DRD DISCUSSION PAPER Report No.DRD242 I ADJUSTAENT HITH A FIXED EXCHANGE RATE: CAl•IEROON, COTE d' IVOIRE AND SENEGAL by Shantayanan Devarajan I Harvard University and I Jairne de :1elo I I World Bank I L---~-------------------------------- j Development Resear~h Department Economics and Research Staff World Bank Tiw Horld Bank does not accept responsibility for the views expressed herein ~r:hicl;.a.r•:! those of the author(s) and should not be attributed to the World Bank or to its ilffiliated organizations. The findings, interpretations, and '.~Oth'lusions are the results of research supported by the Bank; they do not n~cessarily represent •1fficial policy of the Bank. The designations employed, tht: prt!.sentation of material, and any maps used in this document are solely for the c.onv~';nit:~nee of the reader and do not imply the expression of any opinion what~<>ever on tho part of the World Bank or its affiliates concerning the status of any country, territory, city, area~ or of its authorities, or the dc:!limitations of i.ts boundaries, or national affiliationo ADJUSTMENT WITH A FIXED EXCHANGE RATE: CAMEROON, COTE d'IVOIRE AND SENEGAL Shantayanan Devarajan Harvard University Jaime de Melo World Bank February 1987 We thank Dani Rodrik, Alan Gelb, Richard Westebbe, three anonymous referees and seminar participants at Georgetown University and at a CERDI conference in Clermon t-Ferrand for commen t.s on an earlier draft. Gabriel Castillo, Chris Danek, Julie Stanton Gwynn and Jackson Hagargee provided much appreciated support. The World Bank does not accept responsibility for the views expressed herein which are those of the authors and should not be attributed to the World Bank or to its affiliat8d organizations. Please address all correspondence to: Jaime de Melo, The World Bank, 1818 H Street, N.W., Washington, D. C. 20433, USA Abstract " As members of the CFA Franc Zone, Cameroon, Cote d'Ivoire and Senegal cannot use the nominal exchange rate as a tool of macroeconomic adjustment. We consider these countries' responses to the commodity and oil price shocks of the 1970s in light of this and other institutional constraints. Using a two-sector model we show there exist instruments that, in principle, permit the real exchange rate depreciation necessary for adjusting to macroeconomic imbalances. We interpret the very different adjustment experiences of the three countries (despite a common economic structure and institutional set- ting) in terms of different uses of these instruments. Alternative assump- tions about the labor market leave the qualitative nature of the results unaltered. Statistical analysis of data from the three countries confirms the model's linking of the current account and real exchange rate with the instruments of adjustment. ADJUSTMENT WlTH A FIXED EXCHANGE RATE CAMEROON, COTE d'IVOIRE AND SENEGAL I. Introduction A Like most developing countries, Cameroon, Cote d'Ivoire and Senegal were subjected to the external shocks of commodity booms and oil price hikes of the 1970s. As members of the CFA Zone (a monetary union with France) however, these countries could not devalue their nominal exchange rate to adjust to the macroeconomic imbalances that followed. The purpose of this paper is to interpret the adjustment experiences of these three countries in light of this and other institutional constraints. A The cases of Cameroon, Cote d' Ivoire, and Senegal are particularly interesting for another reason. In addition to sharing a common institutional framework for adjustment, they have a similar economic structure: all three are largely primary producers, with a small industrial base and service sector fueled by public expenditures. Yet the outcome of their adjustment experiences were quite different. By the early 1980s, Cameroon was enjoying low foreign debt and steady, 4 percent growth in GDP, while Cote d'Ivoire and Senegal were experiencing high debt-service payments and declining GDP. Our major conclusion is that membership in the CFA Zone does not, in principle, impede adjustment to macroeconomic imbalances. There exist enough instruments to achieve, for example, the real exchange rate depreciation that is necessary to redress a current account deficit. However, in practice, these instruments are not always used, or used in the wrong directlon, and this is why the outcomes were different in the three countries. To make these points, we first describe in the remainder of this Introduction the rules of CFA Zone membership. Next, we look closely at the - 2 - "' adjustment to shocks by Cameroon, Cote d'Ivoire and Senegal, using a set of common "adjustment indicators" for 1973-84 (Section II). These serve as the backdrop to a model of adjustment-with-a-fixed-exchange-rate presented in Section III. The model captures the distinctive features of CFA Zone economies as well as the instruments of adjustment to which they have access. While these countries cannot effect a nominal devaluation, the model shows how a real devaluation can be achieved by a reduction in government expenditure or a change in commercial policy. The roles of wage rigidity and unemployment are highlighted in the analysis. In Section IV, the model is "' tested using data from Cameroon, Cote d' Ivoire and Senegal. Conclusions follow in Section V. The CFA Zone consists of two monetary unions, the Union Moneta ire Ouest-Africaine (UMOA) and the members of the Banque des Etats de l'Afrique Centrale (BEAC). Participation in the Zone sets its members apart from most other developing countries in at least three ways. 1/ Monetary Integration: Member countries pool 65 percent of their foreign exchange reserves with the French treasury. Each union's central bank sets monetary policy based on its overall asset position, and all bank members face the same interest rate. ~/ The central bank influences an individual country's monetary position by imposing country-specific credit constraints and limiting each country's central government's borrowing to 20 percent of its pre ·ious year's fiscal receipts. J.! By pooling reserves, the countries avoid some of the seignorage costs of holding reserves. CurrenDy convertibility: The CFA Franc is convertible since it is guaranteed by the French Franc (FF), itself a convertible currency. Each country has an operations account with the French ·treasury which it can overdraw at a graduated interest rate that rises to the Bank of France's rediscount rate. There are no foreign exchange implications for transactions among Zone members. Convertibility does, however, have implications for asset choice by residents and, in the longer run, for foreign direct investment. Fixed exchange rate: The CFA Franc is pegged to the French Franc at an exchange rate (50 CFAF = 1 FF) that has remained - 3 - unchanged since 1948. Parity adjustment requires unanimous agreement among Zone members. Effectively, CFA countries cannot use nominal devaluation of the exchange rate as an instrument of macroeconomic adjustment. Although a type of CFA Franc had been in use during the colonial era, the two Central Banks were created when the majority of the members received their independence from France. In its early stages, the CFA Zone was de- signed as a means of providing balance of payments credit to these emerging nations. In addition, it was felt that a common and stable exchange rate would attract fo~eign investment into these countries. Over the long run, membership in the Zone has induced a sense of monetary and fiscal discipline, damping the "stop-go" cycles observed in many developing countries. Nevertheless, despite the general consensus that the monetary union has been working fairly well and that its members have probably fared better than they would have in its absence, concern has recently been raised that adjustments to macroeconomic imbalances have not been as prompt and complete as desirable, as sustained periods of real exchange rate apprecj at ion have been observed among many Zone members. Indeed, as a result of the turbulent 1970s, many CFA countries were experiencing macroeconomic "crises" in the early 1980s. Senegal and Cote d' Ivoire -- the two largest UMOA members -- had huge current account and public sector deficits that could in turn lead to debilitating debt-service payments in the future. Cameroon had become an oil exporter and was running sizeable current account surpluses. Some observers began questioning whether the particular nature of the CFA Zone prevented its members from adjusting their economies to these dramatic changes. To assess this question, we turn A now to a detailed analysis of the adjustment process in Cameroon, Cote d'Ivoire and Senegal. - 4- " 4/ I I. Case Stud~es of Adjustment: Cameroon, Cote d'Ivoire and Senegal All three ccuntr ies experienced windfall gains from the commodity "' price increases of the mid-seventies. Cameroon and especially the Cote d' Ivoire benefitted from the coffee and cocoa boom of 1975-77; 6/ Senegal enjoyed a phosphates boom in 1973. 