Devaluation and Economic Stimulation: the Fiji Economy Post-Coup

DEVALUATION AND ECONOMIC STIMULATION

Devaluation and economic stimulation: the Fiji economy post-coup

Mahendra Reddy

The Fijian economy underwent a 33 per cent devaluation of Mahendra Reddy is a its dollar against its major trading partners after the military PhD candidate in the coup in 1987. This move, as part of the broader structural Department of Agricul- adjustment package, was designed to boost the sluggish tural and Resource economy by promoting exports and discouraging imports. Economics, University of Hawaii and an East– This study, which uses elasticities, indicates that the balance of West Center Degree trade will deteriorate in the short run. In the longer run, real Fellow at the East–West net exports will respond positively to changes in relative Center, Honolulu, prices and thus lead to a improvement in trade balance, if Hawaii. combined with other tools to promote private investment and raise aggregate demand.

The mainstream view of using dollar devaluation generally did not work well in depreciation as a means of correcting a their countries, for a variety of reasons. trade imbalance has often been challenged. Various factors such as institutional The three main pillars of the mainstream rigidities, low substitution between view include a policy mix of fiscal imported goods and domestic output, and contraction and monetary expansion internal and external balance conflicts do which drives down the dollar value in real not permit the price and exchange rate terms; a real depreciation is necessary to mechanism to work. Despite these achieve deficit reduction; and the extent of challenges to the mainstream view, depreciation needed is more or less devaluation is one of the most widely-used predictable because of a stable relationship tools in developing economies to correct between trade flows and real exchange current account deficit problems. Countries rates (Krugman 1991). In particular, with fixed exchange rates generally tend to economists from developing economies have an overvalued dollar, so devaluation have often argued that currency is one of the commonly used tools to drive

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down the value of the dollar in order to and long-run price elasticities. Estimating correct the balance of trade deficit. the price elasticities of import and export Using the elasticity approach, the demand will also help determine whether impact of devaluation on the trade balance future devaluations will help stimulate the can be explained as follows. Assuming a economy (Forsyth 1996). Policy implications perfectly elastic supply of imports, it is are drawn to explain the response of import presumed that devaluation initially tends and export demand to a devaluation of the to reduce foreign prices of domestic exports Fiji dollar in the post-coup period. in proportion to the devaluation. At the reduced price, foreign demand for domestic exports will increase. The extent to which Economic performance and the domestic country’s exports will change macroeconomic policy depends on the elasticity of foreign demand for the domestic country’s exports and the The overall growth and development of the elasticity of domestic supply of goods. Fijian economy can be directly linked to the Similarly on the import side, the initial performance of two of its most important effect of devaluation is to raise the domestic industries, sugar and tourism. The sugar price of imports leading to some reduction industry has continued to be the country’s in the country’s demand for imports. The top export earner, with tourism the second. size of these reactions depends on the Export receipts from sugar have been elasticity of import demand. This phenom- greatly enhanced by a preferential trading enon can be expressed using the Marshall- arrangement Fiji has enjoyed with the Lerner condition (that is, the sum of the European Union market since early 1970s, export demand and import demand prior to which Fiji was selling its sugar to elasticities is greater than one). If the the United Kingdom under the Common- Marshall-Lerner condition is satisfied, wealth Sugar Agreement. In the 1972 to then devaluation will help improve the 1981 period, the economy displayed a real trade balance. GDP growth rate averaging 5.1 per cent. With the oil price shocks in 1979 coupled In Fiji’s case, the trade balance with sugar price fluctuations and domestic continued to deteriorate after devaluation. problems, the economy was facing a major The following possible scenarios may help financial crisis in early 1980s. This was the explain this result turning point for the government's policy € the Marshall-Lerner condition for a agenda, a move away from an ‘inward- trade balance improvement is not looking, high tax, and slow growth satisfied economy to a dynamic outward looking, • if it is satisfied, the effect of low tax and high growth economy’ (Fiji devaluation is taking the ‘J-curve’ Ministry of Finance 1991:3). Fiji’s growth pattern (Hooper and Marquez 1993) strategy changed in 1986, with the • the contractionary effects are down- establishment of export processing zones. playing the positive effect of de- Before any benefit could be reaped from valuation (Krugman and Taylor 1978). these, the two successive military coups This paper first attempts to determine rocked the economy with subsequent whether the Marshall-Lerner condition for increased capital outflight, declines in the Fijian economy is satisfied or not. The tourism and instability in the sugar Marshallian export and import demand industry. These shocks led the interim model is estimated to obtain both the short government to consider strongly the

