X >PS - i 2 p9
POLICY RESEARCH WORKING PAPER   2289
Exchange Rate                                                       Lessons from world
experience about the
Overvaluation and                                                   consequences of exchange
Trade  Protection                                                   rate overvaluation (the
frequent cause of
trade crises), the
Lessons from   Experience                                           consequences of trying to
defend an overvalued
exchange rate, and the most
Howard J. Shatz                                                     appropriate policies for
David G. Tarr                                                       resolving an overvaluation
The World Bank
Development Research Group
Trade                                                                       H
February 2000



POLICY RESEARCH WORKING PAPER 2289
Summary findings
Despite a trend toward more flexible exchange rates,        world trading community. In fact, an overvalued
more than half the world's countries maintain fixed or      exchange rate is often the root cause of protection,
managed exchange rates. In the 1980s and 1990s,             preventing the count:ry from returning to more liberal
developing countries as a group progressively liberalized   trade policies that allow growth and integration into the
their trade regimes, but some governments defend their      world community without exchange rate adjustment.
exchange rate in actions that run counter to long-run         Most developing countries have downward price and
plans for liberalization.                                   wage rigidities and, with an external trade deficit, require
Without discussing the relative merits of fixed and      some form of nominal exchange rate adjustment to
flexible exchange rate systems, Shatz and Tarr note that    restore external equilibrium.
exchange rate management in many countries has                Shatz and Tarr pr-sent cross-country econometric and
resulted in overvaluation of the real exchange rate.        case study evidence - citing examples from Argentina,
Roughly 25 percent of the countries for which data are      Chile, Ghana, the Republic of Korea, Malaysia, Turkey,
available have overvalued exchange rates, with black        Uruguay, and Sub-Saharan Africa (including the CFA
market premiums from 10 percent to more than 100            zone) -  that overvalued exchange rates reduce
percent.                                                    economic growth.
After surveying the literature, the authors present         Defending the exchange rate, they show, has no
lessons from experience about what has worked (or not)      medium-term benefits, since falling reserves will
in response to crises involving external shocks and         eventually force devaluation. Better to have devaluation
external trade deficits - and why.                          occur without further debilitating losses in reserves and
Trying to defend an overvalued exchange rate with        lost productivity because of import controls. After
protectionist trade policies is a classic pattern, but      devaluation the exchange rate will reach a new
experience shows such protection to significantly retard    equilibrium, strongly influenced by government and
the country's growth and delay its integration into the     central bank policies.
This paper - a product of Trade, Development Research Group - is part of a larger effort in the group to assess the
consequences of trade liberalization in developing countries. Copies of the paper are available free from the World Bank,
1818 H Street, NW, Washington, DC 20433. Please contact Lili Tabada, room MC3-333, telephone 202-473-6896, fax
202-522-1159, email address Itabada@worldbank.org. Policy Research Working Papers are also posted on the Web at
www.worldbank.org/research/workingpapers. David Tarr may be contacted at c.tarr@worldbank.org. February 2000.
(27 pages)
The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about
development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The
papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this
paper are entirely those of the authors. They do not necessarily represent the view of the Wsrld Bank, its Executive Directors, or the
countries they represent.
Produced by the Policy Research Dissemination Center



Exchange Rate Overvaluation and Trade Protection:
Lessons from Experience
Howard J. Shatz
Center for International Development at Harvard University
and
David G. Tarr*
Development Research Group, The World Bank
* We would like to thank: Julian Berengaut, Dominique Desruelle and Paul Ross of the
International Monetary Fund; Arup Banerji, Fred King, Kiyoshi Kodera, Lawrence
Hinkle, Albert Martinez, Will Martin, Francis Ng and Maurice Schiff of the World Bank;
numerous officials of the Government of Kazakhstan and seminar participants at the
World Bank for helpful comments on earlier drafts. The views expressed are those of the
authors and do not necessarily reflect those of the World Bank, its Executive Directors,
any of its member governments, the International Monetary Fund, the Government of
Kazakhstan or those acknowledged.






Summary
Exchange Rate Overvaluation and Trade Protection:
Lessons from Experience
Despite a general trend toward more flexible exchange rate regimes, over half the
countries in the world maintain fixed or managed exchange rates. There are clearly
advantages and disadvantages of both fixed and flexible exchange rate systems and their
variants, and we do not discuss their relative merits in this paper. Rather, we note that, as
a practical matter, exchange rate management in many countries has resulted in
overvaluation of the real exchange rate. Estimates suggest that about 25 percent of the
countries for which we have data have overvalued exchange rates, with black market
premiums from 10 percent to more than 100 percent.
Since governments are frequently confronted with the problems of external
shocks and external trade deficits in the context of a fixed exchange rate regime, we
found that a concise survey of the literature in terms understandable to policy-makers
was needed. This paper presents worldwide experience regarding what has worked and
what has not worked in response to these crises, and why. It also assess the consequences
of overvaluation -- the frequent result or even cause of these crises -- the consequences of
trying to defend an overvalued exchange rate, and the most appropriate policies for
addressing an overvaluation.
Although as a group developing countries have progressively liberalized their
trade regimes during the 1980s and 1990s, some governments take actions to defend an
exchange rate that are counter to their long run trade liberalization. That is, one classic
pattern is to attempt to defend an overvalued exchange rate by protectionist trade policies.
Experience shows that protection to defend an overvalued exchange rate will
significantly retard the growth of the country and delay integration into the world trading
community. In fact, an overvalued exchange rate is often the root cause of protection,
and the country will be unable to return to the more liberal trade policies that allow
growth and integration into the world trading community without exchange rate
adjustment.
We briefly explain the benefits of an open trade regime, where we maintain that
protectionist policies seriously retard growth and integration into the world trading
community. We then provide a brief theoretical discussion of the many channels through
which an overvalued exchange rate hurts the economy and growth. We argue that the
vast majority of developing countries have downward price and wage rigidities and that
with an external trade deficit they require some form of nominal exchange rate
adjustment to restore external equilibrium. Next we present the cross-country
econometric evidence; this shows that overvalued exchange rates lower economic
growth. Subsequently we provide several specific country historical experiences (Chile,
Argentina, Uruguay, Turkey, Malaysia) where overvalued exchange rates led to severe
problems. In the case of Chile, the reversal of policies, from overvalued exchange rates
i



and protection to competitive exchange rates and low protection, has paved the way for
impressive growth. We also discuss the role of a competitive exchange rate policy in the
impressive Korean growth experience. Given the significant rolXe overvalued exchange
rates have played in Sub-Saharan Africa, we discuss this experience separately and in
some detail. We distinguish the CFA zone from the other countries and provide a case
study of Ghana.
Worldwide experience has shown that defending the exchange rate has no
medium-run benefits, since falling reserves will force devaluation eventually. It is better
that the devaluation be accomplished without further debilitating losses in reserves and
lost productivity due to import controls. Rather, the worldwide experience with
devaluations shows that, post-devaluation, the exchange rate will reach a new equilibrium
and that the equilibrium is strongly influenced by the policies of the central bank and the
government.
Given that the new trade protection in response to balance of payments crises
often leads to very diverse tariffs by sector and country, we discuss the adverse world
experience with industrial policy that provides very diverse incentives to industries.
ii



