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INTRODUCTION
Consumption subsidies and public enterprise prices are important policy
instruments in developing economies. Such policies are typically used for
redistribution purposes, sometimes even to buy votes by populist leaders. Since
economic reform usually requires the shutting down of 'loans' from the central
bank to parastatals, reducing consumption subsidies and increasing public
enterprise prices, price reform plays an important role in IMF and World
Bank programmes. Edwards (1989a), for example, found that public enterprise
price increases and reductions in consumption subsidies were involved in 79
and 44 per cent respectively of IMF programmes between 1983 and 1985.
Trade reforms, in contrast, were present in just 35 per cent of cases.
To date, the real exchange rate effects of public sector price policies have
received no formal attention from economists.' In this paper, we show that
lasting public sector price reforms produce, under plausible assumptions, a
permanent real exchange rate appreciation. This finding has important policy
implications and may provide a partial explanation for the puzzling real
appreciations that have taken place in many developing countries following
economic reform. Typically, such real appreciations are believed to arise
because of lags in inflationary expectations or because of credibility problems.
It is not widely known that real exchange rate appreciations can also arise
from public sector reforms and that such real appreciations are permanent if
the reform is permanent. Thus, they cannot be removed by devaluation.
In this paper we examine the effects of public sector pricing policies in
three areas on the real exchange rate. First, there are direct subsidies for certain
consumers or producers; examples include food and fertilizer subsidies. The
second group of policies are implicit governmental subsidies arising from
public sector enterprises such as steel, fertilizers and petrochemicals. State
enterprises, in addition, are often important in the transport and public utility
areas.2 Finally, we analyse the effects of selective price controls on the real
exchange rate.3
The paper is organized as follows. In Section I we develop a model of real
exchange rate determination. Our model is a purely real one which abstracts
from the monetary and intertemporal effects of public sector pricing. Of course,
public sector price reforms can take place in conjunction with macroeconomic
stabilization or with trade liberalization. There is, however, no necessary
? The London School of Economics and Political Science 1993
I. THE MODEL
The model is a real model in the sense that there is no money or otherassets.4
All markets are assumed competitive. We assume that the economy is a
price-takerproducingone non-tradedgood (services) and a large numberof
traded goods, some of which are produced by governmententerprises.The
assumptionthat public sector output is traded is relaxed later. Withoutloss
of generality,let us choose one of the tradedgoods as our numeraire.Govern-
ment enterprisesare assumedto set marginalcost equal to price.
Let us assumethat the economy consists of a single aggregatehousehold.
This allows us to modelthe demandside of the economyusingthe expenditure
function e(.), given in equation (1). We assume that all goods are normal.
National income is given by the GNP or revenuefunction r(*). In equation
(1), p, is the price of the non-tradedgood, p is a vectorof tradedgoods prices,
m is a vector of imports, U is a scalarrepresentingwelfare, V is a vector of
factorendowments,t is a vectorof tradetaxes and s is a vectorof government
consumptionsubsidies. One element of p, the numeraire,is equal to 1. The
superscriptc denotes prices faced by consumers.Note that the firstderivative
of the expenditureand GNP functionswith respectto the ith price provides
compensateddemandand outputsupplyfunctionsrespectively.Thus,the total
demandand supplyof tradablesis given by ep( - ) and rp(- ), which are vectors
of derivativesof the expenditureand revenuefunctionswith respectto traded
prices.'
For equilibrium,income mustequal expenditureand the non-tradedgoods
marketmust clear. Equation (1) sets expenditureequal to national income
plus tariff revenue minus consumptionsubsidies. We assume that subsidies
are financedby lump-sumtaxes and that tariff revenue is also redistributed
in a lump-sumfashion.
(1) e(pc pSc; U)o= r(p, pa; V)P+otmi - sep.
@) The London School of Economics and Political Science 1993
where
7Lsi >0, _ S >0.
77ss+ ESS 77ss+ rss
The real income effects of a reduction in the oil subsidy are given by (13),
which is positive.'0 To obtain this result, all other distortions in the economy
are set to zero.