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Figure 1 Fiji's nominal exchange rate/F$, 1981–95

2 1.8 1.6 1.4 1.2

e rate ($F) 1 g 0.8 0.6 Exchan 0.4 0.2 0 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 Year UK Pound US$ AUS$ NZ$

Source: South Pacific Economic and Social Database, National Centre for Development Studies, The Australian National University, Canberra. promulgation of the other necessary import and export quantities, and prices to ingredient of a structural adjustment their equilibrium values is instantaneous. program—an export-led growth strategy. In this case, the adjustment takes place Initial policy measures included a two-step within a year. In the dynamic model, the devaluation of the Fijian dollar, with a total above assumption is relaxed and the devaluation of 33 per cent (Figure 1), and possibility of adjustment to equilibrium generous incentive packages and other values with some delay is permitted. promotional measures (such as tax holidays of up to 13 years), to attract foreign and Equilibrium model domestic investment. The demand for Fiji’s exports by its major These four macroeconomic policies: trading partners is specified in the log- deregulation of the economy; restraint in linear form as follows government expenditure; taxation reform ln X = δ + δ ln (PX/PXW) + δ ln (YW) + u (1) and labour market reform, form the pillars t 0 1 t 2 t t of structural adjustment policies (SAPs). where

Xt = quantity index of exports demanded Theoretical specification of export PX = price index of exports and import demand functions t PXWt = weighted average export prices of Two basic versions of the export and Fiji’s major trading partners (Japan, import demand functions are considered United Kingdom, Australia, New here—the ‘equilibrium’ and the ‘dynamic’ Zealand and United States of America) model. The equilibrium model makes the YWt = weighted average of the real simplifying assumption that there are no incomes of the Fiji’s major trading lags in the system, so that the adjustment of partners (F$ billion)

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δ δ δ ut = random error term ln Xt = 0 + 1 ln (PX/PXW)t + 2 ln (YW)t δ Since Equation 1 is specified in + 3 ln Xt-1 + ut (4) δ δ logarithms, 1 and 2 are the (relative) price where Xt-1 is the lagged dependent variable and real income elasticities (of export (exports). demand), respectively. It is expected that δ 1 Based on a priori theory, the expected will be negative and δ will be positive. The 2 signs of the parameters δ , δ and δ are use of PXW as a divisor of PX implies that 1 2 3 jt t negative, positive and positive respectively. Equation 1 explicitly reflects competition The mean time lag in the adjustment of among the different suppliers to Fiji rather exports is equal to l-1 and can be computed than competition between the Fiji’s imports from the parameters of Equation 4 as and its domestic output. δ -1 (1- 3) . In a similar manner, the import demand Similarly, the partial-adjustment equation is specified in the simple form mechanism is also applied to imports where β β β ln Mt = 0 + 1 lnYt + 2 ln (PM/CPI)t + ut (2) the change in imports is related to the where difference between the demand for imports in period t and the actual level of imports in M t = Fiji’s quantity index of imports the previous period. The dynamic import Y = Fiji’s real national income (F$ t demand equation is then stated as follows billion) lnM = β + β ln Y + β ln (PM/CPI) PM = import price index t 0 1 t 2 t t + β ln M + u (5) CPI = Fiji’s consumer price index 3 t-1 t t where M is the lagged dependent u = random error term. t-1 t variable (imports). Dynamic model In order to introduce dynamic behaviour Results and discussion into the model, the adjustment mechanism outlined by Houthakker and Magee (1969), Khan and Ross (1977) and Goldstein and Import and export demand equations Khan (1978) is adopted. In this model, The equilibrium and dynamic forms of the exports are assumed to adjust to the import and export demand equations were difference between demand for exports in estimated using the ordinary least squares period t and the actual flow of exports in method. Due to a poor performance of the the previous period (t ). This mechanism -1 equilibrium model, in particular the import can be stated as follows demand equation, the β and δ coefficients ∆ λ ln Xt = [ln Xt – ln Xt-1] (3) for the import demand and export demand where λ is the coefficient of adjustment and equations respectively, is derived from their ∆ is a first difference operator. respective dynamic equations. At The adjustment function assumes that equilibrium, from Equation 3 we can state the quantity of exports adjusts to conditions ln Xt = ln Xt-1. of excess demand in the rest of the world, Assuming δ to be the coefficient of the and therefore, the price of exports is deter- dynamic export demand equation and δ* mined in the exporting country. Substituting the coefficient of the equilibrium equation, δ Equation 3 into Equation 1, we obtain an then * can be derived from the dynamic estimating equation for exports equation coefficient as follows