Exchange Rate Overvaluation and Trade Protection:
Lessons from Experience
Howard J. Shatz and David G. Tarr
Harvard University and The World Bank
I. Introduction
Despite a general trend in the world toward more flexible exchange rate regimes,
over half the countries in the world maintain fixed or managed exchange rates. '
Moreover, based on a fundamental measure of overvaluation, the black market premium,2
about 25 percent of the countries in the world have exchange rates that are overvalued by
at least 10 percent, and 19 countries have premiums of more than 25 percent. In 10
countries, the black-market premium exceeds 100 percent, which implies that the
exchange rate fails to serve its role in allocating foreign exchange.3
There are many reasons why countries maintain fixed exchange rate regimes:
Their currencies may be linked to the currency of a partner or partners, e.g., the
currencies of the CFA zone in Africa. The exchange rate may be used as a nominal
anchor, as in the Southern Cone of Latin America in the early 1980s. Or the exchange
rate regime may be employed as a means of regulating foreign trade, as in many of the
former communist countries.
There are clearly advantages and disadvantages of both fixed and flexible
exchange rate systems and their variants, and we do not discuss their relative merits in
this paper. Rather, we note that, as a practical matter, exchange rate management in
many countries in the world has resulted in overvaluation of the real exchange rate.
Overvaluation can arise from several factors. Among them: It is the nature of cycles of
international economic activity that from time to time countries are hit hard by external'
shocks. For developing countries, terms of trade shocks are often quite important,
deriving typically from significant swings in energy or commodity prices. Financial
1 As of the beginning of 1999 (the latest available data), the IMF (1999, Appendix I) reported arrangements
for 185 countries. The exchange rate regimes can be divided into pegged (84 countries), floating (75
countries) and limited flexibility (26 countries). Of the 84 with pegged exchange rates, 37 have no separate
legal tender, 8 use a currency board arrangement, 24 peg to another currency, and 15 to a composite of
currencies. Of those floating, 27 maintain a managed float and 48 an independent float.
2 The black market exchange rate is likely to be overly depreciated relative to an equilibrium long run real
exchange rate since an actual real depreciation would increase the supply and reduce the demand for
foreign exchange. See Ghei and Kamin (1999) for a detailed explanation and econometric evidence.
3See Global Currency Report (1999). 38 out of 160 countries had black market premiums of more than 10
percent at the end of 1998. Of these: 19 had premiums of more than 25 percent; 13 had premiums of more
than 50 percent; and 10 countries had premiums of more than 100 percent. These latter 10 included
Afghanistan, Algeria, Angola, Iraq, North Korea, Liberia, Libya, Myanmar, Sao Tome and Principe, and
Somalia.
1



crises are another important source of adverse external shocks, as financial crises
adversely affect not only the countries involved, but also their trading partners. These
external shocks may lead to overvaluation, as in Kazakhstan in 1999. Overvaluation may
be the result of a systemic shift in the competitiveness of a linked currency, as in the case
of the CFA zone in the late 1980s and early 1990s. In some cases inflation has eroded
the competitiveness of the real exchange rate while the nominal exchange rate served as a
nominal anchor (Southern Cone of Latin America in 1979-1982). Or a multiple exchange
rate regime may be used as a means of exercising control over the foreign trade and
exchange regime (e.g., Poland in the late 1980s).4
Although as a group developing countries have progressively liberalized their
trade regimes during the 1 980s and 1 990s, some governments take actions to defend an
exchange rate that are counter to their long run trade liberalization. That is, one classic
pattern is to attempt to defend an overvalued exchange rate by protectionist trade
policies.5 In the paper we present worldwide experience-what are the consequences of
defending an overvalued exchange rate regime. Experience shows that protection to
defend an overvalued exchange rate will significantly retard the medium to long run
growth prospects of the country and delay integration into the world trading community.
In fact, an overvalued exchange rate is often the root cause of protection, and the country
will be unable to return to the more liberal trade policies that allow growth and
integration into the world trading community without exchange r ate adjustment.
Moreover, a devaluation of the nominal exchange rate appears a necessary condition for
achieving a large depreciation of the real exchange rate, as virtually all real devaluations
(above 25-35 percent) have been accompanied by nominal devaluations (Ghei and
Hinkle, 1999).
This paper is organized as follows. In the remainder of thiis section, we set the
stage by discussing the recent experience of Kazakhstan and defining the key concepts of
internal and external balance. In section II, we briefly explain the benefits of an open
trade regime, where we maintain that protectionist policies seriously retard growth and
integration into the world trading community. In section III we extensively treat the
problems caused by an overvalued exchange rate. We begin with a theoretical discussion
of many channels through which an overvalued exchange rate htrts the economy and
growth. We then argue that the vast majority of developing countries have downward
price and wage rigidities that require some form of nominal exchange rate adjustment to
restore external equilibrium. Next we present the cross-country econometric evidence;
this shows that overvalued exchange rates lower economic growth. Subsequently we
provide several specific country historical experiences (Chile, Argentina, Uruguay,
Turkey, Malaysia) where overvalued exchange rates led to severe problems. In the case
of Chile, the reversal of policies, from overvalued exchange rates and protection to
competitive exchange rates and low protection, has paved the way for impressive growth.
4See Tarr (1990, 1990a, 1994).
5 Ghei and Pritchett (1999) call this the "import compression syndrome." Since devaluations (which reduce
imports) are often accompanied by reductions of trade barriers (which increase imports), econometric
evidence on the import reducing impact of devaluation has been weak. Ghei and Pritchett estimate that
devaluations will reduce imports if import compression is properly accounted for.
2



We also discuss the role of a competitive exchange rate policy in the impressive Korean
growth experience. Given the significant role overvalued exchange rates have played in
Sub-Saharan Africa, we discuss this experience separately and in some detail in section
IV. Finally, in section V, given that the new trade protection in response to balance of
payments crises often leads to very diverse tariffs by sector and country, we discuss the
adverse world experience with industrial policy that provides very diverse incentives to
industries.
The Kazakhstan Experience
The first draft of this paper was written in March 1999 due to the practical need to
provide policy advice to Kazakhstan, which was in the middle of a crisis induced by
external shocks. The authors found that a concise survey of the literature in terms
understandable to policy-makers was needed. This paper should be useful as a basis of
discussion in other countries when similar crises arise.
It is useful to discuss some of the specifics of the crisis in Kazakhstan in early
1999 as a motivation for the broader discussion to follow. Kazakhstan suffered several
adverse external shocks in late 1998: it was hit by a fall in the international price of oil
(its principal export product), the East Asian crisis and, most importantly, the Russian
crisis and the Russian ruble devaluation. Given the lack of sufficient adjustment in the
nominal exchange rate, the Kazakhstan tenge became significantly overvalued during
early 1999.6 Kazakhstan defended the tenge with bans on imports from Russia of many
categories of foodstuffs, prohibitively high tariffs on imports of several categories of
products from Kyrgyzstan and Uzbekistan, and threatened "antidumping" actions.7
These actions were potentially disastrous for Kazakh economic growth.
6 While the tenge depreciated in real terms against the US dollar (by about 15 percent from July 1998 to
January 1999) and many other Western currencies, it significantly appreciated in real terms against the
Russia ruble (by about 68 percent from July 1998 to January 1999). Since Russia is the most important
trading partner of Kazakhstan, the data show that a significant real appreciation of the tenge occurred.
Taking all trading partners into account, the real exchange rate appreciated by about 19 percent between
July and December of 1998. The overvaluation resulted in loss of competitiveness relative to partners in
the region, especially Russia, and difficulty in defending the exchange rate. The precise quantitative extent
of the overvaluation is beyond the scope of this note, but the data combined with the difficulties in
defending the exchange rate clearly indicate that the tenge was overvalued.
7 Most countries in the world apply at least some level of tariffs for protective purposes. Compared with
tariffs in the customs code or "safeguard" actions, however, antidumping is an especially inappropriate
manner of conducting international trade policy. The reason is that when import protection is applied, the
costs and benefits to the nation should be evaluated. Evaluation of the relative costs and benefits is
possible in a safeguard action or when the customs code is being changed. Antidumping, however, applies
a tariff based on the practice of a foreign company or country and never asks the relevant question of
whether application of the tariff is in the interest of the country. Moreover, exporters typically avoid
antidumping duties by agreeing to raise the price of their exports, which hurts the importing country by
having to pay higher prices for imports. See Finger (1991, 1996) for details and guidelines on how
protection should be applied.
3



