Exchange Rate Policy for Agricultural Development

In regard to the aforementioned difficulties in sustaining an open trade policy, it should be noted that one of the most effective ways to forestall pressures by farmers for the imposition of import restrictions is to ensure that the exchange rate remains in equilibrium in the sense of purchasing-power parity, because farmers are very aware of the prices of competing imports and an overvalued exchange rate cheapens them in domestic currency units. A policy of overvaluing the exchange rate makes it difficult to implement a policy of agricultural trade liberalization, and of industrial trade liberalization as well. In this sense, it is very important to co-ordinate trade and exchange rate policy and to sequence the measures appropriately.44 This lesson was drawn out clearly from a careful study of the experiences in economic reform in New Zealand and Chile:

The most fundamental issue arising from reform in both Chile and New Zealand is that agriculture, composed largely of tradable goods, is most sensitive to shifts in trade and macroeconomic policies. The main elements are sound fiscal policy and exchange rate management. The level and stability of the real exchange rate in both countries were strategic. A real appreciation of the currency is not conducive to stimulating agricultural output and can create considerable resistance by farm lobbies against trade liberalization, and create strong pressures for special treatment after the major reforms have been implemented.45

The case of the CFA devaluation of 1994 illustrates the effects of the exchange rate on agriculture and also on economy-wide growth. The FAO found that:

in spite of the social and economic management problems caused by the initial price shock . .. the devaluation contributed to a strong expansion of export earnings and a reduction of external deficits. . .. Agricultural exporters benefitted significantly from the devaluation. . .. For instance, Côte d'Ivoire. which had been suffering economic recession since the mid-1980s, increased its economic activity by close to 2 percent in 1994 and is expected to expand it by a further 5 percent in 1995, largely because of booming export performances.. . . Economic growth is also expected to accelerate in Senegal, from 1.8 percent in 1994 to 3.5 percent in 1995, a significant contributing factor being groundnut exports. .. .46

The most important factor in determining these economies' responses to the devaluation was the

43. Further discussion and examples concerning the exchange rate and relative prices are found in Roger D. Norton, Integration of Food and Agricultural Policy with Macroeconomic Policy: Methodological Considerations in a Latin American Perspective, Economic and Social Development Paper No. 111, Food and Agriculture Organization of the United Nations, Rome, 1992.

44. This is one of the principal messages to emerge from the study by Demetrios Papageorgiou, Armeane M. Choksi and Michael Michaely, Liberalizing Foreign Trade in Developing Countries: The Lessons of Experience, The World Bank, Washington, DC, USA, 1990.

45. Alberto Valdés, 'Mix and sequencing of economywide and agricultural reforms: Chile and New Zealand', Agricultural Economics, 8(4), June 1993, p. 307.

46. FAO, The State of Food and Agriculture 1995, Food and Agriculture Organization of the United Nations, Rome, 1995, p. 79.

degree to which the revised export prices were passed on to producers. In some cases, the government controlled the price and passed on only part of the increase:

in the Peanut Basin.. . . the government raised producer prices for peanuts twice - a combined increase of 71 % over pre-devaluation levels, but less than the 100% increase in the CFA value of the world price. Passing on only a portion of the increase in the export price was a common strategy of Sahel governments after the devaluation for sub-sectors with strong government intervention. ... in Mali, there was a rise in the profitability of Malian irrigated rice, whose output price was allowed to rise faster than input costs. ... In the cotton zone of Mali, the net real return to farm output (cotton, maize, sorghum) increased by 14% for the south Sudanian zone and 20 % for the north Guinean zone in the first 2 years after the devaluation. . .. This resulted from higher maize prices and from the government's decision to 'pass through' to producers the higher cotton prices resulting from devaluation

gains.4'

As a consequence of these policies, since 1994 Mali's agricultural sector has been one of the fastest-growing in Africa. Other countries in the region benefitted as well from the devaluation. According to the New York Times Service in March of 1996, in the Ivory Coast the 'devaluation of the [CFA] has given the economy a new competitive edge'. The same New York Times dispatch quoted an Ivorian agro-industrialist, Laurent Basque, on the subject: 'Now we are in a full-blown expansion and attacking new markets. The devaluation has allowed us to grow, and the same is true for most exporters'. In Mexico, after the exchange rate adjustment of 1994, a national federation of farmers issued a public statement vowing that they would never permit the exchange rate to become overvalued again.48

A lesson from the CFA experience is that, since a real exchange rate devaluation has almost entirely positive effects on agriculture, it is important not to dilute or nullify those effects by controlling prices to producers, restraining their response to the devaluation.

Since exchange rate policy can be a contentious subject, it is important to point out that a country cannot 'devalue its way to growth' in the longer run. Trading partners will respond to devaluations that are made artificially for the purpose of enhancing the country's international competitiveness, with the net effect of no gain for anyone and higher inflation all around. The conclusion that is being drawn here is that artificially controlling the exchange rate in the reverse direction, of overvaluing it in an unsustainable manner, has serious negative consequences for agricultural development. If such deviations from an equilibrium exchange rate are corrected sooner rather than later, the magnitude of the required adjustment, and hence the shock to consumers, is less, and the benefits for agricultural and national development greater.

The negative economic consequences of allowing the exchange rate to become overvalued are in fact more pervasive. In the words of T. L. Vollrath, 'exchange-rate overvaluation . . . lowers returns to agriculture, penalizes exports, induces capital flight, depresses foreign exchange earnings, dis

47. Reprinted from Food Policy, 22(4), T. Reardon, V. Kelly, E. Crawford, B. Diagana, J. Dione, K. Savadogo and D. Boughton, 'Promoting sustainable intensification and productivity growth in Sahel agriculture', pp. 320-321, Copyright (1997), with permission from Elsevier. It should be noted that Mali tried to control many prices initially after the devaluation but soon abandoned that policy.