11 In addition, Cameroon became a net oil exporter in 1980. Nevertheless, the adjustment experience of the three countries differed subs-cantially. External borrowing patterns varied as did the rel.:ltive contributions of the private and public sectors to the trade deficits or surp~uses. As suggested by the model to be presented in Section III, the compositional differences in expenditures in turn differentially affected the external sector's competitiveness in each country. To study the adjustment experience of each country, we use a matched set of adjustment indicators suggestive of the model to be presented below. These indicators measure the magnitude of the external shocks and help show how adjustment took place. A first set of indicators is constructed from price indices. The commodity terms-of-trade index is supplemented by an index measuring the ratio of the domestic producer price to the world price for the two most important " export commodities (coffee and cocoa for Cameroon and Cote d'Ivoire; phosphates and groundnuts for Senegal). The impact of the shock on the structure of production is measured by two real exchange rate indices. An index corresponding to the concept of the real exchange rate developed in the model of Section II I is constructed from national accounts data ( tradables include agriculture and industry and ncn-tradables account for the rest). A rise in the index signals an increase in the relative price of tradables. Second, a purchasing power parity index (PPPRER) is used to measure the - 5 - external competi ti·veness of manufacturing. This index is the ratio of an import-trade-weighted manufacturing wholesale price index (WPI) of trading partners to the domestic manufacturing WPI, so that a fall in the value of the index indicates a loss of manufacturing competitiveness. 8! The second set of adjustment indicators measures the sources of current account deficits and the composition of government expenditure. Observing that the current accoun~, CA (expressed as a pernentage of GDP) is equal to net domestic savings, He decompose it into its private and public sector components, i.e. ( 2. 1) CA = Sp - Ip + Sg - I g' where SP' Sg are private and public savings, and Ip, Ig are private and public investment. 2/ The usefulness of this decomposition derives not only from the fact that public sector deficits are, at least in principle, instruments of adjustment, but also from the observation that public sector spending is usually more intensive in non-tradables than private sector spending, an observation that will play a crucial role in the model of Section III. Finally public sector expenditure and investment patterns are tracked to see whether foreign borrowing is guided towards investment which, if it has a higher rate of return than the borrowing costs, would justify the increase in external debt. 2. 1. Cameroon Cameroon was subject to two major positive shocks in the late 1970s. First, the coffee and cocoa boom of 1975-76 J.ed to windfall gains for the commodity stabilization fund (ONCPB), as producer prices were kept down during the boom. Second, the discovery of offshore oil, which went into production - 6 - in 1978, created a one-time opportunity for the government to accelerate its development program. How did Cameroonian policymakers respond to these favorable shocks? Figure 1 summarizes the story. At the time of the 1976-77 coffee boom, pro- duction was at its lowest point since the 1960s. The "spending effect" of the boom was therefore not substantial. The real exchange rate did not appreciate (although its rate of depreciation slowed). Nevertheless, manufacturing competitiveness continued its downward slide, reflecting the country's inward- looking industrial policy, rather than the effects of the shock. After the boom, the government raised producer prices of both cash crops while simultaneously restraining government spending (between 1976 and 1980, both government expenditure and investment declined). The post-1978 oil boom was of much greater significance, but elicited a similar response. While estimates vary, there is reason to believe that up to three-fourths of the oil revenues were saved abroad. 10/ This is confirmed by the sizeable current account surpluses recorded since 1978. In fact, the government has used the oil revenues to retire a small part of its foreign debt. Consequently, and in contrast to other oil exporters' experiences, Cameroon's real exchange rate continued to depreciate (even mining is excluded from tradables) in the first few years of the oil era (Figure 1). To the extent that this windfall was spent domestically, it was channeled into investment rather than consumption; while the share of p~blic expenditure in GDP fell slightly between 1978 and 1982, that of public investment almost doubled. It is often observed that a period of real exchange rate appreciation is followed by a consumption boom because the private sector perceives a - 7 - Figure 1 Cameroon Adiustn1ent Indicators T6rms of Trade Real Gross Dom•stic Product (tt'J'J. 1Ge) 110 (UI73 a 100) 210,-----------------------------------------~ 200 130 1110 180 110 '170 ISO 100 150 . 10 130 10 120 110 70 100 10 10 1170 li7S 1176 80+-----~~---r-----r-----r--~~--~~----~ 1179 1182 1170 1174 Ul?l Ratio of Producer to World Price (%) D•composltlon of Net Domestic Savings (Coffee + Cocoa 10 I,-----------~~~----0-M--~-----~---"--------~----; a .5:1 7 5 50 5 45 3 .., Ill: l 40 ~ 2 1 ~ l5 0 a. ~ 0+-----~-.=Z~~------~~~~--~. .------~ -1 30 25 _, -2 -4 20 -:s 15 1170 1172 ,.,. 1171 ,.,. 11.0 U112 tf84 -e -74-----~~~------~--------~----~~----~ 1970 Ul71 ;:, Pub.Surp Real Exchang• Rates Public Expenditur~ and Investment (1173 - 100) 170 14 110 u 12 I~ It I .COO lO 130 8 I) 0 120 : • 7 110 l ~ 8 100 • a. 5 tO 4 3 ao a 70 1970 1872 11174 ,.,. 1180 1~2 11&4 t tl70 1173 lt7S 1171 11lll2 - Pt~nt ... (fl't/II"A')_-~ Manufacturing lrw/CDfJ ---competitiveness Index (PPPRER) - 8 - permanent increase in wealth. This was avoided in Cameroon. That it was the private rather than the publJc net savings which rose simply reflects the system of budget accounting in Cameroon. The bulk of oil revenues and expenditures financed by them are entered in the compte hors budget, which is outside the official public financial accounts. The government has used its liquid position to raise the producer prices of cash crops, keeping the real exchange rate from appreciating and preventing the traditional export sector from contracting the "Dutch disease". The bias of the public expenditure mix towards investment rather than consumption has also been beneficial for future growth. Because money and real wages have risen, however, (the inevitable consequence of incomplete sterilization), manu[acturing 1 s international competitiveness has fallen, as shown by the PPPRER index. "' 2.2. Cote d 1 Ivoire " With coffee and cocoa accounting for 50 percent of Cote d 1 Ivoire 1 s export earnings, the 1975-77 boom in these commodities led to a sharp, but short-lived, improvement in the overall terms of trade, which then