Box I
Update of Events: Devaluation and Liberalization in Kazakhstan
On April 4, the Kazakh Government and the National Bank announced a free float of the
tenge's exchange rate. They also announced an end to the highly proteclive trade measures
introduced against Russia, Uzbekistan and Kyrgyzstan. The tenge first slumped to around 150 to
the dollar, but later, by mid-April fluctuated between 110-120 to the dollar, and by August 1999
was holding around 132 tenge to the dollar, compared to the pre-devaluation 88 tenge to the dollar
rate. The float was intended to boost Kazakh exports and to allow the National Bank to cease its
costly efforts to support the tenge. These efforts had depleted hard currency and gold reserves to
$1.7 billion, down from $1.9 billion in January.
Commenting on the government's actions, Prime Minister NurIan Balgimbayev noted that
due to devaluations among neighbor countries, Kazakhstan-produced goods had became
uncompetitive. Kazakhstan industry suffered from that, enterprises stopped operating and
unemployment increased. He indicated that foreign trade turnover of Kazakhstan was reduced by
almost 9%, or USD 1.3 billion with exports reduced by USD 1.25 billion. Kazakhstan had to
undertake urgent measures caused by purely external factors and economic policies of neighbor
countries. The trade protection was a response to those pressures.
He emphasized that henceforth the US dollar exchange rate will depend on demand and
supply at the foreign exchange market. The National Bank of Kazakhstun (NBK) will not
substantially intervene in this process. He said that until the announcement, the NBK was spending
its gold and foreign currency reserves in order to support the exchange rate at a certain level, but
that will not happen any longer. "We have no doubts regarding economic stability and our ability
to manage the economic situation... .NBK has significant gold and foreign currency reserves, but
what is the reason to give the currency away and support an excessively expensive tenge?"
Balgimbayev asked.
Regarding the highly protective trade measures against Russia, Kyrgyzstan and
Uzbekistan, he noted that Kazakhstan has borders open for thousands of kilometers with those
countries. Cheap goods from those countries easily compete with local producers and take foreign
currency out of the country. It is practically impossible to close the borders, and it is also wrong
from both economic and political points of view. "Russia and Central A,sian neighbors are our
friends, and there is no reason to develop trade wars. From this point of view, the only solution is
to introduce a floating exchange rate regime."
Source: Oxford Analytica, April 12, 1999 and August 17, 1999; Robert Lyle, Radio Free Europe,
April, 1999.
Some Kazakh authorities feared that devaluation would lead to an unstable
downward spiral of the exchange rate and possibly a Russia-style financial crisis. But the
banking crisis in Russia was precipitated more by the government default on ruble
denominated debt, which dramatically reduced the assets of many Russian banks
overnight; these conditions were not present in Kazakhstan. Moreover, the worldwide
experience, as well as recent experience in transition countries (for example, Ukraine,
Moldova and Russia) has shown that defending the exchange rate has no medium-run
benefits, since falling reserves will force devaluation eventually. It is better that the
devaluation be accomplished without further debilitating losses in reserves and lost
4



productivity due to import controls. Rather, the worldwide experience with devaluations
shows that, post-devaluation, the exchange rate will reach a new equilibrium and that the
equilibrium is strongly influenced by the policies of the central bank and the government.
In April 1999, Kazakh authorities allowed a float of the exchange rate and rev'ersed the
protectionist measures.
The Need to Restore Internal Balance
When a country experiences a deficit in its trade balance, it is not in "external"
balance. It follows from a national income accounting identity, however, that a trade
deficit means that the country is spending more than its income. That is, the trade deficit
allows the country to consume or spend beyond its income (or the value of what it is
producing). When a country's expenditure does not equal its income, it is not in
"internal" balance. These imbalances can severely impede country economic
performance, and it is these imbalances that countries suffering from external shocks
often face.
Although a nominal devaluation is designed to correct the problem of external
balance, it will also be important to assure internal balance or the trade deficit may not be
corrected by the nominal devaluation. For many developing countries the trade deficit
reflects the government's fiscal deficit, which is often financed by monetary expansion.
The monetary expansion in turn leads to inflation. The impact on the real exchange rate
of a nominal devaluation in this environment is likely to be eroded by inflation, since
high inflation tends to appreciate the real exchange rate, making elimination of the trade
deficit problematical.
In general, monetary or fiscal policies will have to be combined with exchange
rate policies to achieve both internal and external balance simultaneously. This is a
special case of a more general principle of economics that multiple policy targets
typically require multiple policy instruments. In this paper, however, we focus on the
experience of countries that have limited the use of exchange rate adjustment as an
economic policy instrument.
II. The Benefits of an Open Trade Regime
As we elaborate in the next section, a serious problem with exchange rate
overvaluation is that it often leads to the imposition of high tariff and non-tariff barriers
to international trade. Worldwide experience in the last 50 years, however, demonstrates
the benefits of open trade regimes. The OECD countries brought trade barriers down
through successive GATT/WTO negotiations and experienced sustained growth in trade
and incomes. Many developing country governments initially felt differently and
attempted to promote industrialization behind high protective barriers. But in the last ten
years or so, the balance of opinion has shifted in these countries as well, as evidence
accumulated that high rates of protection significantly depress economic development,
5



and that open trade regimes are more conducive to growth.8 Mor-eover, virtually all
recent development success stories have been based on strong indlustrial export growth
and relatively low barriers to imports - Chile, Hong Kong, Malaysia, Mauritius, and
Singapore - or continually falling barriers - the Republic of Korea and Taiwan (China).
Industrial sectors in these economies not only have higher export: growth but generate
more employment as well; and trade reforms have usually been accompanied by
increased flows of foreign investment.
An effective trade policy is central to the integration of developing countries into
the international economic system and the growth that will generate. It provides links
with international markets, and, together with the exchange rate, forms the transmission
mechanism through which international trade affects domestic resource allocation, the
efficient and competitive restructuring of industry and agriculture, access to new and
diverse technologies, improved incentives to exporters, and reduction of smuggling, rent-
seeking9 and corruption in customs.
Tariff policy is the centerpiece of trade policy in a markei: system. Tariffs are,
with very few exceptions, the only acceptable policy tool for pro tection under the
GATT/WTO. They are superior to alternative instruments of protection, such as non-
tariff barriers (NTBs) like quotas, licenses and technical barriers to trade (TBTs), because
they are less likely to lead to rent seeking and corrupt practices, and because tariffs limit
the exercise of domestic monopoly power where it exists whereas NTBs do not.
III. The Problems of an Overvalued Exchange Rate
Experience has shown that countries that attempt to maintain overvalued
exchange rates significantly impede their growth in the medium t;o long term. Theory,
cross-country statistical studies, and case histories all reinforce the basic findings that
exchange rate overvaluation can reduce economic efficiency, misallocate resources,
increase capital flight, and most perniciously, lead to exchange aad trade controls.
Problems Caused by an Overvalued Exchange Rate - Theory
Theory suggests that there are many channels through which an overvalued
exchange rate hurts the economy and growth: (1) it discriminates against exports. Since a
significant portion of the costs of production is paid in domestic currency, the overvalued
exchange rate results in a reduction of incentives and ability of exporters to compete in
8Sachs and Warner in a recent article (1995) have estimated that open economies have grown about one
percent per year faster than closed economies, and that the difference is greater among developing
countries. For a review of the extensive literature on the link between open trade regimes and economic
growth see Edwards (1993). See also Dollar (1992).
9 Rent-seeking refers to the expenditure of resources to achieve a favorable re,gulatory intervention by
government. In this context, it refers to lobbying of government officials (including bribes) to achieve
protection from international competition. It is generally rather inefficient since resources that could be
used on productive activities are diverted to influence government decisions regarding protection.
6



