling of 3 percent of GDP for each member, essential to maintain the credibility of the euro. Portugal was forced by members of the euro bloc to slash public spending in 2001, contributing to a deep recession in 2002–03. However, in 2003, the two most influential bloc members, Germany and France, were spared the severe fines and sanctions for running excessive budget deficits, signaling the eventual death of Maastricht (Economist 2003c:45). In mid-2005, European Central Bank Vice President

Lucas Papademost expressed concern about the macroeconomic underperformance of the 12 eurozone members (especially Italy) relative to non-euro OECD members. OECD economists Romain Duval and Jorgen Elmeskov attributed the relatively slow growth of eurozone countries relative to other DCs to the “absence of monetary policy autonomy” (Atkins and Jenkins 2005:1). For LDCs, with even less economic policy discretion than Germany, France, and Italy, the trinity is even less possible.

During the 1980s and early 1990s, countries such as Taiwan and Singapore, however, demonstrated their ability to maintain exchange-rate stability against the dollar or a basket of currencies (Reisen 1993:21–23). Most other emerging nations are too vulnerable to external price and demand shocks to maintain stability of their currencies vis-a`-vis major DC currencies (Wessel 1995:A2). However, the other extreme, relinquishing control over financial policies, is just as bad. The francophone West African countries in the CFA (communaute financiere africaine) franc zone paid a heavy price in growth foregone by maintaining their currencies fixed at CFAF50 equal to one French franc from 1948 to 1994. During much of this period, the CFA countries lacked the autonomy to use monetary, fiscal, and exchange-rate policies to stimulate demand. By the mid-1980s, the United Nations (1994:47–50) contended that “after several years of unsuccessful adjustment, it became increasingly apparent that the center-piece of the franc zone – the fixed exchange rate against the French franc – was seriously impeding the adjustment effort.” Since the mid-1980s, the CFA countries experienced real currency appreciation vis-a`-vis DCs and neighboring countries and falling terms of trade, contributing to chronic current-account deficits. From 1960 to 1994, distorted exchange-rate prices contributed to the negative or negligent economic growth of Chad, Niger, Benin, Burkina Faso, Central African Republic, Mauritania, Ivory Coast, and Senegal.

And the currency crises discussed later indicate the futility of fixed exchange rates for LDCs.

Currency Crises

Chapter 14 discussed LDC financial market weaknesses and Chapter 16 financial crises. Many a financial crisis results from a currency crisis, often from exchange-rate rigidity that, over time, contributes to an overvalued domestic currency that reduces the country’s competitiveness internationally, leading to a chronic current-account deficit.

Manuel Montes and Vladamir Popov (1999:1–19) differentiate between Russia’s 1998 currency crisis, resulting from an overvalued rouble, and the 1997 Asian crisis, which was from excessive private-sector borrowing abroad rather than currency overvaluation. Excessive borrowing contributed to a loss of confidence by lenders in borrowers’ ability to service debt. However, in East Asia, except for South Korea, one component of the crisis was that the domestic currency had been set at a constant nominal exchange rate, leading to real currency appreciation and high currentaccount deficits. Before their financial crises, Asia, Russia, Mexico (crisis in 1994), and Argentina (2001–03 crisis) had overvalued currencies.

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The Russian rouble (Ru) changed from Ru0.67 = $1 (1990), to Ru5 = $1 (1995– 1996), to Ru6 = $1 (1997–1998) (all mid-year). Efforts in the early 1990s by the Central Bank of Russia, supported by the IMF, to defend a currency peg and “maintain a scandalously high domestic interest rate,” (Montes and Popov 1999:52) amid a 325,000-fold inflation, 1990–95 (Table 19-2), inevitably led to export stagnation and rising imports. The resulting chronic international deficit and massive capital outflows forced devaluation in August 1998. With debt restructuring and a continuing rouble fall to rates in excess of Ru200,000 = $1 in 1999–2000, Russia’s exchange rate no longer hampered exports, thus helping restore its external balance.

As indicated in Chapter 14, Argentina experienced four-digit inflation rates two years in the late 1980s. In response, Argentina established a currency board in 1991, requiring the central bank to back its monetary base by 100-percent foreign exchange (or in an emergency, 20 percent of assets could be in dollar-denominated government debt). The currency board guaranteed full, unlimited convertibility of the Argentine peso into U.S. dollars.14 Since the central bank (Banco Central de la Republica´ Argentina) held no domestic assets, it could not run out of foreign-exchange reserves during a speculative attack (Mussa 2002:20).