deterior- ated by a cumulative 37 percent between 1977 and 1980 (partly reflecting the 1979 oil price shock). As in Cameroon, the stabilization fund was the main recipient of the windfall gains between 1976 and 1978. The fund 1 s income reached 16 percent of GDP at the peak of the coffee and cocoa boom in 1977. " Faced with these rapid changes in its external environment, Cote d 1 Ivoire chose a different adjustment path from Cameroon. The government accelerated the investment program it had started around 197 4 (see Figure 2). The increase in public investment was mainly allocated to large projects with high unit costs, long gestation lags, and low foreign exchange earning - 9 - potential. Furthermore, and unlike the other two countries, the government increased the share of public expenditure in GDP immediately following the coffee boom. As suggested b:' the model in Section I I I, this expenditure pattern is consistent with the observed loss of manufacturing sector competitiveness. When the commodity boom came to an end, the government continued its investment program, increasing the share of public investment in GDP. Public expenditure also continued to rise rapidly; its share in GDP rose from 15 percent in 1977 to a peak of 26 percent in 1982. 11 I By contrast, the private sector adjusted rapidly on both sides of the boom, as shown in the decomposition of the net domestic savings. Private expenditure surged immediately following the boom, but fell just as quickly when the terms of trade deteriorated. Part of the increase in public sector borrowing was financed inter- nally (the money supply grew by 33 percent a year between 1975 and 1980), but much of it was external; the debt-service ratio (debt-service payments as a percentage of merchandise exports)~ which had averaged 8 percent during the 1965-75 period, quadrupled during 1980-85. When the time came to adjust in 1980, it was the private sector that generated the large surplus to service the increased external debt. Expenditure switching could have been achieved by reductions in the relative size of nontradable-intensive public expenditure; but little of this occurred. Instead the post-1980 adjustment was mostly achieved by private expenditure reduction an~ a consequent fall in GDP. This slow adjustment by the public sector contrasts sharply with Cameroon's experience. - 10 - Fi~tre 2 COTE d'IVOIRE Adiustment Indicators Terms of Trade Real Gross Domestic Product (1t7~ • 100) Indole t9?J ... 100 110 140 ISO ISO I ,:SO 120 120 ItO 110 100 100 10 10 80~~---r----~-----,--~--r-~--~~--~----~ ttl70 117S ltl78 1171 11&2 1970 1975 19.0 1982 Roti(o of Producer to World Price (%): Decomposition of Net Domestic Savings Coffee + Cocoa) 60~--------------------~---------------------, 18~--~------~~~-----~-~--p~-~--~--~--~-·-·--------------, 14 12 10 8 8 4 2 0~------~£:~~~---+~~~--.~------~~---1 -2 -a -a -10 20+-----~----~--~~----~~----~~--~--~~ -12+------r----~--~-,--~--r-----~----,-----~ 1970 1972 Ul7<4 1971'.1 11i180 1"1182 1984 1970 19?2 11)71 li80 liil82 o Pub.Surl)lu• Tradiii.Sol. Real Exchange Rates P1..1blic Expenditure and Investment (1973- 100) sna ... a i, coP 110 2? 26 25 lOS 24 23 100 22 21 ~ IJ!S 20 Ill 0 18 tKl 17 ~ s 16 as i 15 .. ~ ~ '" j~~ ~ 00 75 ?0 ..I 1170 Ul72 Ill?-' 197& 11J?II 1910 1982 19.... llil70 1\l?J .lil76 : 1979 1982 E)lp/COP + hw/COP - ~/Pnt - 11 - " The implications of Cote d'Ivoire's public sector "boom" for the real exchange rate closely follows the predictions of the model of Section III: an initial real exchange rate appreciation between 1975 and 1977, accompanied by a sharper and sustained loss of competitiveness for the manufacturing sector (see Figure 2). The developments following the commodity boom did not seriously reduce the prices of tradables relative to nontradables, which would have helped achieve expenditure switching towards nontradables and hence restore external balance. Two factors contributed. First, when the boom ended, taxation of coffee and cocoa was reduced, raising the relative price of a component of the tradable sector. Second, public investment had a sizeable import component. Nevertheless, manufacturing lost competitiveness rapidly as the public sector deficit. was financed by money creation. With a fixed exchange rate, expenditure switching would have been better achieved had the public sector curtailed its import-intensive expenditures. Unfortunately, this path was not followed. 2.3. Senegal The 1970s were a particularly volatile period for the Senegalese economy. A phosphates boom in 1973-75 E_/ was followed by two droughts, in 1977-78 and 1979-80. Most observers agree, however, that the policies follow- ing these shocks, as much as the disturbances themselves, brought on the economic crisis that gripped the country in the 1980s. The indicators in Figure 3 lend credence to this view. Soon after the phosphates boom, the real exchange rate appreciated because there was " little taxation of windfall gains as in Cameroon and Cote d'Ivoire. Windfall revenues were spent domestically on consumption rather than investment, as the two lower charts on the right show. Net dissaving was dominated by the - 12 - private sector 1 s contribution, and public investment 1 s share in GDP stayed practically constant. Moreover, when the terms of trade deteriorated after 1977, Senegal continued an expansionary policy of maintaining private consumption and expanding public consumption. The latter grew in real terms at an average rate of 6.7 percent a year during 1975-80, although per capita output fell by 0.6 percent a year during the period. This contributed to the continued real exchange rate appreciation. The government responded to the shocks of 1977/78 and 1979/80 by increasing consumer subsidies, public sector employment, and transfers to the parapublic sector. Meanwhile, incentives to produce exports showed little increase since the domestic prices of the main cash crops remained well below their world levels. The successive droughts and declining terms of trade called for an alternative adjustment path, namely for a real exchange rate depreciation. As the model below shows, this could have been achieved by cutting government expenditure, even if there had been relative price rigidities. The outcome of all this is shown in the stubbornly negative trade balance and oscillating GDP figures of the last fifteen years. In addition, Senegal faces a debt crisis, or more appropriately, a "creditworthiness crisis" in the mid-1980s. The government had to undertake draconian struct- ural adjustment measures in 1984. The results of this program have yet to be seen. There is little doubt, however, that a different set of responses to the favorable and unfavorable shocks of the 1970s would have led to less drastic cutbacks in the 1980s. In sum, despite similar characteristics and institutional frameworks, the three countries adjusted quite differently to a common sequence of terms- - 13 - Figure 3 Senegal Adiustment Indicators Terms of Trade Real Gross Domestic Product (117.5 • 100) (1873- 100) 124 145 122 120 140 ua It I 135 114 IJO nz 110 1.25 tOll 1041 120 104 102 '15 100 1 tO H II 105 14 12 100 10 u filS 1170 1t7S 1171 1170 IIU 1170 Ul72 1974 IG76 1978 11182 HI C.& : iRor~ of Producer. to Wort~ P osphates + Groundnuts Price (%): Decomposition of Net Domestic Savings __ 2 ~----------~~~~~---~---~---fi_w ~--~----------------~ 0~----------------~--------~~~------------~ ;:~ I /\1 -2 f; '~ /~ -& -· -10 -12 14 \ 12 ~. ._.__,. ___,__ - - - - ,- . ~- -. . - r- - -; -16 -Ia 1i: ISI70 li72 1974 15l76 1r.J78 lfil80 1952 11i11J4 -20 -22 -24~---------T--~------r-~--~--,---~~--~--~ tr.J70 t!a73 1971 1982 o Pub.S4olrp - Trado~.Sol Real Exchange Rates Public Expenditure and lnvestement tzs,---------------~'-''-'------~>------------------~ 3 1 00 Shares In GOP 24,-------~--------------------------------------~ 120 22 20 115 18 tto ,, lOS ,... 12 100 10 a 90 2 ~~~--~~--·r-~--~----~----r-~--r---~ 1170 0~----~----~-.--~~--~-.