?lss + Ess
The oil price increase shifts demand towards non-traded goods while raising
costs in the non-traded sector. However, the oil price rise also changes factor
returns, which has indirect effects on the supply of non-traded goods. The
factor price effect can reduce or can even increase the supply of services.
Consequently, the overall effects of a reduction of a mixed consumption
subsidy on the supply of non-traded goods depends on whether the cost-
increasing effects are outweighed by possible changes in factor rewards. If the
cross elasticity of supply of services with respect to the price of oil (eSO) is
negative, then, as shown by (14), the non-traded price level will increase and
the real exchange rate will appreciate.
(15) R =-[ao+ as(wo+ P)]fO-aY9 <0?
Proposition 2. The removal of a subsidy on a good that is consumed and is
used as an input produces a real exchange rate appreciation if non-traded
goods and the subsidized good are substitutes in supply.
price level and hence a real exchange rate appreciation. A more common
situation in developing economies is where price controls are selectively applied
to certain goods or services.13 This section provides a general equilibrium
treatment of the relationship between selective price controls and the real
exchange rate.14
Let us assume that price control is imposed on a non-traded good z
produced by the private sector.15 Define the controlled price as jz. We initially
assume that price control is costlessly imposed and perfectly monitored, that
no black markets emerge and that quality is unchanged. We also assume that
the controlled product is allocated to the highest-value users and that rents
arising from rent control are distributed in lump-sum fashion. Admittedly,
these assumptions associated with traditional textbook treatments of price
control are unrealistic. They do, however, allow us to isolate the economic
forces which determine the impact of price controls on the real exchange rate.
The polar case, where all rents are dissipated, is considered later.
Equation (25) solves for the impact of a relaxation in price control on the
service price level. A relaxation of price control increases the producer price
of z, reduces its virtual price and raises real income.'8 As a result, consumers
substitute from services towards the cheaper z. The pure substitution effect is
? The London School of Economics and Political Science 1993
To sum up, except for an easing of price controls, there is a clear presumption
that public sector price reforms will appreciate the real exchange rate. In this
section we analyze public sector pricing policies associated with the Alan
Garcia and Alberto Fujimori governments in Peru. Our purpose is to illustrate,
for readers unfamiliar with developing economies, the enormous changes in
relative prices that result from such policies. In particular, we focus on the
effects of the large public sector price increases of August 1990 on the Peruvian
real exchange rate.
The Alan Garcia administration took office in August 1985. Its economic
programme called for a partial suspension of payments on international debt,
expansionary demand policies and greater restrictions on international trade.
After an initial growth spurt in 1986-87, Peru ran into severe current account
problems, experienced an acceleration in inflation, and suffered a rapid fall
in output and real wages. We confine our attention to developments in the
areas of interest to the subject matter of our paper: subsidies and public sector
23
pricing.
Before the 1990 reforms, Peru had 135 state enterprises. State enterprises
were the sole producers of electricity, gas, oil and telecommunications and
had roughly a one-third share in mining and transport. In 1982 state enterprises
accounted for 32 per cent of GNP (Balassa et al. 1986).
Table 1 presents data on the real prices of public sector products in Peru
for the 1985-92 period. The public sector price index was constructed using
TABLE 1
REAL PUBLIC SECTOR PRICES IN PERU, 1985-92
aThe public sector price index is computed in terms of all other goods, i.e. all non-public-sector
goods.
Source: Instituto Nacional de Estadistica and Coyuntura Economica, Universidad del Pacifico,
Lima, May 1992.
? The LondonSchool of Economicsand PoliticalScience 1993
Stabilization plan
8 August 1990
60- _
50-
TABLE 2
CHANGES IN PRICES IN PERU, JUNE 1990-OCTOBER 1990
(%permonth)
E pgPS PTP
Source: Nota Semanal no. 6, 7 February 1991, p. 57 and no. 18, 18 May 1992, p.
