IFPRI Discussion Paper 01477 October 2015 Adjusting to External Shocks in Small Open Economies The Case of Honduras Samuel Morley Valeria Piñeiro Markets, Trade and Institutions Division INTERNATIONAL FOOD POLICY RESEARCH INSTITUTE The International Food Policy Research Institute (IFPRI), established in 1975, provides evidence-based policy solutions to sustainably end hunger and malnutrition and reduce poverty. The Institute conducts research, communicates results, optimizes partnerships, and builds capacity to ensure sustainable food production, promote healthy food systems, improve markets and trade, transform agriculture, build resilience, and strengthen institutions and governance. Gender is considered in all of the Institute’s work. IFPRI collaborates with partners around the world, including development implementers, public institutions, the private sector, and farmers’ organizations, to ensure that local, national, regional, and global food policies are based on evidence. IFPRI is a member of the CGIAR Consortium. AUTHORS Samuel Morley (s. [email protected]) is a visiting senior research fellow in the Markets, Trade and Institutions Division of the International Food Policy Research Institute (IFPRI), Washington, DC. Valeria Piñeiro ([email protected]) is a research coordinator in the Markets, Trade and Institutions Division of IFPRI, Washington, DC. Notices 1. IFPRI Discussion Papers contain preliminary material and research results and are circulated in order to stimulate discussion and critical comment. They have not been subject to a formal external review via IFPRI’s Publications Review Committee. Any opinions stated herein are those of the author(s) and are not necessarily representative of or endorsed by the International Food Policy Research Institute. 2. The boundaries and names shown and the designations used on the map(s) herein do not imply official endorsement or acceptance by the International Food Policy Research Institute (IFPRI) or its partners and contributors. Copyright 2015 International Food Policy Research Institute. All rights reserved. Sections of this material may be reproduced for personal and not-for-profit use without the express written permission of but with acknowledgment to IFPRI. To reproduce the material contained herein for profit or commercial use requires express written permission. To obtain permission, contact [email protected]. Contents Abstract v Acknowledgments vi 1. Introduction 1 2. Honduras’s Macroeconomic Environment 3 3. The Model 11 4. The Macro Simulations 15 5. Conclusions 23 Appendix A: Econometric Analysis of the Determinants of Output Growth 25 Appendix B: Supplementary Tables 32 References 35 iii Tables 2.1 Components of gross domestic product 4 2.2 Sector shares in gross domestic product 5 2.3 Growth rates of productivity since 1960 (percent) 6 2.4 Average shares in the capacity to import 8 3.1 2008 macro-SAM for Honduras, in billions of Honduran lempiras 12 4.1 Percentage change in macro variables in response to reduction in remittances and foreign savings 16 4.2 Percentage change in macro variables in response to a 10 percent oil price shock 17 4.3 Percentage change in sectoral output, real wages, and unemployment in response to a 10 percent oil price shock 18 4.4 Percentage change in macro variables in response to coffee and maquila productivity shocks 19 4.5 Percentage change in real wages and unemployment in response to reductions in prices and productivity 20 4.6 Percentage change in macro variables in response to a 10 percent increase in investment financed by foreign savings 21 4.7 Percentage change in sectoral output, real wages, and unemployment in response to 10 percent investment 22 A.1 Regression 1 27 A.2 Johansen cointegration test 28 A.3 Normalized cointegrating coefficients, one cointegrating equation 28 A.4 Engle-Granger first step 29 A.5 Engle-Granger second step 29 A.6 Third step Engle Yoo 30 A.7 Granger causality test 31 B.1 Data for regression 1 32 B.2 Sectors of the disaggregated micro-SAM 33 Figures 2.1 GDP per capita in constant local currency units, 1960–2013 3 2.2 Investment rate and growth in gross domestic product 5 2.3 Gross domestic product and capacity to import, 1974–2011 7 2.4 Remittances 9 2.5 Exports of goods and maquila in real terms 10 3.1 Flow of goods from producers to the national composite commodity market 13 iv ABSTRACT Like the other small economies of Central America, the economy of Honduras is a challenge for all those searching for an adequate and sustainable growth strategy. After growing strongly for the two decades prior to 1980, the economy suffered through more than 20 years of growth so slow that only in 1998 did per capita income surpass the level it had reached in 1980. Then things seemed to change. For five years (2004–2008) the economy grew by an average of almost 6 percent per year, a