ADJUSTING TO THE ECONOMIC CRISIS

MACROECONOMIC ADJUSTMENT AND POVERTY 759 In presenting the simulation results, we focus on GDP growth, investment, and foreign savings, as well as income distribution. To facilitate comparison, our functional income distribution distin- guishes between four groups: urban nonpoor, urban poor, rural nonpoor, and rural poor. These groups are aggregated, according to the level of income, from those found in the income distribution of the underlying Social Accounting Matrices SAMs. 9 Their in- comes per capita in local currency are found in Appendix Table 2A, along with shares of revenue from factors of production and transfers. 10

4. ADJUSTING TO THE ECONOMIC CRISIS

Each of the four countries in this study suffered a terms-of- trade shock, concurrent with a tightening of world capital markets and foreign aid inflows. We, therefore, frame our analysis around the policy response to the adverse shocks experienced by most countries in sub-Saharan Africa in the late 1970s and early 1980s. In particular, to facilitate comparison between countries, the same terms-of-trade shock is modeled for each country: a 10- percent decline in the world price of the major export good. 11 In addition, foreign capital inflows are reduced by an amount equal to 10 percent of base year exports. 4A. Simulating Alternative Policies In the early stages of confronting their economic crises, many African countries avoided necessary adjustments in nominal and real exchange rates by rationing foreign exchange, often through the imposition of import quotas, a policy we refer to as de facto adjustment. In Simulation I, we model this policy alternative by an implicit tariff on imports equivalent to a premium on foreign 9 For details on the SAMs, see Dorosh and Essema-Nssah 1991, Dorosh et al. 1991, Gauthier and Kyle 1991, and Jabara, Lundberg, and Sireh Jallow 1992. 10 Note that in the Gambia and Niger models, the urban poor are classified according to their incomes relative to other urban households rather than vis a` vis a national poverty standard. Thus, average incomes of the urban poor in these countries are higher than average incomes of the rural nonpoor. 11 World prices were reduced for the following export commodities: Cameroon export crops—mainly coffee and cocoa, The Gambia groundnuts and groundnut products, Madagascar export crops—mainly coffee, vanilla, and cloves, and Niger uranium. 760 P. A. Dorosh and D. E. Sahn exchange for imports. 12 With the quota rents accruing to high- income urban households. The level of the implicit tariff is set so as to keep the real exchange rate fixed at the preshock level, thus highlighting the role of real exchange rate depreciation or the lack of it in adjustment. In Simulation II, we model adjustment with a liberalized foreign exchange regime, allowing the real exchange rate to depreciate in the wake of the shock. In reporting the results, we compare the simulated outcomes from Simulation II adjustment through real devaluation with Simulation I de facto adjustment. Next, we examine variants on Simulation II by allowing the real ex- change rate to adjust while reducing government spending Simu- lation III. Finally, we model the imposition of taxes on foreign trade to help maintain government revenues in the face of weaken- ing world prices for exports Simulation IV. In this last simulation, no exogenous change is made in government expenditures. Be- cause Simulations III and IV are variants of the real exchange rate devaluation simulation, these results are presented relative to Simulation II. In all cases, the results are anchored to the same macroeconomic constraint: the current account deficit is held constant across the simulations. Because each of the simulations are designed to meet the same macroeconomic adjustment objectives, the relative out- comes are comparable across countries in terms of the policies undertaken and, within a country, in terms of the macroeconomic target that alternative means of adjustment will achieve. Simulation I: de facto adjustment. Table 2 shows the effects of the external shocks with de facto adjustment. Not surprisingly, real GDP falls sharply in all countries 1.8 to 3.6 as lower export earnings and foreign capital inflows reduce aggregate demand and incomes. By construction of the simulations, there is no change in the real exchange rate. The premium on foreign exchange that helps reduce import demand and equilibrate the external accounts ranges from 14.2 percent in Niger to 35.1 percent in Madagascar. Structural characteristics of the economies, including the size of the external shock