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Table 1 Export demand equation, 1970–94

Variable Equilibrium equation parameters: Dynamic equation estimates: Equation 4

Equation 1 (dependent variable: ln Xt) (dependent variable: ln Xt) Constant -5.141 -2.920*

ln Ywt 0.761 0.432*

ln (PX/PXW)t -0.778 -0.442*

ln Xt-1 0.432* Adjusted R2 0.919 DW 1.877

Sources: South Pacific Economic and Social Database, National Centre for Development Studies, The Australian National University, Canberra; Fiji Bureau of Statistics, Current Economic Statistics, Suva (various issues).

δ δ δ 0* = [( 0)/1- 3], The signs of all the variables in the two δ δ δ 1*= [( 1)/1- 3], models conform to a priori expectations. δ δ δ 2*= [( 2)/1- 3] (6) The short-run price elasticities of demand The final form of the data used in the for exports are negative and significantly estimation process is presented in different from zero (Tables 1 and 2). As Appendix 1. Results of the OLS estimates expected the short-run price elasticities are along with the derived equilibrium smaller than the long-run price elasticities parameters, are presented in Table 1. (Table 3). The short and long-run income

Table 2 Import demand equation, 1970–94

Variable Equilibrium equation parameters: Dynamic equation estimates: Equation 5

Equation 2 (dependent variable: ln Mt) (dependent variable: ln Mt) Coefficient Coefficient Constant 2.173 0.389

lnYt 2.385 0.427

ln (PM/CPI)t -1.530 -0.274

ln Mt-1 0.821* Adjusted R2 0.724 DW 1.987

Note: * denotes 5 per cent level of significance. Sources: South Pacific Economic and Social Database, National Centre for Development Studies, The Australian National University, Canberra; Fiji Bureau of Statistics, Current Economic Statistics, Suva (various issues).

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Table 3 Short and long-run elasticity estimates

Short run elasticity Long run elasticity Mean time lag Income Price Income Price Export 0.43 -0.44 0.76 -0.77 1.76 Import 0.43 -0.27 2.40 -1.51 5.59 Marshall-Lerner Condition 0.71 2.28

elasticities display similar results. The The highly elastic import demand (-1.51) coefficient of lagged exports and imports implies that devaluation in the longer run are both significantly different from zero, will lead to a reduction in the overall implying a degree of dynamic adjustment. expenditure on imports due to a dominant The explanatory power of both models was quantity effect. Hence, a ‘J-curve’ pattern of extremely good, 91.9 per cent for the export response in trade balance to a devaluation demand equation and 72.4 per cent for the of the Fiji dollar is expected. The import demand equation (as expected in beginning of a ‘J-curve’ effect of the Koyck-type lag structure equations). The devaluation on the Fijian economy is short-run and long-run path of balance of illustrated in Figure 2. trade can be explained by examining the 2) Some of the reasons advanced for the Marshall-Lerner condition (Table 3). slow responsiveness of export and import volumes in the short run as compared to Macroeconomic policy implications the long-run period are summarised below. While admitting the possible limitations of € Time lags in consumer and producer using highly aggregate data over such a response—consumers take time to short time horizon in this study, the respond to changes in the competitive following inferences are drawn. environment in both the devaluing and foreign countries. In a small 1) A devaluation of the Fijian dollar can be country like Fiji, this effect is more successful in enhancing the external trade prevalent due to lack of substitutes or balance in the long run period. In the short better quality substitutes to enable run, export and import volumes do not immediate substitution. Similarly, change much. Given the highly price instantaneous response to change in inelastic demand for imports, -0.27 (Table demand can not be expected from the 3), the price effect dominates the quantity export sector. This entails a lagged effect, leading to increased expenditure on response to increased demand for the imports and therefore a trade balance export goods. Also, contractual deterioration. In the longer run, the agreements among trading partners Marshall-Lerner condition for trade prevent instantaneous cancellation balance improvement is satisfied (Table 3). of imports.

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Figure 2 Fiji's balance of trade, the J-curve phenomenon, 1987–95 (F$ million)

1987 1988 1989 1990 1991 1992 1993 1994 1995 0 -50 -100 -150 -200 -250 F$ million -300 -350 -400 -450 Year

Source: South Pacific Economic and Social Database, National Centre for Development Studies, The Australian National University, Canberra.