--~~--~--~ 1974 1978 1SI80 1!il82 1Sil84 Hl70 1972 1974 1978 1980 IQ4 + lrw/GCP - 14 - of-trade shocks. None avoided loss of external competitiveness in manufactur- ing, and only Cameroon avoided real exchange rate appreciation. JJ/ C~te d'Ivoire's manufacturing sector experienced a sustained loss of external competitiveness, and Senegal's real exchange rate appreciated. Given the magnitude of these swings, one must ask whether they could have been dampened so as to avoid costly resource shifts into, and then later out of, nontrad- ables. In our discussion above, we attributed these different patterns of real exchange rate behavior and loss of external competitiveness to different patterns of external borrowing, public expenditure levels and taxation of windfall gains. Below we show that this interpretation is consistent with predictions from a two sector model. The model is also useful tc determine the relative impact of alternative instruments to maintain real exchange rate stability and reduce exte~nal deficits. III. A Model of Medium Term Adjustment The popular model to analyze medium-term macroeconomic equilibrium (when nominal aggregate demand pressures are zero and the focus is on real variables) is the "dependent economy" model due to Salter ( 1959) and SvJan ( 1960) . In that model, the equilibrium r·eal exchange rate or relative price between tradables and nontradables depends on fundamentals (tastes and tech- nology in the relevant sectors) the level of capital inflows and the extent of price rigidity in the labor market or the nontradable sector. 14/ When a current account deficit, (i.e. absorption of goods and services exceeding current income must be eliminated a policy that allows the real exchange rate to depreciate is required. Defining the real exchange rate as - 15 - RER = (PT/PN)e, where e is the nominal exchange rate and PT and PN are indexes of tradable and nontradable sectors, in the case of the CFA Zone where e is fixed what is required is a policy that lower~ PN or the wage rate (in terms of foreign prices) unless fiscal policy is used to raise the relative price of tradables, PT. Thus a policy which switches expenditures towards nontradables is required in addition to an initial reduction in the level of expenditures so as to achieve external balance without experiencing a rise in unemployment. The above analysis leaves out the role of monetary policy in dealing with external imbalance. We now consider this. A current account deficit means the net financial asset position for the nation as a whole is deteriorating (for example, private capital inflow may be so great that Central Bank reserves are increasing). As indicated by equation 2. 1, the deficit may reflect a public or private sector deficit. With the exchange rate fixed, if there is a budget deficit that exceeds net private saving and autonomous capital inflow, foreign exchange reserves will be run down and, unless there is sterilization, the domestic assets of the banking system will decline. The automatic monetary mechanism will then tend to eliminate the deficit as the price of nontradables falls relative to tradables. In practice of course, there is at least partial sterilization of these monetary effects so that the flow equilibrium deficit is partly maintained. The implication of monetary union membership for CFA Zone countries is that there is a limit to the extent to which any individual country can sterilize the monetary implications of its external deficit. l§/ Effective monetary policy will thus speed up the monetary adjustments that are called for by a current account deficit if there is some relative price rigidity in - 16 - the economy. But the implications for the real economy of a current account deficit remain, regardless of the effectiveness of monetary pol icy. It is with these adjustments in the real economy that we are concerned with in the remainder of the paper. We r>eturn therefore to the standard analysis of expenditure policy mixes to restore external balance that are analyzed in the Salter-Swan ''depen- dent economy" model. Jll Here we propose to highlight more precisely what adjustment in real variables are required to correct an external deficit by extending the standard dependent-economy model to consider features typical of CFA Zone countries. 18/ First, a current account deficit is a national deficit. As such it is the sum of the private and public sector financial deficits, the private deficit being the excess of private investment over private savings and the public deficit being the budget deficit. The model recognizes this distinction and assumes -- to approximate the case studies under review-- that the private sector dt!ficit is always zero (i.e. the private sector does not borrow or lend to the government or from or to foreigners). Therefore the current account deficit is the budget deficit. Second, access to the French treasury implies that external borrowing is a possibility open to these countries whenever it is necessary to adjust to macroeconomic disequilibrium. Third, because the exchange rate cannot be used for expenditure switching, trade taxes/subsidies are an important means of adjustment to a current account imbalance. Hence they are included in our analysis. Fourth we consider structural characteristics by our selection of functional forms, thus departing from the standard dependent economy analysis: the export sector is the traditional, price-taking sector but the rest of the economy produces a good which is imperfectly substitutable with - 17 - the imported commodity. We refer to this sector as the "semi-tradable" sector and the elasticity of substitution in use between this sector's output and imports reflects the extent of "dependence" of the economy. 3.1 The Model A typical CFA Zone member's economy is characterized by a primary sector producing a cash crop (coffee, cocoa or groundnuts) that is almost entirely sold in world markets at an exogenously given dollar price, together with a small industrial sector and a sizeable nontradable sector. The indus- trial sector produces goods and services that are imperfect substitutes for goods sold in international markets; by contrast the cash crop is a homo- genous, undifferentiated product. Hence the distinction between the two sectors. Without much loss of generality, we can aggregate the industrial and non tradable sectors into a "semi·- tradable" sector. Since it includes manu- facturing, the semi-tradable sector competes for demand with foreign goods, albeit partially. For simplicity, we assume further that output in each sector is produced by a Cobb-Douglas production function. To reflect the medium term focus of the analysis ~1e assume sector-specific capital. This gives us the following production functions, with the terms for capital suppressed: ( 3. 1) E where E = output (equal to exports) of the primary sector L1 = labor employed in the primary sector. and (3.2) Q where - 18 - Q = output of semitradables L2 = labor employed in the semitradables sector. A bar over a variable indicates that the variable is exogenous. The output of the semi tradables sector is an imperfect substitute in private consumption with imports. Assume that preferences are described by a CES utility function. Then the demand for semitradables, C, and imports, M, is determined by: where P* = the exogenous world price of imports (chosen as numeraire) P = domestic price of semitradables e = the exchange rate (fixed by assumption and set equal to unity by choice of units) t = ad valorem tariff rate a = elasticity of substitution (equal to minus the own price- elasticity of demand for imports). K = a constant. C = private demand for semitradables. M = private demand for imports. Labor is the only mobile factor. If it is available in fixed supply ([) then we have the constraint: Alternatively, we consider the implications of a wage that is rigid in terms of consumption goods. We consider two variants suggested by the two consumption goods in the model. In the first one, we assume nominal wage rigidity in terms of the (tariff inclusive) import price and in the second, - 19 - rigidity in terms of the semi tradable sector price. In the first variant, unless the tariff rate changes, supply response will be from the semitradable sector; in variant two, supply response will be from the cash crop sector exclusively. In both instances, we relax the full employment assumption thereby incorporating Keynesian multiplier effects. In the first alternative, (3.4) is replaced by: (3.4') W/(P *(1 + t)e) =-W and in the second by: ( 3. 