Argentina needed an exchange-rate peg for a few years in the early 1990s to serve as an anchor to prevent cost–push inflation. Indeed, the stable peso helped generate a “miracle” of inflation deceleration from 1989 to 1995 (Chapter 14). However, a currency board is too rigid, lacking flexibility when inevitably, as in the early to mid-1990s, an increasingly overvalued peso made Argentine exports uncompetitive, contributing to chronic international payments deficits through the 1990s and 2000– 03. A floating or crawling peso with a speed limit, on the heels of a short period of a pegged currency would have helped restore Argentina’s exports and trade balance, and provided more options for macroeconomic expansion to prevent the 1998 to 2002 depression and 2001–03 default to the IMF and other creditors (Moffett 1994:A10).

Joseph Stiglitz (2002a), although admitting Argentina’s mistakes, faults the IMF for its insistence on Argentine economic austerity and the United States for its lack of trade credits. “The IMF,” according to Stiglitz (2002b:27) “seems to confuse means with ends. . . . A country like Argentina can get an ‘A’ grade, even if it has double-digit unemployment for years, so long as its budget seems in balance and its inflation seems in control!” For Stiglitz (2002a), if the United States had provided trade credits to Argentina, as U.S. importers did to Mexico in 1995, or as Japan’s Finance Minister Kiichi Miyazawa did for East Asian LDCs during their crisis, Argentina’s depression and debt crisis would have been less serious (Stiglitz 2002a).

14Argentina considered moving toward dollarization, but never did (Mussa 2002:22). A currency board differs from dollarization, in which foreign currency is used as the dominant (Russia in the early 1990s) or exclusive (Panama, Ecuador, and El Salvador) legal tender (Schuler 2004).

The adoption of the U.S. dollar by El Salvador on January 1, 2001, limited its ability to escape the stagnation that began in the mid-1990s. El Salvador’s chronically high production costs limited its export competitiveness. However, dollarization prevented El Salvador from increasing its export competitiveness by matching neighboring countries’ devaluation (Silver and Authers 2004:2).

Managed Floating Plus

Stanley Fischer (2001b:1), as IMF First Deputy Managing Director, in a distinguished lecture to the American Economic Association, contended that during the 1990s and early years of the 21st century

many countries . . . changed their exchange rate regimes, moving from crisis-prone soft pegs to hard pegs or floating regimes. This trend is likely to continue, particularly among emerging market countries.

For Fischer (2001a:1), “soft” pegs referred to anything other than the bipolar or twocorner solutions, which are hard pegs (currency boards and dollarization) and managed or independent floats, on the other. For countries open to international capital flow, Fischer (2001b:4) contends, “the excluded arrangements are fixed, adjustable peg, and narrow band exchange rate systems.” His view that soft pegs are unsustainable is based on an IMF survey of de facto emerging markets’ exchange rates, although it is likely that soft pegs include countries attempting one of the corner solutions but failing, thus biasing the sample. Moreover, IMF and U.S. Treasury pressure may have been a factor moving LDCs away from intermediate (soft peg) exchange-rate regimes (Fischer 2001b:4).

The Argentine crisis later in 2001 contradicted Fischer’s view that very hard pegs are sustainable for countries open to international capital flows. The only corner solution left is managed or independent floating.

The Institute for International Economics’ economist Morris Goldstein (2002:1, 43–44) argues for “managed floating plus.” A managed float indicates no publicly announced exchange rate target and a determination of exchange rates mainly by the market. However, monetary authorities would intervene into the exchange market to “smooth” excessive short-run fluctuations or to maintain market liquidity. The float not only allows the exchange rate to serve as a market gauge for assessing policies (Tavlas 2003:1215–1246) and a shock absorber to “accommodate better external shocks” (Edwards 2004:63), but also permits more freedom to pursue domestic macroeconomic objectives of growth and full employment (see Chapter 19 on internal and external balance).