performance unmatched since the late 1970s. But then the world financial crisis of 2009 put an end to the boom and pushed Honduras into recession. While the economy subsequently recovered, it has never come close to the growth rates of the early 1990s. Indeed, the growth rate appears to have settled back to around 3.3 percent, enough to produce only a slight increase in per capita income. In this paper we address several growth-related questions. First, what are the drivers of growth, how have they changed, and are the changes related to the cyclic nature of growth in Honduras? Second, how important are negative exogenous balance-of-payments shocks in explaining the many periods of lackluster growth? Third, what can policymakers do to offset the exogenous external shocks and increase the growth rate? We rely on several fundamental inputs in addressing these questions: first, observed patterns of sectoral growth and their changes over time; second, changes in two key determinants of growth, capital and the capacity to import; and third, changes in important exogenous variables such as the real exchange rate and the terms of trade. Finally we develop and present a model of the economy with which we will simulate the impact of various exogenous shocks as well as the policy responses to ameliorate or offset the effect of negative shocks. Keywords: general equilibrium models, Honduras, economic development, macro shocks, foreign exchange constraints v ACKNOWLEDGMENTS This project was financed by the Inter-American Development Bank. We wish to thank Alejandro Quijada Briceño and Jose David Sierra Castillo for their comments and support. vi 1. INTRODUCTION Small open economies like that of Honduras present difficult macro policy challenges to policymakers as they search for the least harmful way to adjust to negative macro shocks imported from abroad. These economies are likely to be quite sensitive to such shocks because of their openness and their limited ability to shift production toward the traded-goods sector with the speed and volume necessary to offset the shock. This makes it all that much more important that policymakers be aware of the challenge they face as they attempt to choose an appropriate policy response to a negative external shock. In this paper we develop a computable general equilibrium (CGE) model based on data for Honduras to explore policy options available to the government. We are particularly interested in how the outcomes of various policies are affected by both the structure of the economy and the degree of real wage and exchange rate rigidity. The first eight years after the turn of the millennium were good for Honduras, with gross domestic product (GDP) growth averaging more than 6 percent for the five years 2002–2007. Then in 2008, the first external shock hit in the form of a rapid rise in the prices of petroleum and other imports for which there were few domestic substitutes. To complicate matters further, two of the major sources of foreign exchange, maquila exports and remittance inflows, have both declined significantly in real terms since 2007. These are major shocks for an economy as open as that of Honduras. The question we wish to address here is the effect of these shocks on the Honduran economy under a number of different policy scenarios. If we use a CGE model in which we assume or posit full employment of both capital and labor, we know what the effect of a negative-balance shock will be. There will have to be a real devaluation sufficient to offset the shock at full equilibrium. That means that either the nominal exchange rate itself must be devalued or, if it is fixed, domestic prices and wages have to fall by an amount sufficient to produce the same real devaluation that would have been produced by permitting the nominal exchange rate to rise. In either case the relative price of tradables has to rise, but in one case that rise is produced by a rise in the domestic price of tradables because of the devaluation, and in the other it is produced through a decline in the price of nontradables. The CGE model will not show much difference between these two alternatives, assuming that wages and prices are flexible. But in actual practice there is a world of difference between them. With flexible exchange rates there will be a general rise in the price level. Bondholders will lose, and so will those unwise enough to have borrowed in US dollars. If the government tries to defend the nominal exchange rate, prices and wages have to go down. The only way that can happen is through a recession whose economic function is to force that downward adjustment. In this case bondholders gain while debtors and workers in the nontraded goods sector lose. The problem is far more complicated if we introduce several real-world factors relevant to Honduras into the adjustment process.