relative to investment spending and overall GDP, explain the variations in foreign exchange premiums across countries. For all four countries, the external shock measured in terms of lost foreign exchange earnings is between 9.7 and 12.0 12 See de Melo and Robinson 1982. MACROECONOMIC ADJUSTMENT AND POVERTY 761 Table 2: Simulation I: De Facto Adjustment—Impose Import Quotas Percentage change a Cameroon The Gambia Madagascar Niger Real GDP 21.83 23.55 22.32 22.94 ConsumptionGDP 22.09 22.76 22.49 21.33 Total investmentGDP 20.89 26.37 21.03 23.78 Government recurrent expendituresGDP 0.00 0.00 0.00 0.00 Government revenueGDP 20.73 20.97 20.88 20.12 ExportsGDP b 22.21 0.75 20.98 21.25 ImportsGDP b 23.36 24.83 22.18 23.45 Change in foreign savingsbase year exports 210.00 210.00 210.00 210.00 Prices Foreign exchange premium level in percent 26.83 16.97 35.10 14.22 Real exchange rate 0.00 0.00 0.00 0.00 Real wage rates Skilled labor 29.97 211.01 219.58 211.00 Semiskilled labor 29.08 27.87 217.33 — Unskilled labor 212.02 24.64 28.27 25.44 Real incomes Urban nonpoor 21.14 4.32 16.33 14.33 Urban poor 28.81 28.75 213.51 26.68 Rural nonpoor 210.09 26.51 25.61 24.09 Rural poor 210.04 25.71 25.25 24.67 Small farm—export-oriented 25.77 24.17 Total 23.22 23.78 23.23 21.52 Source: Model simulations. a Percentage change relative to base SAM. b Exports and imports valued at base year real exchange rate. 762 P. A. Dorosh and D. E. Sahn percent of the initial level of imports. However, for The Gambia the most open economy considered, the ratio of the shock to GDP is 6.3 percent, compared to 1.7 to 3.5 percent for the other three countries. Given the large reduction in foreign savings and export earnings, total savings in The Gambia declines steeply, and along with it, total investment and demand for services of the labor-intensive construction sector. Real wages for both skilled and unskilled urban workers fall, helping to reduce the price of hotel and other services and permitting an increase in tourism exports. Thus, the loss of foreign exchange revenues is partially offset, so that a premium of only 17.0 percent is sufficient to restore equilibrium in foreign exchange markets. In Niger, the initial foreign exchange shock is also relatively large, 3.5 percent of GDP, so that investment and consumer demand for livestock falls. As a result, the exportable surplus of livestock rises, softening the decline in foreign exchange availability, so that the simulated foreign exchange premium is only 14.2 percent. In contrast, with Madagascar’s very closed economy, the shock is a small 1.7 percent of GDP, so there is little impact on savings and thus total invest- ment. Because investment demand for manufactured imports which accounts for a large share of total imports changes little, the bulk of the adjustment must be borne by a reduction in con- sumer demand. To achieve this shift in demand, a large increase 35.1 percent in the exchange rate premium and the price of imported manufactured goods is required. The price elasticity of the export good suffering the simulated terms-of-trade shock also significantly affects the size of the pre- mium by influencing he extent of the loss of foreign exchange earnings through decreased volume of exports. In Niger, uranium export supply is very inelastic so the 10-percent decline in the price of uranium reduces total uranium revenues by only 11.7 percent. The 10-percent decline in world prices of Madagascar’s export crops coffee, vanilla, cloves reduces export revenues from these crops by 17.1 percent. Nearly all household groups suffer as the effects of reduced export earnings and lower foreign capital inflows reverberate throughout the economy. The decline in the output of the services sectors and reduced agricultural incomes due to the declines in overall demand lead to a decreased demand for labor, and to lower real wages and returns to land and agricultural capital in all countries. Declines in returns to informal sector capital also contribute to reduced incomes of the urban poor. As a group, the MACROECONOMIC ADJUSTMENT AND POVERTY 763 urban high-income households actually see a rise in their real incomes in this scenario, however, because they collect the rents associated with the import quotas. Of course, in practice, it is likely that only a small number of the urban elite would gather the lion’s share of the rents. Urban nonpoor households not receiving rents suffer a decline in real incomes in this scenario. Simulation II: Adjustment through real exchange rate deprecia- tion: in the second simulation we allow the real exchange rate to adjust freely to the negative terms-of-trade shocks to restore the equilibrium in the external accounts. Although most nominal deval- uations are actually accompanied by changes in fiscal policies e.g., cuts in government spending or trade policies e.g., reductions in trade taxes, such policies remain unchanged in this simulation. Compared with the de facto adjustment simulation Simulation I, liberalization of foreign exchange markets leads to a real exchange rate depreciation of 15.7 percent in Cameroon, 4.3 percent in The Gambia, 11.5 percent in Niger, and 9.2 percent in Madagascar Table 3. 