“Plus” stands for inflation targeting and measures to reduce currency mismatching. This regime combines the best of the float, monetary independence and resilience to large external shocks, but also provides a nominal anchor to prevent cumulative currency depreciation and inflation and limits exchange-rate movement to address LDCs’ “fear of floating” (Fischer 2002b:7–8). Allowing exchange rates to move enough to remind private market participants, such as DC portfolio investors, of currency risk, should reduce the onrush of capital inflows that often gives rise to large reversals of panic-induced capital outflows (Goldstein 2002:viii).

Inflation targeting means a public announcement of a numerical target (or sequence). The government provides the central bank with enough independence to set monetary policy to achieve the targeted rate. Central bankers are also subject to transparency and accountability, so that they inform the public of the reasons

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for monetary policy and the extent to which they have obtained their objectives (Goldstein 2002:44).

Goldstein (2002:44) defines a currency mismatch as a situation in which the currency denomination of a country’s (or sector’s) assets differs from that of its liabilities such that its net worth is sensitive to changes in the exchange rate.” Local currency depreciation would impose large losses on banks and their customers. The monetary authorities can discourage mismatches by allowing exchange rates to move enough to remind market players of risk, publishing data on mismatches, limiting banks’ net open positions in foreign currency through regulations, developing deeper capital markets that enable better hedging, prohibiting government borrowing in foreign currency, or making foreign currency obligations incurred by domestic residents unenforceable in domestic courts” (ibid., pp. 44–45).

Chile and Israel have used inflation targeting with success. Chile took nine years from the inception of inflation targeting in 1990 to stabilize, whereas Israel stabilized in six years after targeting began in 1991 (Goldstein 2002:62). Indeed, Frederic Mishkin and Klaus Schmidt-Hebbel (2001:33) indicate that despite unresolved issues, over the previous 10 years, “inflation targeting has been quite successful in controlling inflation and improving the performance of the economy.”

Still, as the reviewer Tavlas (2003) indicates, Goldstein does not regard managed floating plus as a Holy Grail. Much depends on government credibility. No exchange rate regime can eradicate failed efforts at stabilization. However, managed floating, together with inflation targeting and avoiding currency mismatching, has as much potential as any exchange rate regime to help LDCs disinflate with a minimal sacrifice of growth and employment.

Regional Integration

In 2001 only 25 percent of LDCs’ total exports of $658 billion went to other LDCs (World Bank 2003h:314–318). To some economists, this indicates the substantial output gain potential from greater intra-LDC trade (and factor movements). Many LDC leaders, frustrated by DC protectionism, a lack of internal economies of scale, and declining terms of trade for primary products, have advocated economic integration, a grouping of nations that reduces or abolishes barriers to trade and resource movements among member countries. Integration ranges along a continuum from its loosest form, a preferential trade arrangement, to a free trade area, a customs union, a common market, an economic union, and to the most advanced integration, a complete economic and monetary union.

A preferential trade arrangement, illustrated by the Preferential Trade Area for Eastern and Southern African States (PTA), launched in 1982, provides lower tariff and other trade barriers among member countries than between members and nonmembers; in 1995 PTA was transformed into the Common Market for Eastern and Southern African States (COMESA), which despite the name became a customs union in 2000. The South Asian Association for Regional Cooperation Preferential

Trading Arrangement (SAPTA), which includes India, Pakistan, Bangladesh, and Sri Lanka, was established in 1995.

A free trade area (FTA), such as the North American Free Trade Agreement (NAFTA) signed in 1993 among the United States, Mexico, and Canada, removes trade barriers among members, but each country retains its own barriers against nonmembers. NAFTA provides for free trade of goods and most services (phased in by 2009) and free capital movement in most sectors, but not free labor migration. Because external tariffs vary, FTAs need rules of origin, for example, to ensure that a majority of the value-added originates in member countries. In NAFTA, these rules prevent Asian and European companies from establishing assembly operations in Mexico as a back door to U.S. and Canadian markets (Morici 2004). In 1991, NAFTA negotiators overruled the U.S. challenge to a 50-percent domestic content of Canada’s export of Honda automobiles.

Visionaries had hoped that a U.S. bilateral free trade agreement with Chile, signed in 2003, would be the first step toward an eventual Free Trade Area of the Americas, that is the Western Hemisphere; in 2004, progress toward this goal was uncertain, although, as indicated later, not necessarily a loss. Another example is AFTA (the FTA of ASEAN, the Association of Southeast Asian Nations, ECOWAS (Economic Community of West African States), and SADC (Southern African Development Community, established in 1992 as a successor to the Southern African Coordination Conference (SADCC), founded in 1980 by nine antiapartheid independent states.

