Second-Best Foreign Exchange Policy in the Presence of Domestic Price Controls and Export Subsidies

Abstract

Poland, like many developing countries, has required its exporters to surrender a share of their foreign exchange earnings to the government at an overvalued exchange rate. During the late 1980s, it progressively increased the share which exporters were allowed to retain (the retention ratio), but other distortions to the trade regime remained. A model developed here estimates the effects of these policies on welfare under different foreign exchange elasticities, export and import subsidies, official exchange rates, and policies on exporter retention of foreign exchange earnings. The retention ratios in effect in early 1989 were equivalent to a 51 percent tax on exports or an import tariff of 130 percent. As economic theory would suggest, maximum social benefit would derive from removal of the full range of distortions. Full retention of foreign exchange by exporters in the absence of other distortions would provide social benefits equivalent to 8 percent of gross domestic product. But the net effect of the other policies together is a bias toward tradables, so that a policy of somewhat less than full retention of foreign exchange is optimal in this second-best world.