13 Real GDP is also slightly higher by 0.2 to 1.3 in all countries. The depreciation of the real exchange rate spurs exports by 3.2 and 3.5 percent in Niger and The Gambia, respec- tively, and by 9.0 percent in Cameroon and 10.4 percent in Mada- gascar. This increase in export earnings permits a higher level of imports as well. But what of the effect of such policies on income distribution? As intimated above, much of the early writing on the deleterious impact of adjustment focused on the harmful effects of exchange rate adjustments on the poor, who were assumed to be net consum- ers of tradable staple foods and net suppliers of labor, and for whom a combination of greater unemployment and lower wages would have adverse consequences. In practice, the results indicate that with the removal of the quota rents, the urban nonpoor households suffer a loss in real incomes by 4.6 to 20.4 despite the overall increase in economic activity and an increase in real wages for skilled labor Table 4. Lower incomes for the urban 13 Although nominal exchange rates vis-a`-vis the French franc were fixed for CFA countries such as Cameroon and Niger during the 1980s, changes in real exchange rates did occur through differential rates of inflation between each CFA country and its trading partners, as well as through changes in the nominal exchange rate between the French franc and other currencies. Moreover, a combination of import tariffs and export subsidies can substitute for a nominal exchange rate devaluation in changing the relative price of tradables and non-tradables in the economy. 764 P. A. Dorosh and D. E. Sahn Table 3: Simulation II: Real Devaluation Percentage change a Cameroon The Gambia Madagascar Niger Real GDP 0.68 1.25 1.28 0.23 ConsumptionGDP 0.85 1.13 0.74 20.50 Total investmentGDP 20.17 0.12 0.54 0.71 Government recurrent expendituresGDP 0.00 0.00 0.00 0.00 Government revenueGDP 20.20 0.04 0.93 20.21 ExportsGDP b 2.25 2.04 1.16 0.68 ImportsGDP b 2.25 2.04 1.16 0.68 Change in foreign savingsbase year exports 0.00 0.00 0.00 0.00 Prices Foreign exchange premium level in percent 0.00 0.00 0.00 0.00 Real exchange rate 15.66 4.27 11.46 9.16 Real wage rates Skilled labor 6.88 8.62 18.32 5.43 Semiskilled labor 6.15 9.48 6.75 — Unskilled labor 9.77 1.88 6.97 2.90 Real incomes Urban nonpoor 215.92 24.61 220.36 218.92 Urban poor 5.51 8.37 11.56 2.94 Rural nonpoor 7.91 2.88 4.23 2.13 Rural poor 7.39 2.78 4.53 2.69 Small farm—export-oriented 5.02 2.52 Total 1.26 1.84 0.84 21.71 Source: Model simulations. a Percentage change relative to Simulation I. b Exports and imports valued at Simulation I real exchange rate. MACROECONOMIC ADJUSTMENT AND POVERTY 765 Table 4: Simulation II: Income Breakdown Percentage Change Urban Urban Rural Rural nonpoor Poor nonpoor Poor Total Cameroon Formal skilled labor 0.761 1.137 0.855 0.209 0.718 Formal semi-skilled labor 1.198 1.751 1.597 0.402 1.280 Formal unskilled labor 0.229 1.538 0.641 0.679 0.540 Informal labor 0.158 1.891 2.916 7.108 2.881 Land 0.000 0.000 0.909 0.335 0.553 Capital 1.076 0.000 0.293 0.000 0.455 Government transfers 0.357 0.000 0.045 0.000 0.123 Firm transfers 0.831 0.000 0.226 0.000 0.352 Rents 220.770 0.000 0.000 0.000 25.716 Subtotal 216.160 6.317 7.482 8.733 1.186 Consumer price effect 0.286 20.756 0.398 21.231 0.072 Total 215.770 5.513 7.910 7.394 1.259 The Gambia Skilled labor 3.005 3.476 0.238 0.105 1.833 Unskilled labor 2.059 4.012 0.845 1.260 2.075 Largeholder land 0.003 0.000 0.280 0.000 0.060 Smallholder land 0.000 0.005 0.000 0.032 0.009 Informal capital 2.561 0.678 0.202 0.171 1.039 Housing 0.056 0.068 0.237 0.299 0.156 Transfers 0.118 0.103 0.936 0.361 0.345 Rents 211.683 0.000 0.000 0.000 23.623 Subtotal 23.880 8.341 2.738 2.228 1.893 Consumer price effect 20.763 0.026 0.140 0.538 20.073 Total 24.614 8.369 2.881 2.777 1.836 Madagascar Skilled labor 5.863 0.000 0.000 0.000 1.028 Semi-skilled labor 0.198 7.761 1.007 0.000 1.203 Unskilled labor 0.036 2.350 2.105 4.607 2.765 Informal capital 0.000 0.143 0.279 0.069 0.132 Largeholder land 0.000 0.000 1.809 