4'') W/P = W. Finally, profit maximization and perfect competition require equality of the value of marginal product across the two domestic sectors: (3.5) an(l-s)eAL~- 1 = SPBL~- 1 where n is the world price of the export sector and s is the ad-valorem export tax rate. We assume that the government exogenously purchases only semi- tradables, amounting to G. This assumption is subjected to sensitivity analysis and Appendix 1 formulates the model for the case where an exogenous fraction, m, of G is spent on imports. Mat~rial baJ ance for semi-tradables requires that: (3.6) Q =C+ G The government's budget ~onstraint is: (3.7) e(F + tP*M + snE) = PG where F is forei~n borrowing (e.g., borrowing from the operations account) by the governmen 1 and e the nominal exchange rate, set equal to unity. Net private domestic savings are assumed zero. - 20 - By Walras' Law (the equality between income, including foreign borrowing by the government, and expenditure), the difference between the value of imports and exports equals the current account deficit, F, i.e.: (3.8) * -rrE +F. PM= Since we have assumed for simplicity that the fiscal deficit is the cu:..·rent account deficit, this abstracts from any real effects arising out of the government's borrowing from the central bank, and from the fact that some foreign borrowing may be done by the private sector. This roughly fits the countries studied in which private borrowing was transitory whereas public borrowing was often sustained. Note further that (excluding the effects of taxes and subsidies) there are two relative prices in our model: -rr and P. A rise in -rr is an improvement in terms-of-trade. A rise in P is a rise in the price of semi- tradables relative to imports. A rise in 7r/P represents a change in the relative price of exportables to semi-tradables. Excluding again the effects of taxes and subsidies, 7r/P is the real exchange rate facing producers. In the remainder of the paper, when we speak of the real exchange rate we shall mean the value of 7r/P (inclusive of export taxes) since its value signals the relative profitability of engaging in exportables vs. domestic production (see Figure 4). The model represented by equations ( 3. 1) - ( 3. 8) is sufficiently simple for qualitative analysis. Its solution in log-differential form is given in the appendix and comparative static solutions for typical parameter values are given below. The model can also be illustrated graphi. · .. ly. We do "' so and show the effects of the shocks experienced by Cameroon, Cote d'Ivoire and Senegal, as well as of the policy responses (import tariffs, export taxes - 21 - and changes in government expenditure). We restrict ourselves in the graphical analysis to the full-employment case, leaving the implications of wage rigidity for the multiplier analysis reported in Section 3.3. 3.2 Graphical Analysis Figure 4 portrays an equilibrium in the model for the full employment case. Assume that export taxes and import tariffs are zero. Assume further that there are constant terms of trade, defined to equal 1 so that P* = n. The pror·tction functions together with the full-employment condition imply that there is a well-behaved transformation frontier between E and Q, as shown. For a given price ratio n/P, production is determined by the point at which the slope of the tangent equals n/P. The private consumer's budget line is given by the line from the production point with slope P*/P, which by assumption equals n/P, since s=t=O. Private consumption is determined by the point where the indifference curve is tangent to this budget line. Equilibrium is defined as the price level P where the production of the semitradable Q is exactly G units above private consumption of the semi tradable, C. The government budget deficit, which is here assumed to equal its consumption of semitradables G, is equal in value to the current account deficit OM 1 - OE 1 . Now suppose t>O. Holding P fixed, the consumer's budget line rotates clockwise (not drawn in Figure 4) and is no lopger equal to the producer budget line as P*(1+t)/P > n/P. If the substitution effect dominates the income effect of the tariff, the demand for C will rise and the relative price of the semitradable will have to rise to eliminate excess demand for Q. In - 22 - Figure 4 Equilibrium in the Dependent Economy Model ~ 1------ 1 i Icc l I - G ' l t e ~- ---: I 1T' -p 0 EI - 23 - the new equilibrium, the income consumption curve (ICC) will rotate counter- clockwise but by less than if P were to remain unchanged. In order to perform comparative statics exercises with this appar- atus, it is useful first to describe the supply and demand curves for semi tradables. This is done in Figure 5 where the top part of Figure 5 is used to motivate the shape of the privata demand curve, C, in the bottom part of Figure 5. For deriving total demand we consider only cases of a budget deficit (G > 0) so that the equiJibrium production point on the transformation frontier is above the intersection point of the relevant income consumption curve (ICC) with the budget line. As P rises, the slope of 1r/P flattens out and Q rises. Hence, the supply curve of Q is upward- sloping. The slope of the demand curve depends on a, the elasticity of substitution between imports and semitradables. Notice that for higher levels of P, not only does the slope of the consumer's budget line shift, but so does the point on the transformation frontier whence it is drawn. The latter represents the general equilibrium income effect while the slope rotation reflects the substitution effect. In equilibrium, the income effect for this nontraded good is not zero because the government buys a fixed amount, G, of it. Now consider extreme values of a in the top half of Figure 5. For a = 0, the income-consumption paths for all prices are a unique ray through the origin. In this case, asP falls (the slope of the tangent gets steeper), private demand for C declines. That is, the private demand curve for C in the bottom half of Figure 5a is upward-sloping. 1.2 1 With a = 0, there is no substitution effect; hence the general equilibrium income effect dominates. The intersection of C and S in the bottom half of Figure 5a is not an - 24 - Figure 5 Comparative Statics in the Dependent Economy Model (P2>P1) (J =0 r.= \ I I.e' (P,) I 1f/ti ( c(p1..) / ( t P,) E, M G(P1.). 1, the tariff lowers demand for M but raises it for C causing the demand curve in Figure 5{c) to shift to the right, raising P. - 26 - Whether or not P declines, an increase in the tariff rate lowers the current account deficit. This is because we assumed no private borrowing. If the private sector always balances its budget, the increased tariff revenues contribute one-for-one towards reversing the government's deficit, and therefore the trade deficit. Third, the same mechanism is at work for a favorable terms-of-trade shock (an increase in n). It will improve or worsen the current account deficit depending on the value of a. This can be explained by observing that the effect of an increase in n is to shift the supply curves for Q to the left. In addition, the demand curve shifts to the right (the income effect). For low a, this can lead to an increase in P and Q. If Q rises, E must fall, given the transformation frontier. Moreover, as P is higher demand for M is greater. The higher M and lower E leads to an unambiguous increase in the current account deficit. For high a, the substitution effect dominates, consumers demand less Q, thus releasing resources to the exportable sector and yielding an improvement in the current account deficit. Finally, the effect of an increase in the export tax is to shift the supply curves in Figure 5 to the right. Since exporting is less profitable, resources shift to semitradables. This always implies a decline in P~ For a low a, this shift also causes Q to decline, implying an increase in E. When a > 1, the impact on E is in the opposite direction. In both cases P declines. Moreover, the current account deficit improves because of the increased public revenues from the tax increase. - 27 - Figure 6 Current Account Multipliers *I IMPORT TARIFF EXPORT TAX RATE ;:j 0 -o5 -12 _, _," ~ _, -1 5 -1 5 -2 _,. ~ -1 7 -1 e -25 _, 9 -2 i . -21 -.:S 5 -22 -2 3 -4 -2 4 -2 5 -· 5 0::! 