foreign markets. This chokes foreign exchange receipts and damages a country's ability
to purchase the imports needed for economic activity; (2) an overvalued exchange rate
means that import-competing industries are faced with increased pressure from foreign
companies, resulting in increased calls for protection against imports from industrial and
agricultural lobbies. The political pressures for protection eventually prove to be
overwhelming and governments yield to lobbying and offer increased tariffs on imports.
This closes the economy to international competition, reduces access to needed imported
inputs and technology, and growth falls as a result. Devaluation serves the dual purpose
of unifornly protecting import competing industries and increasing the incentives to
exporters; (3) another way that overvalued exchange rates impede growth is that
productivity advances are less rapid. This is because the export sectors and the import
competing sectors are disadvantaged by an overvalued exchange rate, and it is in these
sectors that productivity advances are often most rapid (Cottani, Cavallo and Khan,
1990); (4) overvaluation induces capital flight among domestic citizens anticipating a
devaluation. As a result, less foreign exchange is available for needed imports; (5)
foreign exchange may become rationed and allocated inefficiently by the government;
and finally, (6) efforts to defend an overvalued exchange rate through very tight monetary
policy can plunge the country into severe recession. This last concern was very relevant
in Kazakhstan before the move to the free float, since monetary and fiscal policies were
under too much pressure to defend the exchange rate, risking adverse impacts on
investment and output.
The Problems with "Automatic" Adjustment Mechanisms to an Overvalued
Exchange Rate
Unless the central bank takes offsetting action, a trade deficit will result in a
decline in the domestic money supply. Thus, one response to an overvalued exchange
rate is to hold the nominal exchange rate fixed and assume that domestic prices and
wages will fall to help bring tradable goods prices back to internationally competitive
levels. This is the mechanism known as the specie flow mechanism described by David
Hume in the 18th century. The problem with this strategy is that prices and wages tend to
be sufficiently inflexible downward in most modem economies that sustained and
substantial periods of unemployment must be endured if the strategy is to have a chance
of being successful. Most countries are unwilling to endure these high costs.'0 Some
prominent examples are provided here. Further insight is provided in the section below
on "case studies of the effects of overvaluation."
England 1924. In October 1924, England embarked on a policy of increasing the
value of sterling relative to gold to its pre-World War I level. This amounted to a real
appreciation of 10 percent and required export industries to reduce their prices if they
wanted to stay internationally competitive. Furthermore, in order to avoid trade and
payments imbalances, the Bank of England increased interest rates and restricted lending
abroad. John Maynard Keynes (1925 in 1963 edition, pp. 247 and 256-257) described
the difficulties of this strategy:
'° See Sachs and Larrain (1999) for a further discussion.
7



Our export industries are suffering because they are the first to be asked to
accept the 10 per cent reduction . . . Our problem is to reduce money
wages and, through them, the cost of living, with the idea that, when the
circle is complete, real wages will be as high, or nearly as high, as before.
By what modus operandi does credit restriction attain this result? In no
other way than by the deliberate intensification of unemployment
(italics original).
CFA Zone. In more recent times, the CFA zone countries in Africa attempted
such internal adjustment during the period of their real overvaluation, 1986 to 1994
(Clement et al., 1996, and Nashashibi and Bazzoni, 1994). This resulted in disastrous
consequences for the CFA countries as the economic contractions in some of them were
comparable to the Great Depression of the United States. (See l.able 1 below for data on
the two largest CFA countries.) Large increases in poverty and other economic problems
ensued (see Devarajan and Hinkle, 1994, and further discussion in section IV).
Table 1. Comparing Great Depressionis:
Cameroon, C8te d'Ivoire and the United States
All numbers are the percentage decline in per capita GDP.
Measure of Output Decline \ Country    Cameroon    Cote d'Ivo ire      United States
Purchasing Power Parity a/            31.4              29.1               N.A.
Purchasing Power Parity with Terms of  38.5             34.5                N.A.
Trade adjustmentA'
Market Prices b/                      41.5              18.8               30.9
a Author's calculations for 1986-1992 from the Penn World Table Mark 5.6, described in Summers and
Heston (1991) and available on the website: http://pwt.econ.upenn.edu. Post-1992 data are unavailable.
b/ Authors' calculations from the peak to the trough of the depression. This is 1986-1994 for Cameroon
and C6te d'Ivoire, and 1929-1933 for the United States. Data are from the World Bank (1999) and
U.S. Bureau of the Census (1975).
c Not Available.
Governments tried especially hard to rein in wage costs, but without success. In
fact, wages actually rose relative to GDP. In addition, the high real exchange rate hurt
the export and formal manufacturing sectors, undermining the domestic tax base and
widening budget deficits. Furthermore, the economic slowdown called for by internal
adjustment caused a change in the composition of imports, to lower-value items, and
increased the level of informal imports so that tariff revenues also fell. This meant that at
a time when internal adjustment called for the CFA zone governments to decrease their
fiscal deficits, these deficits actually increased since the governments could not reduce
'1 For example, the incidence of poverty doubled in Cote d'Ivoire from 30 percent to 60 percent between
1985 and 1992.
8



their spending by as much as their revenue fell. As noted below, the CFA franc
devaluation of 1994 - external adjustment - was followed by a return of economic
growth and increased trade.
The CFA zone experience also casts doubt on the claim that countries should
avoid devaluations in order to retain international investors. The zone certainly had
stable prices and exchange rates, but its failure to solve the problems brought on by the
overvalued real exchange rate decreased its attractiveness to foreign investors
substantially. Capital flight increased in anticipation of an eventual devaluation (Clement
et al.).
Chile 1999. Faced with weak demand from Asia and falling prices for its
principal commodity export, copper, Chile saw its current account deficit widen and its
currency come under attack. At first the central bank raised interest rates, but the high
interest rates cut domestic demand on top of the decline in demand for exports, and
plunged the country into its worst recession in 16 years and its highest unemployment
rate in 10 years. On September 2, the Central Bank allowed the currency to float,
suspending its formal commitment to intervene in the foreign exchange markets to keep
the peso within a band. The currency immediately fell by a small step, from 519.35 to
the dollar to 523.25 to the dollar (Torres, 1999).
Real Exchange Rate Overvaluation and Cross-Country Economic Performance
Cottani, Cavallo, and Khan (1990) investigated the effects of real exchange rate
misalignment and variability on the economic performance of 24 developing countries
from 1960-1983. They found that exchange rate misalignment was strongly related to
low growth of per capita GDP. Furthermore, misalignment was also related to low
productivity. Capital did not go to the companies or sectors that could make the best use
of it. Finally, misalignment was also related to slow export growth and slow agricultural
growth.
A study of growth in 12 countries from 1965-1985 (Edwards, 1988 and 1989),
reinforced these findings.'2 The greater the misalignment, the lower the growth during
the period. Furthermore, exchange controls and trade impediments, proxied by the black
market exchange rate premium, were negatively related to growth. 13
In a study of economic growth in 18 Latin American countries between 1950 and
1980, Cardoso and Fishlow (1989) showed that growth was very uneven among the
12 The 12 are Brazil, Colombia, El Salvador, Greece, India, Israel, Malaysia, Philippines, South Africa, Sri
Lanka, Thailand, and Yugoslavia.
13 Faini and de Melo (1990) took a somewhat dimmer view of the impact of the real exchange rate on
economic performance. They found a positive, but usually not significant, relationship between
devaluations and the improvement of the trade balance for 49 developing countries between 1965 and
1985. However, they also found for a smaller sample, different because of data availability, that a
depreciated real exchange rate promoted investment. Furthermore, they found that for adjusting countries
during the 1980s, the higher prices of imported intermediates brought about by devaluations were not
important determinants of depressed investment.
9