68 and author's calculations.
five times its previousaveragein one month.Inflationwas 397 per cent in the
month of August.Equallynoticeablefromthis table is the fall in the relative
price of non-tradedgoods in August.This is less of a puzzleonce it is realized
that the currencydepreciationand rise in consumerprices reduced the real
money supplyby 40 per cent havinga negativeliquidityeffecton the price of
services.27Finally,the trade liberalizationaccountsfor the relativelylow rate
of increase in the price to tradablesin Septemberand October,when traded
price level fell by 38 per cent in termsof the exchangerate.28
Table 3 gives the decompositionof the sourcesreal exchangerate changes
accordingto equation (31). The reformsof August were accompaniedby a
real appreciationdespite the huge devaluation.The final column of the table
shows that changes in the externalprice level played little role in explaining
m The LondonSchool of Economicsand PoliticalScience1993
TABLE 3
DECOMPOSITION OF CHANGES IN THE REAL EXCHANGE RATEa.b
(% per month)
real exchange rate developments over this period. In fact, the large real
exchange rate appreciation of 36 per cent in August 1990 is explained mainly
by public sector price increases. Finally, the real depreciation of September
1990 is largely accounted for by the trade liberalization.
Augmented Dickey-Fuller tests for the real exchange rate and the relative
price of public sector goods in terms of the exchange rate are displayed in
Table 4. The data are monthly from July 1985 to March 1992. As shown by
the results, both of these variables appear to be non-stationary I(1) variables.
It follows that we may test for the existence of a long-run relationship between
these variables by testing for co-integration.
Following Engel and Granger (1987), we tested for co-integration using
an augmented Dickey-Fuller test (with three lags) on residuals obtained from
regressing the real exchange rate on the relative price of non-traded goods.
The augmented Dickey-Fuller test produced a t-statistic which is significant
TABLE 4
STATIONARITY TESTS*, PERU,
JANUARY 1985-APRIL 1992a
Variable ADF
In R 0.46
In (E/pg) 0 07
A ln R 6.02**
A ln (E/pg) 5.80**
Residuals 2.85*
a The variablesare: R = the real exchange
rate, (E/pg) = the ratio of the price of the
dollar to the price of the public sector
output as in equation (31). All variables
are measuredin logarithms.A refers to
first differences.ADF is the augmented
Dickey-Fullerstatisticwiththreelags.The
symbols ** and * indicate rejections at the
1 and 5 per cent levels, respectively.
( The LondonSchool of Economicsand PoliticalScience1993
at the 6 per cent level, thus providing further evidence suggesting a long-run
relationship between public sector prices and the real exchange rate.
V. CONCLUDING COMMENTS
We have examined the effects of public sector pricing policies on the real
exchange rate. Our principal results are as follows.
1. The removal of a consumption subsidy on a traded good used solely
for consumption purposes will appreciate the real exchange rate, owing to
increased demand for non-traded goods.
2. When a traded good is consumed directly and is also used as an input,
the removal of a subsidy will appreciate the real exchange rate if non-traded
goods and the previously subsidized good are general-equilibrium substitutes
in supply.
3. Increases in the relative price of public sector products tend to increase
the demand for other nontraded goods and thus to appreciate the real exchange
rate. However, the increase in the supply of other non-traded goods arising
from the contraction of the public sector may outweigh the demand effects.
In practice, we expect that the direct effects will outweigh indirect effects.
4. A relaxation of price control increases the measured price of controlled
goods, thus having a direct influence toward real exchange rate appreciation.
However, counter-effects on the supply side, notably through the expansion
of the previously price-controlled sector, may offset the direct effects. Con-
sequently, the net impact on the real exchange rate of a relaxation of price
controls is ambiguous.
5. As an empirical matter, we believe that comprehensive public sector
price reforms tend to appreciate the real exchange rate permanently unless
previous subsidy levels are restored. The public sector reforms of Peru in
August 1990 were followed by a large real appreciation which is still in place.29
The same forces are at work in many other reform packages. Thus, for public
sector programmes which involve the reduction of subsidies and public enter-
prise price increases, we expect real appreciations to be the norm rather than
the exception.30
ACKNOWLEDGMENTS
We are indebted to an anonymousreferee for particularlyhelpful suggestionson a
previousdraftof this paper.
NOTES
1. Dornbusch et aL (1990) and Buffie (1992) examine some macroeconomic issues arising from
public sector pricing without mentioning the real exchange rate.