05 2 10 100 02 05 10 100 Su~titution Elasticity (~gno) Cl FLEXIEl.E WAGE + FIX WAGE P* ( 1 +t) <> FIX WAGE (P) GOVERNMENT EXPENDITURE TERMS OF TRADE _,0 -2 -3 _, -5 -6 -e..J -7 .. 6 ... I -8 i ••+----.-- -9 02 OS 5 10 100 02 05 10 100 :.1 Multipliers are defined as the percentage change in F = P*M - 1rE for a one percent change in the corresponding exogenous variable (e.g. the import tariff). - 28 - 3.3 Adjustment with Rigidity: Parametric Analysis We now supplement the graphical analysis with multiplier calculations derived from solving the model under different demand and supply elasticities and three different assumptions about labor market behavior. Since the elasticity of substitution in demand between imports and the semitradable is an important parameter, we start with a systematic variation of a under the three model variants. This allows us to examine simultaneously the influence of relative price rigidity and inflexibility in demand and supply. For all calculations, we take as a starting point a small government sector in total expenditures (i.e. a small budget deficit) and a small external deficit. Government expenditures are 5% of total expenditures, foreign exchange revenues are 95% of foreign exchange expenditures, and initial tariff and export taxes are 25% and 10% respectively. These parameter values are roughly representative of the initial situation in the three countries. Figures 6 and 7 display the_multipliers for the current account, F, and the real exchange rate, RER, where the plotted values are percentage changes in F and RER for a one percent change in the selected instrument (e.g. the import tar iff) or exogenous variable (e.g. the terms of trade) under different values for a. ~/ Starting with the current account multipliers for a given government expenditure increase, the more elastic is domestic demand (i.e. the higher the value of a) the less is the real exchange rate appreciation and hence the sma.ller is the corresponding increase in the current account deficit. The full employment case lies between the two fixed wage cases. When the wage is fixed with respect to the world price of imports, the semitradable sector can - 29 - Figure 7 Real Exchange Rate MultiQliers *I IMPORT TARIFF EXPORT TAX RATE 04 011!1 016 03 014 0.12 0.2 01 001!1 01 0.06 0 0.04 0.02 -o 1 0 02 -o2 ,04- 06 -oJ Otl -o' -o' 2 10 '100 02 OS s 10 100 0.2 o.s Substib.Jtlon Elasticlly (signa) 0 FLEXIBLE WAGE + FIX WA.:£. P*l1 +t) FIX WAG; (P) TERMS OF TRADE GOVERNMENT EXPENDITURE 0 08 -o05 06 04 -o1 02 -cHi -o2 -<1.2 -o4 -oe -o~ -oe -1 -o.3 -12 -oJS -1 4 _, 6 -o.4 _, 8 -2 -o 45. 10. 100 02 0!1 5 10 100 02 OS 2 *I Multipliers are defined as the percentage change in the real exchange rate RER = (n(1-s)/P) for a one percent change in the corresponding exogenous variable (e.g. the import tariff). - 30 - expand without limit, reducing the current account worsening. Fixing the real wage in semi tradables curtails its supply response which in turn raises the value of t~-.-- current account multiplier. Sensitivity analysis with the assumption that all government spending is on semitradables reveals that this conclusion is qualitatively robust. If 20 percent of government spending is on imports, the full employment deficit multiplier ranges from 3.7 to 3.4 as a ranges from 0.2 to 100. An improvement in the terms-of-trade on the one hand raises real in'.)ome which contributes to an increase in the current account deficit. On the other hand, government revenues rise even though the export tax rate remains unchanged. In turn lhis windfall gain reduces directly the current account deficit as the government deficit declines, real government spending remaining constant. For low values of a, the income effect dominates the substitution effect. P rises, attracting labor out of the cash crop sector, and leading to a shift in consumption towards impc~ts. Buth effects work to raise the current account deficit. Thus when the price elasticity of demand for imports is low, the current account will deteriorate when the terms of trade improve. The multiplier cnanges sign for values of a around 2 except for the case when the wage is tied to the numeraire which restricts the labor migration out of cash crops. This in turn contributes to a smaller current account deficit and hence to switching at a lower value of a. Multiplier values with respect to export taxes and tariffs should be viewed together since they are alternative instruments for achieving expendi- ture switching towards semi tradables. 22/ Raising a tar iff reduces the current account deficit both because it increases government revenues and because it lowers imports. The reduction in imports is much lower than the - 31 - tariff increase, so that tariff revenues always rise. However, this positive effect is mitigated by the resource shift out of cash crops (into semi- tradables). The positive effect of raisine_: a tariff to reduce the current account deficit is also mitigated in another way. Recall that government expenditure is fixed in quantities. The higher semitradable price accompany- ing the resource shift to semitradables increases the government's total expenditure which works to increase the current account deficit. An increase in export taxes also raises government revenues, and hence reduces the budget deficit. Although exports decline, the net effect is an increase in revenues from this source. It apo~ars from the multipliers in Figure 8 that an export tax is a more potent instr~ment than an import subsidy in reducing a current account deficit. This is because the current account is endogenous in our model. Note that this result obtains even though we assume an infinite foreign elasticity of demand for cash crop export.3. If the current account were fixed, then Lerner symmetry would prevail and an import tariff would be equivalent to an export tax. Indeed, the two multipliers converge to the same value as a + ro because, in this case, F + 0 and we approximate balanced trade at the margin. However, for finite values of a, especially in the plausible range 0.5 < a < 2, the export tax dominates the import tariff because of its impact on P. An export tax increase releases resources to the semitradable sector, increasing the latter's competitiveness and thereby lowering the deficit. By contrast, an import tariff, by increas- ing demand for semitradables, bids up P which counters the favorable impact of the increased tariff revenues on the deficit. In sum, raising the export tax on the cash crop sector lowers the level of exports, but the revenue effects - 32 - in reducing the government deficit -- are sufficiently strong to result in an improvement in the current acco~~t deficit. The above analysis can be used to shed light on another issue of current interest to CFA Zone members. Since they cannot devalue the nom\nal A exchange rate, some Zone members (Cote d' Ivoire and Senegal in particular) have introduced an import tariff combined with an export subsidy to "simulate" a real depreciation. In our framework, this amounts to combining the effects of the import tariff and a negative export tax. Our results show that, if the current account deficit were due to a fiscal deficit, such a tariff-cum- subsidy scheme may not have the desired effect. First, to the extent that the scheme