countries of the region. They found that the most important determinant of Latin
American country growth rates in these years was export performance and access to
imports. While they did not discuss the real exchange rate, their findings are valuable for
showing the importance of the trade channels through which the exchange rate affects
country economic performance. Exports were important not only because competing in
international markets induced efficiency, but also because export earnings could avert
recurrent stabilization crises. Imports contributed to growth because the region's
industrialization strategy demanded imported inputs. Countries fbrced to limit their
imports performed less well.
Case Studies of the Effects of Overvaluation
The economic histories of developing countries that followed a classic import-
substituting industrialization strategy after World War II provide good illustrations of the
negative effects of an overvalued exchange rate combined with trade controls. Latin
America, more than any other region, followed this strategy but wvas not alone. We select
illustrative episodes from Argentina, Chile, Uruguay, and Turkey.
Argentina, Chile, and Uruguay. Argentina, Chile, and lJruguay all followed
import-substituting industrialization policies that led to a bias against exports, extremely
uneven rates of trade protection across sectors, and controlled financial systems. They
also experienced recurrent balance-of-payments crises and slow growth (Corbo, de Melo,
and Tybout, 1986). By the early 1970s, all three had accelerating; inflation, bottlenecks in
production, slow export growth, and balance of payments difficulties (Corbo and de
Melo, 1987).
In response, they went through two phases of stabilization and reform, one in the
mid-1970s and the other from 1979-1982. The second phase is most applicable to
judging the effects of an overvalued exchange rate and import controls on economic
performance.
In the second phase, all three countries used a nominal exchange rate anchor to
halt inflation. The exchange rate appreciated, and when it became apparent that the
nominal rate could not be sustained, capital flight resulted. In Uruguay and Argentina,
where there were no capital controls, major capital outflows occurred. In Chile, where
there were capital controls, people engaged in capital flight by buying imported consumer
durables. This capital flight occurred in all three countries well before the onset of the
debt crisis in 1982.
Other problems resulted. Profitability fell in the tradable goods sectors. In
Argentina, which remained quite restrictive to imports throughout, the gross margins of
exporting businesses were hurt much more than those of import-competing businesses.
In Uruguay, the rate of growth of nontraditional exports fell sharply from 1979-1981.
And in Chile, the leading growth sectors during the period became construction, internal
trade, and financial services, all nontradables, even though reforms during the 1975-1979
period had reduced the bias against exports significantly by June 1979.
10



Chile: The Aftermath. Chile is now well known for its economic success. Its
average annual rate of growth of real GDP has been more than 7% since 1984. Its
policies following a crisis of 1982-1983 are instructive.
It is true that Chile experienced high rates of growth in the late 1970s. This
followed a deep contraction in 1974-1975, and came as a result of a number of
deregulation and reform measures, including instituting a uniform 10% tariff on all goods
except automobiles. However, as alluded to above, inflation persisted, hurting the
reforms, and Chile fought back with a fixed rate as a nominal anchor in 1979. Combined
with other policies, this at first led to large external borrowings, most of which were at
variable interest rates. In the early 1980s, the external financing dried up as confidence
in the sustainability of the exchange rate ebbed. Making matters worse, Chile
experienced a deterioration in the terms of trade, and then foreign interest rates rose,
further hurting the Chilean financial and business sectors. In 1982-1983 Chile
experienced its worst depression since the 1930s, with real GDP falling 15 percent.
During and immediately after the recession, Chile tried a number of policies,
including an increase in tariff rates to switch domestic spending to domestic products. In
June 1982, the government abandoned the fixed rate and eliminated compulsory wage
indexation, and initiated a series of nominal devaluations. For a short time, Chile
allowed the exchange rate to float (Corbo and Fischer, 1994). However, Chile then
followed an erratic policy, implementing five different exchange rate regimes (Laban and
Larrain, 1995).
In 1985 the government embarked on the strategy it maintains to this day,
specifically, an export-oriented structural adjustment. This included steady devaluations
and a staged lowering of uniform tariffs from 35% in 1984 to 11% by 1991. Importantly,
the new nominal exchange rate system featured a crawling band, and policy makers
intended to use it to maintain the international competitiveness of Chilean exports
(Dornbusch and Edwards, 1994). In fact, though they used the nominal rate as the policy
variable, they focused on the real exchange rate, adjusting the nominal rate for the
differential between domestic and foreign inflation. Using an index of 100 as the value
of the real rate in 1977, the real exchange rate appreciated to 84.5 in 1981, then fell to
118.2 in 1984, and then following the introduction of the new policy, depreciated to
145.2 in 1985. It continued depreciating to 180.1 in 1990 (Corbo and Fischer). In 1998
the Chilean legislature approved further lowering of the uniform tariff to 6% in stages,
and in late 1999 Chile abandoned the exchange-rate band system for a float.
The improved incentives to exporters from the reduction in the import tariff and
the devaluation led to an expansion of nontraditional exports (10.5% a year from 1985-
1989) and efficient import substitution. Macroeconomic stabilization, tax reform, and
cuts in govermment spending combined to promote savings and investment. And
privatization of state-owned firms, rehabilitation of the financial sector through
recapitalization, and the strengthening of bank regulation combined to spur private
business activity.
11



Turkey. Three episodes from the post-WWII history of Turkey, recounted in
Krueger (1995), also illustrate the problems created by an overvalued exchange rate
combined with import restrictions.
Like the Latin American countries, Turkey followed an import-substituting
industrialization growth strategy. Starting in 1953, export growth ceased for a number of
reasons and inflation accelerated. Inflation combined with a fixed nominal exchange rate
meant a strengthening real exchange rate and a bias against exports. Foreign exchange
became scarce, so the country started import licensing in 1954. 'By 1957, export earnings
were falling and imports were severely restricted, damaging domestic economic activity.
By 1958, Turkey could not finance imports and it appeared that the country would not
even be able to obtain gasoline for trucks to move that year's harvest to ports. In
response, Turkey adopted an IMF stabilization plan featuring de valuation, import
liberalization, and fiscal and monetary restraint. Real GDP had been declining, but
started growing immediately in response to the availability of irnports. Inflation fell and
export earnings started to rise again. Turkey was among the most rapidly growing
developing countries of the 1960s.
In the late 1960s, however, Turkey's exchange rate agairn became overvalued due
to moderate inflation throughout the decade (five to 10 percent annually), combined with
a fixed nominal exchange rate. The high demand for imports combined with the bias
against exports caused foreign exchange to become scarce. The resulting problems
getting imports caused a slowdown in both production and real investment. The country
responded in 1970 with a nominal devaluation, and the result was extremely rapid export
growth. Turkey then experienced rapid economic growth through 1975.
The third Turkish episode occurred in the late 1970s. Large fiscal deficits, a
failure to change the internal price of oil following the 1973 oil shock, and an overvalued
exchange rate, made worse by extremely high inflation, spurred this third crisis. Once
again, the country ended up with severely constrained imports, f'alling real output, and
falling income.
Exchange Rates and Economic Performance in East Asia
Despite the recent Asia crisis, the record of economic development in Asia
remains enviable. A large reason for rapid Asian growth was exchange rate management
(Roemer, 1994). Successful Asian countries kept their nominal rates close to market-
clearing levels, exhibiting low or no parallel-market premiums. Importantly, this
flexibility allowed their real exchange rates to remain constant or depreciate gradually,
maintaining real returns to exporters over long periods. In some cases, policy makers
carried out nominal exchange rate devaluations with the real exchange rate in mind. Oil-
exporter Indonesia devalued substantially in 1978 even though export earnings were
rising, because policy makers were concerned that a real exchange rate appreciation
during the previous six years was hurting non-oil sectors. When oil prices fell in 1983,
12



