Aid and Exchange Rate Adjustment in African Trade Liberalisations

Abstract

Most African governments must, except for short periods of time, set macroeconomic policies which are compatible. That is, trade restrictions, the exchange rate, and budgetary-cum-monetary policy must be coordinated in such a way as to avoid depletion of foreign exchange reserves. Often, the potential for departure from compatibility is minimal: for example, for some years the Tanzanian economy was run with reserve cover of only a few days of imports.2 Trade liberalisation must, therefore, involve continuous coordination with other policies so as to maintain compatibility. One theoretical possibility is for a gradual creep towards liberalisation with coordination achieved by ex post 'fine tuning'. However, recent surveys of numerous non-African trade liberalisations (Papageorgiou et al. i99i) conclude that large, abrupt liberalisations have proved more sustainable. Apart from economic considerations, it is quite possible that for political reasons gradual trade liberalisation is not feasible in Africa: transient political windows of opportunity are either seized with an abrupt liberalisation or missed altogether. Further, donors may insist on liberalisation being abrupt. Such a liberalisation starkly poses the coordination problem, and this paper uses a simple computable general equilibrium model (CGE) to explore alternative compatible strategies in an Africa-type economy. The essence of the compatibility problem can be seen by considering the consequence of a liberalisation in which no other policies are changed. The reduction of tariffs, or more commonly the relaxation of quotas will lower the domestic price of importable goods and thereby reduce the demand for money.3 Being a stock effect, in the short term this will dominate any changes in the money supply brought about by the fiscal implications of liberalisation, since these are flow effects. Hence there will be an excess supply of money and so a payments deficit. The paper investigates three alternative strategies which prevent such an outcome, each maintaining compatibility. The first (Section 2) is to achieve an offsetting increase in the demand for money through devaluation. The second (Section 3) is to. use programme aid to finance a deficit until the money supply is sufficiently depleted. These two extremes respectively characterise the post-I986 Nigerian trade liberalisation and all