is not revenue-neutral, it will affect the current account deficit, possibly in a perverse manner. Second, even if the scheme were revenue- neutral, it would not be "deficit neutral", given the change in the semi- tradable price. Unless government spending is also reduced, the tariff-cum- subsidy scheme can worsen the current account deficit and appreciate the real exchange rate. In comparing the impact of various tax and subsidy schemes, we are not addressing the question of allocative efficiency or its analogue, consumer welfare. An export tax or import tariff may improve the deficit, but what does it do to welfare? To answer this, an explicit welfare function must be introduced, which is somewhat problematic in our model with separate government expenditure and a non-zero trade deficit. The only result we can claim is that, if the welfare function were that implied by the demand system in (3.3), then the welfare maximizing tax to raise a given level of revenue would be an export tax of zero combined with an import tariff and domestic tax on semitradables at equal positive rates. This is a special case of the - 33 - result of Diamond and Mirrlees ( 1971) and is one of the recommendations in Shalizi and Squire (1986) for tax policy in Sub-Saharan Africa. Real exchange rate multipliers appear iP Figure 7. Their interpretation is straightforward. As a + oo, the autonomy of the relative price of the semitradable vanishes as the domestic relative price becomes determined by the fixed world price. Multiplier values approach zero, regardless of labor market assumptions. Also labor market assumptions do not affect multiplier values significantly in the range 0.5 < cr < 2. Finally the tariff and terms-of-trade multipliers change sign at a = 1 for reasons associated with the slope of the demand curve i~ Figure 5. We conclude with estimates of the likely range of real exchange rate and current account multipliers. The range is derived by assigning share parameters in the production functions that bracket the range of cash crop and manufacturing sector supply elasticities in the literature which we summarize in Appendix 2. This is done for the flexible wage model which is also likely to be more representative of labor market behavior in CFA countries. The multipliers are displayed in Table for two sets of values for m, the import share of government expenditure. How do these figures relate to the adjustment experience of Cameroon, " Cote d'Ivoire and Senegal? Consider first the multipliers displayed in Table 1 resulting from a terms-of-trade improvement with and without increase:3 in government spending and export taxation. The figures suggest that terms-of- trade improvements will result in real exchange rate appreciation if one considers the more realistic low elasticity case. This appreciation will be dampened by windfall taxation but is nonetheless likel- ;o prevail. Contrast - 34 - Table - -- 1 Multipliers Under Different Elasticities of Supply and Demand 11 Lot,; High a = 0.5; ¢ = 0.14 a= 2.0; ¢ = 1.7 Q = 0.2 Q = 0.85 Real Current Real Current Exchange Account Exchange Account Rate Deficit Rate Deficit m=O m=.2 m=O m=.2 m=O m=.2 m=O m=.2 Terms of Trade -1.7 -0.6 4.9 2.9 0.3 0.3 -1.7 -2.4 Gov't Expenditure -0.4 -0. 1 6.7 5.5 -0. 1 0.0 5.3 5. 1 Export tax 0.0 0.0 -3.3 -3.0 -0. 1 -0. 1 -2.0 -1.8 Import tariff 0. 1 0. 1 -2.2 -2. 1 0.0 0.0 -1.6 -1.6 1/ See Appendix 2 for definition and derivation of parameters ¢ and Q which stand for supply elasticities in agriculture and semi tradable sectors, respectively; m is the share of government expenditure that is imported. - 35 - " the experience of Cameroon and Cote d' Ivoire. Even though export taxes were " raised in Cote d' Ivoire, government spending was increased sharply and real exchange rate appreciation occurred. By contrast Cameroon avoided real ex- change rate appreciation by avoiding increases in government spending and by taxing the windfall gain. Now consider the adjustment phase that corresponds to the need to " reduce external financing. This was the situation facing Cote d'Ivoire in the early eighties. In the absence of devaluation, expenditure switching can in principle be achieved by a combination of decreases in export taxes and gover- nment spending, and increases in tariffs. However, in the low elasticity case, changes in export taxes have no effect or1 the real exchange rate, where- as when the elasticity is high, import tariffs become an ineffective instru- ment. Nevertheless, increases in export taxes are a more effective way of reducing the external deficit than increases in tariffs even when the supply elasticity in the cash crop sector is low. Reduction in the government deficit has the highest multiplier value on the current account and is not very sensitive to the range of elasticities considered. Note finally that the results are robust to variations in the import content of government expend- iture, signifying that it is the size of the budget, rather than its composition, that is crucial. IV. Determinants of the Current Account and Real Exchange Rates The case studies as well as the model results suggest some fundamental determinants of the current account and the real exchange rate for CFA Zone countries. Therefore, we conclude ~ith a statistical analysis of the current account and real exchange rate in the three countries. Ideally, - 36 - Table 2 Determinants of the Current Account (CAR) PUBDR DLNY WR DV 2 ( +) R2 DW X (-) (-) (-) (prob) p( -1) Cote la 0.8 -26.0 -1.6 13 ~7 -0.4 d""Ivoire (2.4)** (2.5)** co. n 0.99 1.6 (O .13) ( 1. 5) 1965-84 lb 0.9 -19.1 o.o 0.99 10.5 -0.4 (2.8)** ( 2. 5)** (0 .o) 1.7 (0 .40) (1. 6) 2a 1.1 20.6 -3.1 Senegal (4.2)*** 0.99 2.2 9.5 -0.'3 (2.5)** (4. 9)*** (0.22) ( 1. 6) 1965-83 2b 1.2 18.9 0.1 -5.8 0.99 5.q (-0.3) (5.2)*** (2.2)** (2.1)** (4 .2)*** 2.1 (0 .54) (1.4) 3a 0.7 20.9 -0.'3 Cameroon (4. 6)*** 0.92 1. q 7.5 -0.4 (5.2)*** (0.3) (0 .58) ( l.R) 1965-83 3b 0.7 20.7 o.o (4. 5)*** 0.93 2.0 9.9 -0.3 (5.4)*** (1.2) (0.45) ( 1.5) Notes Expected signs in parentheses (under the variables). Definition of variables (also see text). CAR = (X-M)/GDP; PUBDR = (GR-GE)/GDP; DLNY = First difference of natural logarithm of real national income; WR = real manufacturing wage; DV = dummy variable (set to 1 for 1974- 85). Estimation: Ordinary least squares with 1st order correction for auto- correlation after data deflation to remove heteroskedasticity. 2 0 : E(u~) = cr ; Value in parentheses x is White2s (1980) statistic for H 2 is Prob > x . p(-1) is the estimated value for che first order autoregressive process. Intercepts omitted. *** = significance at 1% level; ** = significance at 5% level; * = significance at 10% level. - 37 - econometric analysis would proceed from full-information estimation of a structural simultaneous equation model of' the current account and the real exchange rate. Unfortunately, not enough restrictions can be imposed on the model in Section 3 for it to be identified. Availability of time series data for the three countries imposes further limitations. These considerations lead us to concentrate on reduced form estimation for the current account and the real exchange rate. Since our model suggests that these two variables are jointly and endogenously determined, neither variable is included in the estimation equation of the other. The results from estimating the current account and real exchange rate equations appear in Tables 2 and 3. For the current account equation, the dependent variable is the current account surplus over GDP, (X-M)/GDP, and the regressors with expected signs are: the public sector surplus, (GR- GE)/GDP (+); real national income growth, DLNY; the manufacturing sector real wage, WR(-) and a dummy variable, DV, taking a value of 1 for 197 4 and beyond, zero otherwise. Since we do not report values for the intercept, a negative (positive) sign for DV implies a smaller (larger) current account surplus for the post 1973 period. The x2 statistic is White's (1980) joint test for misspecification and heteroskedasticity. Hence, the relatively low values of the statistic in Table 2 are reassuring as they suggest both low heteroskedaticity and no serious misspecification. 