• Political instability—structural (Table 3). Assuming a point-balanced adjustment policies are more likely to trade, the same income growth and succeed when macroeconomic constant prices, the higher income problems are of more manageable elasticity of imports implies that if proportions, the economy less Fiji’s and the rest of the world’s vulnerable to external shocks, and output were to grow at similar rates, there is political stability (Dunham then Fiji would need a persistent and Kelegama 1997). The establish- depreciation of the dollar in order not ment of the interim government at the to have a steadily widening trade will of the military, followed by the deficit. promulgation of a racially discrim- • Limited domestic capacity—the trade inatory constitution against the will of deficit can increases either through the majority of the population in the an increase in imports, decreases in post-coup era, created a cloud of exports or a simultaneous occurrence uncertainty and risk, which limited of both. Following the devaluation in major long-term investment proposals. 1987, imports increased by 162 per € Income elasticity differential— cent (until 1995), while exports Johnson (1978) pointed out that in a increased by 129 per cent. What this two-country model with balanced may imply is that no matter how trade, the same income growth and conducive the export market is, if Fiji constant prices, the country with a doesn’t have the capacity to meet the higher income elasticity of import increasing export demand, export demand than the income elasticity of supply would not be able to increase demand for its export, will rapidly enough to balance trade. experience a more rapid deterioration • Initial ‘gap factor’—in 1987, prior to of its terms of trade. The long-run devaluation, Fiji’s imports greatly income elasticity of imports is greater exceeded exports. This created a ‘gap than the income elasticity of exports factor’, in which the growth in

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imports from economic activity necessary confidence to the private sector tended to raise the deficit unless to make long-term investments. The current offset by a significantly faster rate of developments in national politics, increase in exports. especially with regard to the constitution, 3) It should also be noted that devaluation are a step in the right direction. will only stimulate the economy through an increase in output if unemployed Acknowledgement resources exist. If resources are not available to support increased demand, prices will The author is indebted to an anonymous increase causing a fall in aggregate demand. reviewer for numerous helpful suggestions. Theorists like Hirschman (1949), Diaz- Alejandro (1963), and Cooper (1971) have References suggested that falling output and employ- ment can be frequently expected after Cooper, R.N., 1971. ‘Devaluation and devaluations. Therefore, economies with a aggregate demand in aid-receiving very narrow resource base require careful countries’, in J.N. Bhagwati et al., Trade, evaluation of their resource capacity before Balance of Payments and Growth, North- major policy initiatives are put in place. Holland, Amsterdam:355–76. Dunham, D. and Kelegama, S., 1997. Final remarks ‘Stabilization and Adjustment: a second look at the Sri Lankan experience, 1977–93,’ The Developing Economies This study uses elasticities to determine 45(1):166–84. whether devaluation would help to stimulate the Fijian economy. The long-run Diaz-Alejandro, Carlos F., 1963. ‘A note on import and export demand elasticities the impact of devaluation and the satisfy the Marshall-Lerner condition for a redistributive effect,’ Journal of Political positive impact of devaluation on the Economy 71(6):577–80. economy. As evident from the balance of Fiji Bureau of Statistics, 1985–95. Current trade figures since 1987, devaluation has Economics Statistics, Bureau of Statistics, had an immediate impact on export and Suva. import volumes. Instead, the price effect Fiji Ministry of Finance, 1991. 1992 Fiji increased the overall value of imports, Government Budget Address, Suva. further deteriorating the trade balance. Therefore, the short-run impact of Forsyth, D.J.C., 1996. ‘Fiji’s economy at the devaluation can be quite costly and, in crossroads’, Pacific Economic Bulletin some cases, unacceptable. In such cases, 11(1):1–30. government may combine it with other Goldstein, M. and Khan, M. S., 1978. ‘The tools that will help promote private sector supply and demand for export: a investment and thus raise aggregate simultaneous approach’, Review of demand. Economics and Statistics 60(2):275–86. The overall performance of these ——, 1985. ‘Income and price effects in policies, embarked on as part of the export- foreign trade’, in R.W. Jones and P.B. led growth strategy, will only be successful Kenen (eds), Handbook of International if the political environment provides the Economics, Vol. II:1041–105.