A customs union is exemplified by the European Community (EC), 1957 to 1970. In addition, the Mercado Comun del Sur (Mercosur) customs union, signed in 1991 by Brazil, Uruguay, Argentina, and Paraguay, provides for progressive tariff reduction (with a number of exceptions) and free movement of people. Other customs unions include the Andean Pact (Bolivia, Colombia, Ecuador, Peru, and Venezuela), and (despite its name) the Central American Common Market (CACM), which go beyond the free trade area to retain common trade barriers against the rest of the world.

A common market moves a step beyond a customs union by allowing free labor and capital movement among member states. An economic union, not yet achieved by the European Union despite its name, goes further by unifying members’ monetary and fiscal policies. The success of the United States, whose 1789 constitution made 13 states a complete economic and monetary union, and that of the EU have partly served as a spur to increased economic integration by LDCs (Asante 1986:24–28; Salvatore 1995:299–328; Schiff and Winters 2003:26–29).

The African Economic Community (AEC), in operation since 1991, seeks to create an African Common Market (ACM) in six stages, using the nine existing regional trade organizations as building blocs. The contributors to Daniel Bach’s Regionalisation in Africa (1999) indicate that, except for what was the franc (now pegged to the euro) zone, African regional trade organizations (including the ACM) exist only on paper. Borders are generally not costly impediments to the movements of goods and resources, however, even in failed states, as there is a large volume of unrecorded trade, including drugs and mineral smuggling.

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Many LDC attempts at economic integration have not succeeded. Sometimes less advanced nations have been discontented that the most advanced members of the union receive (or are thought to receive) the lion’s share of the benefits. East African Cooperation (EAC), an example of this discontent, broke up in 1977 and was revived in 1996; the overwhelming amount of new industrial investment went to the relatively developed center, Nairobi, and other cities in Kenya. Working out agreements to compensate members with the smallest shares of gains, or to assign some industries to each member country, is difficult. Moreover, the market size of many unions, such as the EAC and CACM, is too small to attract industries that require substantial internal economies of scale. A related dilemma is an externally oriented transport system that lacks adequate intraregional transportation facilities (Kreinin 1987:394–396). Furthermore, although theory indicates the union gains most from specialization reallocation from less efficient producers exiting the industry and shifting their resources to activities with a greater comparative advantage, most LDCs perceive this “creative destruction” as harmful. LDCs made only modest gains in South–South integration and trade in the last half of the 20th century. However, because of the increasing importance of the South in global income trade, we can expect increasing efforts at integration of the developing world.

We turn now to a consideration of LDCs involved in efforts at regional economic integration with DCs beyond efforts by the European Union with ACP countries. All 15 E.U. members before 2004 plus Slovenia (ahead of Greece and Portugal in the inside cover table) were high-income countries. The remaining former communist countries – Poland, Czech Republic, Hungary, Slovakia, Estonia, Latvia, and Lithuania – in addition to Malta and Cyprus, are middle-income countries. The major economic advantages to the 10 acceding countries are the continuing structural reforms of their economies, specialization and scale economies from integration into the world’s largest market (455 million in 2004), free movement of labor after 2011, and attracting capital flows because of lower labor and other input costs.

The gist of this chapter is to support an open, multilateral global free trade system to maximize growth and efficiency in resource allocation. Are preferential trade pacts building or stumbling blocs for an open multilateral system?

GATT (now WTO) allows regional trade organizations (RTOs) that remove barriers among members (in no more than 10 years after the formation of an RTO) and do not raise trade barriers against nonmembers. RTOs can reduce total world welfare by trade diversion from a member country displacing imports from a lowest-cost third country. NAFTA diverts some U.S. sourcing from lower-cost Korea, Taiwan, and Asian and Caribbean countries to Mexico. However, regional economic groups are also responsible for some trade creation, in which a beneficiary country’s firms displace inefficient domestic producers in a member country. For example, under NAFTA, the United States increased U.S. beef, pork, and poultry exports to Mexico, whereas Mexico increased exports of electronic products and ladies’ dresses to the United States.

But some economists are convinced that RTOs reduce world welfare. Grossman and Helpman (1994) argue that political pressures to form RTOs are greater when