2 31 The results indicate that public sector deficits consistently exerted pressure on the current account in the three countries, supporting the model of Section 3. Real income growth also contributed to the worsening external A position in Cote d' Ivoire but not in Senegal where, to the contrary, the current account improved with income growth. This is not surprising since - 38 - Table 3 Determinants of the Real Exchange Rate Multiplier (RER) PUBDR TOT 2 CO NCR DV DW X p(-1) (+) (-) (-) (-) R2 (pro b) Cote la 0.7 -o.s 2.0 1.0 16.7 -0.2 d'Ivoire (2.6)** (9 .. 7)*** (2.0)* 1.8 (0 .05) (0.8) 1965-84 lb .... 0.9 -7.5 11.3 -0.5 0.99 1.6 (1.5) ( 1. 8) * (0.08) (2. 7) 2a 2.7 -o.o -1.8 0.99 1.!1 II.o -0.3 Senegal (3.2)*** (0 .4) (0. 6) (0.23) (1.4) 1961-83 2b 2.8 2.0 -2.4 10.9 -0.3 (3.4)*** (1.0) (O.Q) 0.99 1.9 (0.28) (I. 5) 3a o.o 0.1 3.1 ().99 16.0 -0.7 Cameroon (0.1) (2. 7)** (0. 7) 1.2 (0.06) (4.0) 1965-83 3b 0.2 1.2 -L.4 16.1 -0.7 (0. 6) (0.5) (0.4) 0.99 1.1 (0.06) (3. 9) Notes Expected signs in parentheses (under the variables). Definition of variables (also see Table 2 and te~t). RER :: Ratio of agriculture and manufacturing price indexes to constructed and services price indixes. PUB DR = See Table 2. TOT = Ratio of indexes of exports to imports. CONCR = Official development assistance/GOP DV = Same as Table 2 Estimation: Ordinary least squares with 1st order correction for autocot'- relation after data deflation to remove heteroskedasticity. x2 is White's (1980) statistic for H0 : E(u~) = cr2 ; Value in parentheses is 2 l Prob > x . p(-1) is the estimated value for the first order autoregressive process. Intercepts omitted *** = Significance at 1% level; ** :: significance at 5% level; * = significance at 10% level. - 39 - Senegal suffered from droughts which, in turn, hampered export earnings. The positive influence of income growth on the current account of Cameroon is also to be expected from the impact of the oil discovery. The regressions also show a marked deterioration of the average current account deficit after 1974 " for Cote d'Ivoire and Senegal in comparison with the earlier period. Finally, the real wage variable does not enter significantly. This is not surprising since the wage series only pertain to manufacturing and had to be constructed from incomplete data. Turning to the results from the real exchange rate equation estimations in Table 3, the results are more mixed as misspecification and/or heteroskedasticity is present in most equations. Two new variables are introduced, concessionary lending/GDP, CONCR(-), and the terms of trade, TOT " (-). For example, for Cote d'Ivoire, much of the variation is ca~cured by the intercept. Though to a lesser degree, this also occurs for other equation estimates, probably suggesting that our measure of the real exchange rate index which corresponds closely to our model (namely the relative price of agricult11re and manufacturing) 24/ is inaccurately measured. However, the significantly negative value for the dummy variable in the equations for Senegal confirms a sharp real exchange rate appreciation after 1974, as government policy and droughts combined to sustain a deteriorating external balance. V. Conclusions This paper has addressed the theme of medium-term macroeconomic adjustment with a fixed exchange rate in three countries in the CFA Zone: A Cameroon, Cote d' Ivoire and Senegal. We showed how different adjustment - 40 - responses to similar shocks took place in the three countries. In Cameroon, despite i~proved terms of trade and windfall gains from the oil price hike of the late seventies, the government avoided real exchange rate appreciation by restraining public expenditure and sterilizing most of the foreign exchange gains. The real exchange rate was also stabilized by taxing the proceeds of coffee and cocoa exports during the boom and then raising producer prices when "' the boom was over. By contrast, Cote d'Ivoire expanded public sector investment, financing it partly by external borrowing. The real exchange rate appreciated and manufacturing sector competitiveness fell sharply for some time until adjustment to the growing external deficit took place. In Senegal, public sector subsidies continued to be financed by taxation of exports so the real exchange rate depreciation needed after successive droughts did not occur. The government remained in deficit and adjustment was postponed. "' Unlike Cameroon, therefore, neither Senegal nor the Cote d'Ivoire achieved the real exchange rate depreciation called for by adverse terms-of-trade and output trends. These three cases led us to develop a stylized dependent-economy model to show the relationship between the instruments of adjustment (tariffs, taxes and government expenditure) and the associated targets (the real exchange rate and the current account deficit). This model was then used to illustrate the combination of current account deficits and real exchange rate changes resulting from a terms of trade shock and different government ex- penditure patterns. The model also highlighted the implications for the real exchange rate of changes in taxation of cash crops and in restrictions on imports. - 41 - Finally we used reduced-form estimation to analyze the determinants of the real exchange rate and current account in the three countries. The results indicate that a small number of variables explain a great part of the real exchange rate and current account variations in the three countries over the period 1963-85. Although a structural model corresponding to the stylized model would need to be estimated to explore further its usefulness, the reduced form results are consistent with the model in the text. - 42 - APPENDIX 1 Solution of the Model The model considered in tte main text is repeated here for convenience in level form. Exogenous variables are indicated with a bar and parameters with greek letters. The equations describing the full employment version are: E = ALa. 1 ( 3. 1) Q = BLS 2 (3.2) c a K(P*(~+t)e) M= (3.3) L1+ L2 =[ . !, (3.4) - a.-1 1 a.n(l-s)eAL 1 = SPLS- 2 (3.5) Q =c + G( 1-m) (3.6) e[F + tP*M + sn]E = (1-m) PG + mP *- G (3.7) * P (M + mG) =n E+ F (3.8) This is a system of eight equations with the follo~Jing eight endogenous variables: Q, M, E, C, L1 , L2 , P, F. Exogenous policy variables are G, t, s, and m, the fraction of government expenditures spent on imports. The terms- of-trade represented by n, are also considered exogenous. The model is homogenous of degree zero in all prices and the exchange rate, so we select P* =1 as numeraire and by choice of units we choose e = 1. Thus, a terms of - 43 - trade change will come from changes in the exogenous export price n. When the wage is fixed in terms of the domestic price of the import good, ( 3. 4) is replaced by W/(P * (1+t)e) =Wand when it is fixed in terms of the price of the semitradable, P, (3.4) is replaced by W/P = W. Log-differentiation of the above system of equations yields the "' following (where Z = dZ/Z): E = aL (A1) 1 Q = SL ( A2) 2 " " c - M= a('r - P) ( A3) "' J.L1 + (1-J.)L 2 = 0 (A4) ~ ~ n+~ +(a-1) L = P + (S-1)L 2 (A5) 1 ~ " "' yG + (1-y)C = Q (A6) #"'. " A A ,... ;o.. 1'\ ~ F (A7) -" 3 + "' ~ 1 (t + M) + " A ~ (s 2 + n +E) = (1-e)P + G ,.,_ M + pG = o(n +E) + (1 - o)F (A8) where "' t ~ G mP *- G T =T+tt y = G+ C 8 = (1-m)PG + mP *- G L1 tM snE f. = L1 + L2 111 - PG' ~2 = PG and 113 = 1 - 111 - 112 -s 'lfE mG ~- = 1 - s s 0 =M p = M + mG When W/(P*(1+t)) = W, (A4) becomes W = -r, and when W/P = W, (A4) becomes W= P. - 44 - Note from the definition of the parameters that an increase in the tariff rate implies an increase in T but that an increase in the export tax implies a decrease in '· Combining (A1), (A2), (A4) and (A5) gives us the following output supply elasticities for the export and semi-tradables sectors E =~ (1T - p + ,) (A9) ,.. "' E = .)

-(1-S) + (1->.)(1-a.)