Macroeconomic adjustment and inconvertible currencies in the third world

Abstract

In 1987, Zimbabwe experienced serious difficulties in expanding mineral production, notably gold, due to a shortage of foreign exchange for the importation of spare parts and mining equipment ["Zimbabwe Survey," 1987]. Since gold can easily be converted into foreign currency, this may seem rather startling and paradoxical on a superficial level. Foreign exchange production declined as a result of a foreign exchange shortage. Similarly, in 1979, a World Bank Program loan was used to fmance the foreign exchange requirements of Jamaica's export industries. In theory, the profitable production of exports should generate more foreign exchange than it requires. The World Bank loan should have been completely unnecessary ['Report and Recommendation, ~ 1979]. Throughout the Developing World, there are many more examples of such self-perpetuating foreign exchange shortages. Often such countries undergo what is known in the local press as a "foreign exchange crisis:" a catastrophic collapse of the economy's ability to maintain the flow of essential imports resulting in draconian trade and exchange controls. Although terms of trade fluctuations or disturbances in world markets may play a role, "foreign exchange crises" typically arise when governments allow their domestic currencies to become seriously overvalued but resist devaluation because they feel that it will fan the flames of inflation. For a period of time, external borrowing or reserve depletion can maintain import levels, but sooner or later these wells run dry. Then the government must resort to foreign exchange or import controls if the authorities still cannot accept a devaluation. This creates a new foreign exchange regime-one where quotas are used to reduce import levels to the available supply of foreign exchange. Because such regimes involve a fixed exchange rate at which the Central Bank buys foreign exchange and sells rationed amounts of foreign exchange, they can be confused with standard, fixed exchange rate regimes. But there is a vital difference between these two types of regimes. Under a standard, fixed rate regime, the Central Bank buys and sells foreign exchange to equilibrate the supply and demand for foreign exchange. By contrast, in an import control regime, the Central Bank does not have usable foreign exchange reserves to sell. It must ration imports in order to reduce the level of demand for foreign exchange. Many attempts to model the effects of import controls, such as Occampo [1987] are not as useful as they first appear because they treat import controls as exogenous, rather than determining the quotas as a result of foreign exchange availability. Consequently, they are not true general equilibrium models. Although they are common in the Third Wodd, there is little good general equilibrium literature on this topic. McKinnon [1979, p. 440], in a review of the multiple volume NBER study, Foreign Trade Regimes and Economic Development, headed by Bhagwati and Krueger, pointed out that "Devaluation in the presence of exchange controls and other QRs has not been well worked out in