0.000 0.574 Smallholder land 0.000 0.000 0.000 0.796 0.317 Dividends 6.040 0.000 0.000 0.000 1.059 Rents 235.000 0.000 0.000 0.000 6.253 Subtotal 223.536 10.254 5.200 5.472 0.824 Consumer price effect 4.156 1.176 20.926 20.895 0.171 Total 220.358 11.550 4.226 4.528 0.838 Niger Skilled labor 3.380 0.000 0.000 0.000 0.678 Unskilled labor 0.138 1.731 1.592 2.658 1.658 Informal capital 0.212 0.610 0.494 0.070 0.317 Large holder land 0.000 0.000 0.584 0.000 0.207 Small holder land 0.000 0.085 0.000 0.159 0.061 Rents 223.534 0.000 0.000 0.000 24.722 Subtotal 219.803 2.426 2.670 2.887 21.800 Consumer price effect 1.102 0.496 20.529 20.194 20.015 Total 218.919 2.934 2.127 2.687 21.815 Source: Model simulations. 766 P. A. Dorosh and D. E. Sahn nonpoor, who have relatively high marginal propensities to save, help offset the gain in savings of other households so that total savings and total investment rise relatively little and actually falls slightly in Cameroon. Most important, the average real incomes of the poor, including the rural poor who have lowest per capita incomes, rise with real exchange rate depreciation. This increase results because the removal of distortions in the prices of importables leads to a more efficient allocation of resources: demand for unskilled labor increases, as do returns to informal sector capital, benefitting poor households in both urban and rural areas. Urban poor households also benefit from lower prices of importable goods they consume. For example, the reductions in the household consumer price indices for urban poor households in Madagascar and Niger raise their real incomes by 4.16 and 1.10 percent, respectively Table 4. A major factor contributing to increased real wage payments to unskilled labor for rural households is increased profitability of agricultural traded goods, due to the depreciation of the real exchange rate. Real incomes of small farmers who cultivate export crops in Madagascar increase by 5.0 percent compared to the average country-wide increase of only 0.84 percent. 14,15 Simulation III: Reductions in government spending: In Simula- tion III, real government expenditures are cut by 10 percent to increase government savings reduce the government deficit and 14 Our modeling assumptions regarding household transfers have little impact on these results. Not explicitly incorporating international transfers to households in the Cameroon, Madagascar, and Niger models is equivalent to assuming that all international transfers accrue to the urban nonpoor, and that these transfers are fixed in dollar terms. National household survey data from Madagascar Government of Madagascar, 1993, in fact, show that reported international transfers are both small and concentrated among the urban nonpoor, with per capita transfers equal to FMG 54,522 1.1 of expenditures for the richest 5 percent of households and only FMG 1,747 0.2 of expenditures for the poorest 40 percent. Data in Ghana show a similar pattern. Note that these national household surveys each captured about one-quarter of private household transfers shown in the balance of payments. 15 The result that real exchange rate depreciation tends to benefit the poor is consistent with findings by Schneider et al. 1992 in a study using a CGE model for Coˆte d’Ivoire with both real and financial variables. The equations of the Coˆte d’Ivoire model used derive from Bourguignon, Branson, and de Melo 1989a, 1989b. Model simulations show that a 22 percent real devaluation of the CFA franc in 1981 spurs exports, increases employment, and reduces poverty in both urban and rural areas. MACROECONOMIC ADJUSTMENT AND POVERTY 767 permit an increase in private investment Table 5. 16 Because, in this, and the two following simulations, the real exchange rate is allowed to adjust without an imposition of quotas, results of these runs are thus compared with the results of Simulation II. The biggest effect of reducing the size of government is that it allows investment to increase by 4.5 percent Cameroon to 20.3 percent Niger. Government recurrent expenditures are very large rela- tives to private investment in Madagascar and Niger, so the change in investment is greater in these two countries. Real GDP falls slightly in The Gambia, Madagascar, and Niger, and the real ex- change rate depreciates slightly in all countries 0.3 to 0.8. Gov- ernment revenues fall in Niger as income taxes on wages of skilled government workers an important source of revenues decline. In general, urban households are hurt more by the decline in government expenditures because government employment is concentrated in urban areas. The