2. For many developing countries, state enterprises produce between 10 and 20 per cent of GNP.
They are particularly important in Africa and Latin America. Short (1984), for example, found
that the average share of public enterprises for African economies was 18 per cent while
Balassa et al. (1986) estimated that the average for large Latin American economies was 19
per cent. See also Ayub and Hegstad (1987) and World Bank (1988).
3. We ignore pricing in the education and health areas.
4. Here we follow the approach of earlier papers on the real exchange rate such as Neary (1988)
and Edwards (1989b).
5. For details of the GNP and expenditure functions, see Woodland (1982).
6. In this purely real model, the exchange rate plays the role of a unit of account or 'conversion
factor'.
7. Using the approach of Woodland (1982) and Neary (1988), the model can be extended to
allow for a vector of non-traded goods. In addition, Neary (1985) allows for unemployment.
These extensions complicate the model without changing our results.
8. The results are unchanged if a producer price index is substituted for the consumer price index.
9. We adopt this assumption for simplicity. The more general case, where the supply of oil is
variable, requires that separate revenue functions be specified for the oil and the non-oil
economy. Our results continue to hold in the more general model.
10. From Shepard's lemma, the first derivative of the revenue function with respect to the price
of oil (r' ) gives the demand for oil as an intermediate input by the non-oil domestic economy.
11. The Esgterm is negative in the specific factor model, but can be positive or negative in the
Heckscher-Ohlin model. In general, there is a presumption that Esg is negative.
12. In practice, public-sector reform means that public enterprises are often sold to the private
sector. If the public-sector enterprise has monopoly power, this changes our results in two
ways. First, the price increases arising from 'privatization' are likely to be greater, and second,
the real income effects are uncertain.
13. Selective price controls have long been a feature of Latin American economies (see Balassa
et al. 1986 for evidence).
14. For partial equilibrium approaches to price controls, see Barzel (1974), Cheung (1974) and
Sah (1987).
15. Our results are readily generalized to cover shortages that arise when public sector prices lag
behind inflation, or to cover the imposition of price controls on traded goods.
16. For details of the restricted expenditure function, see Deaton and Muellebaur (1980) and
Cornes (1992).
17. For a different general equilibrium treatment of price control, see Helpman (1988).
18. These results can be obtained by totally differentiating (3), (24) and (25) and using the
assumption of substitutability in demand and supply.
19. Gould and Henry (1967) showed, in a partial equilibrium model based on Tobin and
Houthakker (1950-51), that the effects of price control on the demand for substitutes is
uncertain; see Neary and Roberts (1981) and Fallis and Smith (1984).
20. If trade ceases, price controls on importables and exportables have identical real exchange
rate effects. If trade continues for an export good, an easing of price controls raises the
non-traded price level.
21. Strictly speaking, this result holds only when all other distortions are set to zero. With more
than one distortion, rent-seeking can increase welfare from second-best considerations.
22. In short-run models this parameter is negative.
23. Much of the following discussion relies on the World Bank (1989). Paus (1991) presents a
more sympathetic account of Peruvian economic policy over this period.
24. The model of the previous section used a traded good as the numeraire. However, in this
context it is more informative to deflate prices by the consumer price index.
25. The Garcia administration intensified trade restrictions. By 1987, all imports required a licence.
The unweighted average tariff for manufactures was estimated at 69 per cent in December
1987 by the World Bank Mission (World Bank 1989). The average effective rate of protection
arising from trade restrictions and multiple exchange rates was estimated at 141 per cent.
26. The 50 per cent rate was abolished in April 1991.
27. For a model of this process, see Connolly and Taylor (1976).
28. The theory of trade liberalization and its effect on the relative price of non traded goods is
dealt with in Connolly and Devereux (1992).
29. Many argue that the real appreciation of the new sole is a result of Dutch Disease, caused
by coca paste exports. This argument, however, if true, applied before the 1990 reforms and
thus could not explain the subsequent real appreciation.
30. The results also hold in intertemporal models. In particular, a permanent reduction in
consumption subsidies or public sector prices will appreciate the real exchange rate. Inter-
temporal models also allow us to analyse the effects of public sector pricing on the current
account. It can be shown that a temporary consumption subsidy along with a public sector
price reduction worsens the current account.
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