48. Examples of the effect of the exchange rate on agriculture are abundant. In the case of Ecuador, a modelbased study concluded that 'macroeconomic policy, via the exchange rate, was responsible for a large part of the reduction in the share of agriculture in the economy between 1971 and 1981'. (From Grant M. Scobie and Veronica Jardine, 'Macroeconomic Policy, the Real Exchange Rate and Agricultural Growth: The Case of Ecuador', paper presented to the Annual Conference of the Australian Agricultural Economics Society (New Zealand Branch), Blenheim, New Zealand, July 1988, p. 12.)

courages domestic savings, crowds out productive investment and creates import restrictions that allocate resources to unproductive rent-seeking activity'.49 In brief, it is hard to overestimate the importance of an appropriate exchange rate policy for economic development, and not only for the agricultural sector. India's strong economic growth in the 1990s was in good measure a result of a substantial real depreciation of the rupee achieved through nominal devaluations.50

A special case of exchange rate policies is found in currency boards, which not only fix the exchange rate with respect to an international reserve currency but also tie monetary policy by fixing the rules for determining the money supply.51 Bulgaria, Estonia, Hong Kong, Djibouti and, until early 2002, Argentina are the main examples of the few countries that adopted this approach to macroeconomic policy in the past decade. Under a currency board, in effect, monetary policy loses all discretionality and disappears for all practical purposes.52 The noteworthy advantage of this system is that it undoubtedly delivers price stability, albeit after a lapse of time which may last several years (in the case of Estonia). The guarantee of eventual price stability that is inherent in the system helps it overcome the usual tendency of overvalued exchange rates to encourage capital flight, and in fact currency boards have proven able to stimulate capital inflows, at least in the short run.

Their disadvantage is their rigidity: economic adjustments are forced to occur in the realms of interest rates and the labor market, and hence the consequences can include very high rates of unemployment. The system requires exceptional bank solidity, and therefore there is an increased risk of bank failures in the early years of its implementation (e.g. Estonia) and in crisis situations. There is a real danger that the system's rigidity can convert a recession into a depression, as happened in Argentina. This country saw its rates of unemployment rate rise to 18% in the years immediately after the introduction of the currency board, and the rate rose to explosive levels by the beginning of this decade, with the result of abandonment of the system. Lack of fiscal discipline at the national and provincial levels was a major reason for the collapse of the Argentine currency board, but that outcome only reinforces the point that such systems become straitjackets on policy in the face of economic shocks and stresses.

The most important operational concern about currency boards from an agricultural viewpoint is that the exchange rate should not be pegged at too strong a level (too appreciated a value). The reason is that there almost always is a considerable amount of residual inflation that needs to work its way out of the system before price stability is achieved. In the face of a fixed exchange rate, several years of continuing inflation, even if its annual rate is declining, can result in a considerable appreciation of the real exchange rate. This effect, of course, drives down real agricultural prices. The same prescription applies to economies that 'dollarize', or accept another major currency as their own: care should be taken with the rate of conversion of currencies, to avoid handicapping domestic producers in both agriculture and industry.53

49. T. L. Vollrath, 'The role of agriculture and its prerequisites in economic development: a vision for foreign development assistance', Food Policy, 19(5), October 1994, p. 476.

51. A thorough explanation of currency boards from an advocacy standpoint is found in Steve H. Hanke and Kurt Schuler, Currency Boards for Developing Countries: A Handbook, Sector Study No. 9, International Center for Economic Growth, San Francisco, CA, USA, 1994.

52. The Argentinian currency board allowed exceptions to this rule which, for example, permitted the Central Bank to increase the liquidity in the banking system after the devaluation of the Mexican peso in 1994.

53. The decision to convert East German marks to West German marks at 1:1 made many industries in Eastern Germany uncompetitive and cost West German taxpayers very large sums over 10 years to compensate the East in the form of unemployment insurance and other subsidies.

The importance for productive sectors of pegging the exchange rate appropriately has been underscored by Sebastian Edwards: 'The adoption of an exchange rate-based stabilization program, where the nominal exchange rate is either pegged, or its rate of change is predetermined at a rate below ongoing inflation, carries a serious danger of provoking a major overvaluation. This can even happen if the fiscal deficit is fully under control. . . . This suggests then that in instances when exchange rate pegging indeed becomes part of the anti-inflation program, the initial starting point should be one of undervaluation. . . .' (Sebastian Edwards, 'Stabilization and Liberalization Policies in Eastern Europe: Lessons from Latin America', Working Paper IPR4, Institute for Policy Reform, Washington, DC, USA, 1991, p. 42. )

In the Estonian case, the Bank of Estonia estimated that, between the date of fixing the exchange rate, June of 1992, and June of 1996, cumulative inflation was over 450%54 and the real exchange rate appreciated by 268 %. This was the main reason why real agricultural prices declined by about 50% during that period, after having declined substantially in the preceding period as a consequence of the elimination of Soviet-era price controls. The consequences included widespread bankruptcies of agricultural enterprises, abandonment of agricultural land and intensification of rural poverty.55

This experience highlights another lesson: that currency boards should not be implemented when inflation still is at very high levels. In Estonia, inflation for the entire year 1992 was about 1000 %. The boards may be effective in bringing down inflation from moderate levels, and in keeping it down, but implementing one in the midst of high inflation practically ensures a strong subsequent appreciation of the real exchange rate, with very negative consequences for real agricultural prices.56

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