export earnings were not as badly hurt as in other oil-exporting countries, and further
devaluations from 1983 to 1986 encouraged a non-oil export boom (Lewis and
McPherson, 1994). We present two more detailed cases, Korea and Malaysia.
Korea. Korea is often viewed as an example of a country that grew despite (or
because of) interventionist government policies. While the actual effect of government
policies is hotly debated, one fact is clear - Korea avoided overvaluation of its exchange
rate to encourage its exporters. Thus, many regard its exchange rate management policy
as a key to Korea's successful long-term economic performance (see Nam, 1995).
Before 1960, the government kept the nominal exchange rate fixed with only small
adjustments, resulting in overvaluation and balance-of-payments problems. These
problems forced the government to use multiple exchange rates, import licensing, and
high and diverse tariffs. In this way, Korea was a typical inward-looking developing
country.
Starting in the early 1960s, however, Korea shifted its strategy to export
orientation. It unified its exchange rate in 1961 and devalued from 130 won to the dollar
to 255 won to the dollar in May 1964. With Korean inflation much higher than the levels
of Korean trading partners, Korea avoided overvaluation by gradually devaluing the
nominal rate, reaching 893 to the dollar at the end of 1985.14 Only during the second half
of the 1970s, in an effort to dampen domestic inflation, did policy makers fix the nominal
rate at 484 won to the dollar. The fixed-rate policy, along with a number of other factors,
resulted in overvaluation and a stagnation in growth and export performance. These
economic problems led policymakers to devalue the won in 1980 to 580 to the dollar, the
first devaluation since 1974. Afterwards, they allowed the won to depreciate gradually
through the end of 1985.
The most telling result of Korea's policy of exchange rate flexibility is that from
1953 to 1960, per capita GDP measured in constant purchasing power parity dollars grew
at an average annual rate of 1.8 percent. From 1960 to 1991, it grew at an average annual
rate of 6.9 percent, from $904 to $7,251. Analyzing data for 126 countries for the period
1960 to 1992, Pritchett (1997) showed that Korea had the highest growth rate of real per
capita GDP measured in purchasing power parity dollars.'5 Nam reported that in
addition, exports rose even more rapidly than GNP. The ratio of exports to GNP was 2.4
percent in 1962, and 25.6 percent in 1991. Manufactured goods as a share of exports rose
from 27 percent in 1962 to 95.4 percent in 1991.
Malaysia. In some ways, the problems faced by Malaysia in the early 1980s were
similar to those of Africa, to be described in section IV. Malaysia faced decreases in
14 The nominal rate appreciated once again betweenl986 and 1989, and then depreciated through 1991, the
end of the period under study in Nam.
'5 Using real GNP data from the Bank of Korea, Nam reported an aggregate growth rate of 3.6 percent
annually in the 1950s, and 10.6 percent annually from 1962 to 1991. World Bank (1999) showed an
average annual growth rate of real aggregate GDP of 8.6 percent from 1962 to 1991, but did not have data
for the 1950s. The per capita GDP figures cited in the text and by Pritchett are from the Penn World Tables
Mark 5.6 (Summers and Heston, 1991). We downloaded the data from the University of Toronto,
http://datacentre.chass.utoronto.ca/pwt/index.html.
13



world commodity prices, a current account deficit, and an overvalued real exchange rate.
The country had a much more successful adjustment, however, and embarked on a
decade of rapid growth.
As recounted in Demery and Demery (1992), Malaysia had high levels of economic
growth and rapid rates of growth of manufacturing exports between 1968 and 1984, but was
a major natural resources exporter as well. Key commodity exporus included tin, rubber,
petroleum, natural gas, and palm oil. Commodity and oil prices boomed in 1979 and 1980,
and the government expanded spending. These prices started decl ining significantly in
1981. The terms of trade reversals cost the country real income amounting to seven percent
of GDP in 1981 and three percent in 1982. However, expecting the reversals to be
temporary, the government maintained its fiscal expansion, relying on foreign borrowing to
finance growing government deficits. The large inflows of debt finance, combined with
government spending tilted towards the nontradables sectors, resulted in an appreciation of
the real exchange rate.
Starting in 1984, the Malaysian government embarked on an adjustment program. It
cut government spending to reduce the deficit.36 To restore external competitiveness and
profitability in tradables, it depreciated the nominal exchange rate and reduced external
borrowing. Combined with lower domestic inflation, these policies led to a real
depreciation between 1985 and 1987 ofjust under 30 percent.
The change in the real exchange rate, along with the other adjustment policies, had
several beneficial effects. The current account returned to surplus in 1986 and 1987 and
resources started to move back to the tradables sectors.'7 The adjustment also restored
growth. According to World Bank data (World Bank, 1999), aggregate real GDP growth
averaged 8.3 percent annually from 1987 to 1991, well above the rates before the
adjustment.'8 And for the whole decade 1987 to 1996 aggregate real growth averaged 8.5
percent.
16 Lower tax revenues resulted in the deficit rising again in 1986 and 1987, though the government financed
this mostly with domestic borrowing. Foreign borrowing was actually negative in 1987. Another result of
the government's expenditure reduction policies was that private consumption and investment fell from
1984 to 1987. This kept demand for imports flat while the level of exports rose, helping bring the current
account back into balance.
17 Between 1979 and 1984, these sectors (agriculture, mining, and manufacturing) fell from 56 percent of
GDP to 52 percent, but recovered to 54 percent in 1987.
18 Although GDP grew by 6.8 percent annually between 1980 and 1984, Demery and Demery attribute this
largely to government spending, which was unsustainable, given the current account deficit, the growth of
government debt, and terms of trade reversals. During 1985 real GDP fell by 1I.1 percent, and then rose by
1.2 percent the next year.
14



IV. Exchange Rates and Economic Performance in Sub-Saharan Africa
Introduction
While the countries of post-colonial Africa represent a remarkable diversity of
people and geography, their economic policies leading up to the 1980s bore a striking
similarity (Foroutan, 1997). They established tight control over economic activity using
import and export quotas and prohibitions, price controls, foreign exchange controls,
interest rate ceilings, state-owned enterprises, and marketing monopolies. This produced
a layering of policies with a strong bias against trade (Nash, 1997). By the early 1980s,
many countries faced balance of payments crises and economic decline.
Terms of trade shocks played a large role in triggering these problems (Bouton,
Jones, and Kiguel, 1994). Commodity booms in the second half of the 1970s led to
higher government revenues and the rapid expansion of government spending. In the
early and mid-1980s, commodity prices fell, but governments did not adjust. Continuing
to spend, they financed their mounting deficits with external debt and inflation. For
example, Madagascar's budget deficit grew from four percent of GDP in 1978 to 17
percent in 1982, inducing inflation. Kenya's foreign debt, very low at the beginning of
the 1970s, reached 50 percent of GDP a decade later. The foreign borrowing appreciated
the equilibrium real exchange rate. Inflation and a lack of adjustment of nominal
exchange rates led to significantly overvalued real exchange rates throughout Africa.
In response to the real appreciation, countries imposed exchange controls and
import restrictions rather than devalue, and this triggered a downward spiral. The
overvalued rate reduced incentives for exporters and the trade balance worsened, forcing
officials to impose even tighter restrictions. Many countries ended up with negative
growth. Ghana's real per capita income, for example, declined 30 percent between 1970
and 1983, and real export earnings declined 52 percent. Throughout Africa, real per
capita income fell by 15 percent between 1977 and 1985 and export perfornance
collapsed from about 10 percent annual growth in the early 1970s to declines in the early
1980s (Jones and Kiguel, 1994). These problems resulted in a period of painful
adjustment programs.
The valuation of the real exchange rate proved a key to successful reforms.
Comparing three areas of policy - exchange rate, fiscal, and monetary - Bouton, Jones,
and Kiguel conclude that exchange rate reforns had the biggest effect on growth.
The Exchange Rate: Cross-Country Studies
Any analysis of the continent's experience must differentiate between the CFA
franc countries, which peg their currency to the French franc, and the countries of the rest
of Sub-Saharan Africa, which independently determine their exchange rate policies. 19
19 The West and Central African Monetary Unions, which together with Comoros, form the CFA
(Communaute Financiere Africaine) zone have convertible currencies pegged at a fixed rate against the
15