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Hill, J.K., 1990. ‘The trade balance and the real exchange rate,’ Economic Review November:1–15. Hirschman, A.O., 1949. ‘Devaluation and the trade balance: a note,’ Review of Economics and Statistics 31(1):50–53. Houthakker, H. and Magee, S., 1969. ‘Income and price elasticities in world trade,’ Review Economics and Statistics 51(2):11–125. Hooper, P. and Marquez, J., 1993. Exchange Rates, Prices, and External Adjustment in the United States and Japan, International Finance Discussion Papers, No. 456, International Monetary Fund, New York. Johnson, H.G., 1958. International Trade and Economic Growth, Harvard University Press, Cambridge. Khan, M.S and Ross, K.Z., 1977. ‘The functional form of the aggregate import demand equations,’ Journal of International Economics 7(2):149–60. Krugman, P., 1991. Has the Adjustment Process Worked? Policy Analysis in International Economics, Institute for International Economics, Washington, DC. Krugman, P. and Taylor, L., 1978. ‘Contractionary effects of devaluation’, Journal of International Economics 8(3):445–56. World Bank, 1995. World Tables, 1988–95, World Bank, Washington, DC.

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Appendix Table 1 Data used for analysis, 1971–92

YEAR Export Import Pex Pim PXW (Quantity index) (Price index) (Weighted average) 1971 1.1445 4.7487 14.1570 20.6700 31.1388 1972 1.0547 5.7219 19.8020 25.5250 36.6840 1973 0.6652 5.1764 26.1410 32.2680 47.3035 1974 0.4938 4.3685 70.1690 50.1340 57.6366 1975 0.6978 3.9777 52.7400 48.4611 56.6478 1976 0.7466 4.1292 41.4570 54.5960 60.2221 1977 1.1240 4.1456 33.7250 54.1880 62.0235 1978 1.2313 4.2830 33.6440 58.1900 68.9098 1979 1.2507 4.5189 41.2640 69.8610 82.3255 1980 0.7631 4.0086 73.7730 73.7730 91.6872 1981 0.9404 5.1457 64.5750 88.6588 93.9514 1982 1.2803 4.8187 47.3620 91.5350 90.3274 1983 1.2804 5.1760 50.6940 96.3650 90.6543 1984 1.6497 5.1775 45.2300 99.9430 90.7714 1985 1.9081 5.3861 39.1510 104.1200 89.6856 1986 2.3296 5.4302 39.3240 103.1410 92.0224 1987 2.7518 4.6367 47.4910 119.0270 101.4938 1988 2.5374 6.5725 78.5710 137.8590 113.9385 1989 3.2291 8.4226 79.2040 145.9450 117.9679 1990 3.1084 9.0067 91.3110 176.3610 120.9280 1991 2.7614 8.6357 94.5850 160.9110 122.6674 1992 3.0973 8.2949 97.8140 181.9740 125.7505

YW Fiji-RY CPI Ex-1 IM-1 (F$ billion) (F$ billion) (Quantity index) 1971 259.0896 0.6182 24.3000 1.4303 4.9696 1972 308.4109 0.6711 29.7000 1.1445 4.7487 1973 334.2928 0.7662 32.9000 1.0547 5.7219 1974 364.2458 0.7941 37.7000 0.6652 5.1764 1975 387.1711 0.7931 42.6000 0.4938 4.3685 1976 462.9726 0.8158 47.5000 0.6978 3.9777 1977 501.3680 0.8626 50.8000 0.7466 4.1292 1978 558.9112 0.8849 54.0000 1.1240 4.1456 1979 628.0865 0.9849 58.2000 1.2313 4.2830 1980 647.7674 0.9691 66.6000 1.2507 4.5189 1981 785.4055 1.0374 74.0000 0.7631 4.0086 1982 860.1016 0.9550 79.2000 0.9404 5.1457 1983 991.1966 0.9135 84.6000 1.2803 4.8187 1984 1125.8383 0.9899 89.0000 1.2804 5.1760 1985 1264.1996 0.9477 93.0000 1.6497 5.1775 1986 1383.1608 1.0232 94.6000 1.9081 5.3861 1987 1682.9368 0.9527 100.0000 2.3296 5.4302 1988 2202.8163 0.9582 111.8000 2.7518 4.6367 1989 2248.5925 1.0648 118.7000 2.5374 6.5725 1990 2307.9019 1.1349 128.4000 3.2291 8.4226 1991 2364.0979 1.1407 136.7000 3.1084 9.0067 1992 2478.5850 1.1496 143.4000 2.7614 8.6357