increase in investment spending tends to help offset this decline, however. The effect on rural households varies across countries: rural households enjoy slight increases in real incomes in The Gambia and Madagascar, mainly due to effects of the small depreciation of the real exchange rate in boosting incomes for producers of tradable commodities. Simulation IV: Maintaining government revenues through in- creased trade taxes: in Simulation IV, in addition to allowing the real exchange rate to adjust, taxes on foreign trade are increased uniformly by 10 percent in an attempt to maintain government revenues in spite of the shock of lower world prices for exports and reduced foreign capital inflows. 17 Greater trade taxes in this simulation raise real tax revenues by 8.4 to 32.5 percent, thus increasing the pool of total savings in the economy Table 6. Real investment increases sharply in all four economies. Taxing trade, however, introduces distortions in the economy by reducing incentives for both exports and imports and leading to shifts in resources away from production of ex- portables and towards importables and, to a lesser extent, non- traded goods. Real GDP thus falls by 0.1 to 2.5 percent in this 16 Note that in the models, total investment is determined simply by the availability of total savings; thus, investment increases automatically with a cut in government expendi- ture, which increases government and total savings in the economy. 17 Export taxes are imposed on the export sectors listed in footnote 4 except for The Gambia, where only groundnut products are taxed and Niger where cowpeas and livestock exports are taxed. 768 P. A. Dorosh and D. E. Sahn Table 5: Simulation III: Real Devaluation with Reduction in Government Spending Percentage change a Cameroon The Gambia Madagascar Niger Real GDP 0.03 20.38 20.20 20.18 ConsumptionGDP 20.09 20.32 0.00 21.13 Total investmentGDP 0.85 1.26 0.71 2.23 Government recurrent expendituresGDP 20.65 21.32 20.92 21.33 Government revenueGDP 0.05 0.03 0.32 20.01 ExportsGDP b 0.07 0.16 0.10 0.12 ImportsGDP b 0.07 0.16 0.10 0.12 Change in foreign savingsbase year exports 0.00 0.00 0.00 0.00 Real exchange rate 0.41 0.29 0.58 0.84 Real wage rates Skilled labor 21.97 20.36 28.32 211.40 Semiskilled labor 20.52 0.48 23.83 — Unskilled labor 0.16 20.02 0.64 0.31 Real incomes Urban nonpoor 0.11 20.76 0.93 27.66 Urban poor 20.78 20.97 23.12 20.96 Rural nonpoor 20.28 0.14 0.04 20.66 Rural poor 20.11 0.05 0.56 20.44 Small farm—export-oriented 0.67 20.49 Total 20.16 20.42 0.00 21.75 Source: Model simulations. a Percentage change relative to Simulation II. b Exports and imports valued at Simulation II real exchange rate. MACROECONOMIC ADJUSTMENT AND POVERTY 769 Table 6: Simulation IV: Real Devaluation with Increased Taxes on Foreign Trade Percentage change a Cameroon The Gambia Madagascar Niger Real GDP 20.66 22.47 21.12 20.09 ConsumptionGDP 21.72 25.74 22.18 22.19 Total investmentGDP 1.05 3.27 1.06 2.10 Government recurrent expendituresGDP 0.00 0.00 0.00 0.00 Government revenueGDP 1.33 5.18 3.16 3.24 ExportsGDP b 21.12 23.23 21.00 20.80 ImportsGDP b 21.12 23.23 21.00 20.80 Change in foreign savingsbase year exports 0.00 0.00 0.00 0.00 Real exchange rate 1.31 1.14 7.76 23.81 Real wage rates Skilled labor 21.96 212.97 28.01 23.00 Semiskilled labor 21.23 213.02 28.89 — Unskilled labor 27.65 24.08 24.99 22.86 Real incomes Urban nonpoor 0.49 212.12 21.93 24.12 Urban poor 20.50 211.73 26.99 23.11 Rural nonpoor 23.76 24.02 22.14 22.35 Rural poor 24.54 23.34 22.98 22.77 Small farm—export-oriented 23.34 22.70 Total 22.92 28.28 23.05 22.87 Source: Model simulations. a Percentage change relative to Simulation II. b Exports and imports valued at Simulation II real exchange rate. 770 P. A. Dorosh and D. E. Sahn simulation. In Cameroon, The Gambia, and Madagascar the real exchange rate depreciates because the negative effect of raising taxes on agricultural exports in reducing supply of foreign ex- change is relatively more important than the effect of the increased import tariffs on reducing demand for foreign exchange. Real incomes of all household groups except the urban nonpoor in Cameroon fall, despite the increase in investment spending. De- clines in urban incomes are generally larger than declines in rural incomes, as reduced economic current domestic production leads to declines in returns to informal and formal sector capital. Farmers producing export crops tend to suffer larger declines in real incomes than other small farmers, because of the decline in the real domestic price of export crops due to the increased export taxes.

5. CONCLUSIONS