The growth records of these twvo groups are very different, as shcown in the following
table. The resumption of aggregate growth for each group coincided with real exchange
rate adjustments.
Table 2: Real Growth Rates in Africa, 1981-1995 (antnual averages)
Country Group         1981-1985      1986-1993       1994-1995
Non-CFA Zone Countries
GDP Growth                 0.4            4.4            3.0
Per-Capita GDP Growth     -2.5            2.1            -0.2
CFA Zone Countries
GDP Growth                 4.3           -0.4             2.8
Per-Capita GDP Growth      0.6           -3.2            -0.8
Source: Klau (1998)
Outside of the CFA zone, most Sub-Saharan African currencies experienced large
real appreciations in the 1970s and early 1980s, estimated at about 44 percent on average.
The CFA-zone overvaluations started a bit later, in the mid-1980s.
There is strong evidence that the overvaluation of real exchange rates contributed
a great deal towards Africa's poor economic performnance. Ghura and Grennes (1993)
analyzed the relationship betw-een the real exchange rate and macroeconomic
performnance in 33 Sub-Saharan African countries between 1972 and 1987. They found
that misalignment, or overvaluation, was associated with lower levels of growth of real
GDP per capita, lower levels cif exports, lower levels of imports, lower levels of
investment, and lower levels of savings, even when correcting for other causes.
Klau (1998) showed that the CFA franc overvaluation of the late 1980s and early
1990s was one of the principal causes of output decline in those countries. In both CFA
zone and non-CFA zone countries, he showed that real devaluations are associated with
short-run and long-run improvements in economic activity, as suggested in the table.
Real devaluations are also associated with improvements in African export
perfornance. Sekkat and Varoudakis (1998) analyzed the real exchange rate and
manufactured exports in three sectors in 11 African countries from 1970 to 1992. They
found that an overvaluation was negatively associated with exports in all three sectors,
textile products, chemical products, and metal products, for the non-CFA zone countries.
The next section presen-ts case studies of Ghana, one of the non-CFA reformers,
and the CFA countries as a group.
French franc. Their monetary arrangements help guard against large losses of reserves and shortages of
foreign exchange. Membership in the zone has changed somewhat over time, but in general has included
Benin, Burkina Faso, Cameroon, Central African Republic, Chad, Congo, Coinoros, C6te d'Ivoire,
Equatorial Guinea, Gabon, Mali, Niger, Senegal, and Togo.
16



Case Studies of Reform and Adjustment
Ghana. Ghana's reform record has been one of the better in Africa, as detailed in
Nowak, Basanti, Horvath, Kochhar, and Prem (1996). Part of this record included the
transformation of the currency, the cedi, from one of the most overvalued in the world to
a convertible currency by 1992. Ghana also moved its budget towards balance and
liberalized its trade policies, and began to see significantly improved growth.
Reforms, known as the Economic Recovery Program (ERP), took place in two
phases, 1983 to 1986 and then 1987 to 1991. In the period leading up to the program,
1978 to 1983, real GDP fell at an average annual rate of 1.6 percent, and gross
investment, merchandise exports, and merchandise imports were all about five percent of
GDP. One sign of the problems of the economy was the currency's black-market
premium, the exchange rate in informal markets compared to the official rate. It finished
the period at 223 percent in 1983, after exceeding 500 percent earlier in the 1980s (see
Sekkat and Varoudakis, 1998).
The first phase of reforms aimed at stabilization, along with major changes to the
trade and exchange rate rules. Ghana lowered the level and dispersion of average tariff
rates, eliminated quantitative restrictions, and corrected the exchange rate. Inflation fell
from almost 123 percent in the years before the program, to 24.6 percent during the first
period of the program. Real GDP started growing again at an average annual rate of 3.6
percent, and gross investment rose to 7.5 percent of GDP. Exports and imports both rose
above eight percent of GDP, through exports remained concentrated in cocoa.
The second period of reforms attempted further structural and institutional
changes. The unification of foreign exchange markets in 1990 brought an end to the
black market premium, which measured 0.4 percent in 1991. GDP grew even faster in
the second period at an average annual rate of 4.8 percent. Gross investment rose to 14.7
percent of GDP, while merchandise exports and imports rose to 15.5 percent and 19.1
percent respectively. Exports rose despite a decline in the terms of trade. Nowak et al.
find econometric evidence that the elimination of the exchange rate overvaluation helped
improve both investment and growth.
Poverty fell between 1987-88 and 1991-92, especially in rural areas, partly due to
increased trade (World Bank, 1995). Overall, the incidence of poverty decreased from
36.9 percent to 31.5 percent. Rural areas account for two-thirds of Ghana's population,
and rural poverty fell from 41.9 percent to 33.9 percent. Poverty increased in Accra, the
capital, from 8.5 percent to 23.0 percent, but fell in other urban areas, so that urban
poverty actually fell from 27.4 percent to 26.5 percent. Decreases in poverty were
especially sharp for female-headed households and for non-farm rural households, but
were present in nearly all population groups.
Economic growth caused most of the reduction in poverty, with the bulk of
income growth in non-farm self-employment, especially wholesale and retail trade. Part
of the increased activity in domestic trade came from a rebound from depressed levels
17



before the start of the ERP. However, the other was from the suige in both imports and
exports, a direct result of the ERP and its exchange rate and other reforms.
While Ghana was a successful reformer on many dimensions, its experience also
illustrates the difficulties of reform in a highly distorted economy with a history of
government intervention. Not all reforms remained in place. In 1992, with a new
constitution in April and elections in November and December, the government gave
large increases in wages and benefits, throwing the budget far out of balance and
increasing the rate of inflation. Private saving and investment subsequently declined as
well (see Nowak et al.).
Despite those problems, Ghana has benefited from its reforms. GDP growth has
remained strong, averaging more than four percent each year frorm 1995 to 1997, and the
black-market premium has stayed almost non-existent.
The CFA Zone Countries. Background and Devaluation. Until the second half
of the 1980s, the countries of the CFA zone experienced stable arnd positive economic
performance (Elbadawi and Majd, 1996). For example, their average annual real GDP
growth rate from 1973 to 1981 was 5.7 percent, compared to an average of 2.8 percent
for 18 non-CFA Sub-Saharan African countries. In addition, their annual average export
growth rate was 7 percent, compared to 1.2 percent, while their irnvestment and savings
rates were about equal with those of the rest of Africa. This better economic performance
was partly due to the exchange rate link, at 50 CFA francs to one French franc, at a time
when the French franc was depreciating against the U.S. dollar and the terms of trade
were relatively favorable on average.
However, the economic performance of the CFA zone countries began to
deteriorate in the mid- 1980s for two reasons, the appreciation of the French franc and a
series of primary-commodity price shocks (Azam and Devarajan, 1997). Devarajan
(1997) shows that for most of the CFA countries, these changes brought about real
exchange rate overvaluations. Studying 12 countries20 he found an average overvaluation
of 31 percent in 1993 on the eve of the devaluation, with Cameroon's real exchange rate
the most overvalued (78 percent) and Chad's real rate the only undervalued one. Eight of
the 12 had overvaluations of 201 percent or more. Making matters worse, other African
countries were devaluing during the 1980s, contributing to the overvaluation of the real
rates of the CFA zone countries compared to those of their export competitors.
Because of the overvaluations and mounting structural problems, such as rigidly
high wages, economic performance started to deteriorate. The zone saw no economic
growth between 1986 and 1994 when other Sub-Saharan African countries were growing
at 2.5 percent annually (Clement, 1994). In fact, as mentioned above, for some of the
countries there was an output contraction comparable to the Great Depression in the
United States.
20 Countries analyzed included Benin, Burkina Faso, Cameroon, Central Africai Republic, Chad, Congo,
Cote d'Ivoire, Gabon, Mali, Niger, Senegal, and Togo.
18



There were a large number of other ill effects from the period of overvaluation in
the CFA zone. A number of countries suffered large increases in poverty (Devarajan and
Hinkle, 1994). For example, the incidence of poverty doubled in C6te d'Ivoire from 30
percent to 60 percent between 1985 and 1992. Devarajan and Hinkle also note that
banking systems in a number of countries became insolvent or illiquid as a result of the
private sector's inability to repay debts, government and public enterprise arrears, and
capital flight. Export earnings collapsed in response to the adverse terms of trade shocks
and the overvaluation of the real exchange rate. The contractionary macroeconomic
policies adopted by most of the CFA countries reduced import levels and inflation
remained low; but budget and external deficits rose. The fixed nominal rate and various
policy-induced rigidities in domestic prices - particularly in wages and non-tradable
goods prices - meant adjustment had to come through reduced employment, output, and
growth.21
Analyzing data through the end of the 1980s, Elbadawi and Majd showed the
effects on CFA economic performance by comparing average annual changes in various
economic aggregates for the CFA countries with other sub-Saharan African countries.
The CFA countries had real GDP growth of 2.9 percent between 1982 and 1985, but 0.4
percent from 1986 to 1989. The other African countries had -0.2 percent growth in the
first period, when they were starting to adjust, and 2.8 percent growth in the second
period. Export growth fell from 3.4 percent to -4.4 percent for the CFA countries, but
rose from 0.6 percent to 4.4 percent for the other African countries. Investment fell in
both groups, while savings rose only in the non-CFA group. Elbadawi and Majd showed
statistically that CFA membership, and by implication the high real exchange rate level,
was partly to blame for the poor economic performance of the late 1980s.
Constrained by their fixed exchange rates, at least two of the CFA zone countries
tried to undergo so-called mock devaluations, with subsidies to exports and increases in
import tariff rates. In C6te d'Ivoire, the scheme collapsed after a short trial because of
administrative difficulties, inability to give the export subsidy plan a sufficient budget,
and lack of support by the government. In Senegal, administration proved difficult, and
the scheme encouraged overinvoicing by exporters and smuggling and underinvoicing by
importers. The plan also proved costly to the budget, as tariffs were already high and the
increases could not generate much more revenue.
Finally, the countries held a "maxi-devaluation" on January 12, 1994, changing
their rates to the French franc from 50 to one to 100 to one.22
21 For example, both Senegal and C6te d'Ivoire had rigid labor laws that kept wages high throughout the
pre-devaluation period (Foroutan, 1997). Clement (1994) noted that throughout the CFA zone, rising wage
costs contributed to substantial drops in public enterprise profitability, expanding the public sector
financing requirement. Extensive controls over both producer prices and retail prices, particularly non-
tradable goods prices, also added to the price rigidities in many countries.
22 The Western and Central African Monetary Unions (comprising Benin, Burkina Faso, Cameroon, CAR,
Chad, Congo, Cote d'Ivoire, Equatorial Guinea, Gabon, Mali, Niger, Senegal, and Togo) changed their
rates from 50 CFA francs to one French franc to 100 CFA francs to one French franc. Comoros changed its
rate from 50 Comoros francs to one French franc to 75 Comoros francs to one French franc at the same
time.
19



Results. The CFA devaluation has had excellent intermediate-term effects on
growth. For the 12 CFA countries in Devarajan's sample, real GDP growth from 1990 to
1993 averaged almost negative 0.3 percent annually weighted by GDP, according to
World Bank data (World Bank, 1999). However, from 1994 to 1997, growth in these
same countries averaged 5.1 percent annually, according to the same data source.23
Cameroon, the largest country in the CFA zone, grew at an annual rate of-3.4 percent in
the first period, but 4.5 percent in the second period (World Bankc, 1999). Devarajan
found that a year after the devaluation, the average undervaluation was two percent for
the group, but with significant variance.
Lessons from Africa
The countries of Sub-Saharan Africa have made significant strides in correctly
valuing their exchange rates. In 1980, 45 African countries had pegged exchange rates,
four had managed floats, and none had independent floats. By 1996, 25 had pegged
exchange rates, six had managed floats, and fully 19 had independent floats, according to
Sekkat and Varoudakis. In both years, 14 were pegged to the French franc. This move
towards a flexible exchange rate allowed most non-CFA zone countries to experience a
real depreciation, starting in 1984-5. The CFA zone countries had their own depreciation
in 1994.
By the late 1990s, much of Africa had returned to growth. Herndndez-Catd
(1999) reported that real GDP grew 4.25 percent annually from 1995 to 1998, up from
less than 1.5 percent from 1990 to 1994, with per capita output up one percent in the later
period, against a decline of 2.25 percent in the earlier period. Inflation peaked at 47
percent in 1994, and dropped to 10 percent 1998. He credited the improved perfornance
to better policy rather than external developments, which were adverse in 1998.
A great deal of policy reform remains for Africa. Though policy makers have
taken large steps, there has been backsliding and failure to implement some important
measures. Aggregate growth has returned, but per capita growth is only slightly positive
and investment and savings both remain lower than in other developing regions.
However, the continent has seen significant successes, and a realistically valued
exchange rate has proved essential to these.
V. Diverse versus Uniform Tariffs and Incentives
In defense of the exchange rate, countries often apply trade protection that is very
high or prohibitive on selected products or countries. The experience in Kazakhstan in
early 1999 is a case in point. We question the efficacy of these policies. Even with a
limited objective of reducing the demand for foreign exchange, depending on how porous
the borders are, we will observe an increase in imports through informal channels. And
with diverse protection, while some sectors will be protected, the burden of the costs of
23 The unweighted averages are 0.1 percent for 1990 to 1993 and 4.7 percent for 1994 to 1995.
20



adjustment to the overvalued exchange rate will be borne by the unprotected sectors,
those sectors that are more susceptible to informal or illegal imports, and the export
sectors.
Although protection is unlikely the appropriate response to a balance of payments
crisis, if any protection is offered for this purpose, it should be uniform, not a diverse
protection structure.24 A uniform tariff is sometimes applied for balance of payments
reasons; this achieves the same impact on reducing imports as exchange rate
depreciation, but it fails to achieve the beneficial effects on the export side. The optimal
tariff structure, given that it is a surrogate for a devaluation (without export incentives),
must uniformly induce resources to flow into import competing industries in general
rather than any particular import competing industry.
At the practical level, the arguments for a diverse tariff structure rest on the ability
of governments to: (i) "pick the winners," that is to identify the candidates that are most
likely to meet the conditions justifying intervention, and choose and maintain the
appropriate level for the policy variable (tariff, subsidy). In general, the market is a more
reliable indicator of the industries that have comparative advantage than any economic
model. Over time this is particularly true, as comparative advantage changes with
technological development; (ii) be immune to the pressures from vested groups that
inevitably arise once the willingness to grant special status is established; and (iii)
prevent any protection granted from becoming permanent.
The empirical evidence in both developed and developing countries during the
past three decades casts doubt on most governments' ability to meet these conditions.
Endorsement of a more general approach - with little differentiation in the level of
assistance - thus emanates from a wider skepticism about the practical merits of targeting
of any kind.25
Moreover, the economy must provide its most talented members with the
incentive to engage in entrepreneurial activities such as starting or expanding firms,
developing new products and lowering costs. If the economy provides tariffs that differ
greatly by sector, or extensive subsidies or tax exemptions to industries or firms, or
presents a difficult regulatory framework within which to do business, talented people
will find it more profitable to engage in the socially. wasteful activity of lobbying the
government for tariffs, subsidies, protection, tax or regulatory relief (Murphy, Shleifer
and Vishny, 1991). This socially wasteful lobbying is especially harmful because it
attracts one of the scarcest resources in developing countries: entrepreneurial talent that
would otherwise be helping the economy grow. Thus, World Bank experience indicates
(see Leiberman, 1990; Atiyas et al. 1992) that the best industrial policy is for the
government to provide a stable macroeconomic and regulatory environment conducive to
business development with neutral incentives to all firms and industries.
24 See Tarr (1998) for an elaboration of the arguments for and against a unifonn tariff.
25 See Westphal (1990) and Krugman (1989, 1992) for details.
21



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I



Policy Research Working Paper Series
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In East Asian Financial Institutions   Stijn Claessens                     33722
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