VII Cost-Price Distortions and Adjustment
- Rattan Bhatia
- Published Date:
- May 1985
The earlier sections have demonstrated that, notwithstanding the reforms of the BCEAO in 1974, monetary and fiscal developments have differed considerably among member countries. Theoretically, in a union with more integrated commercial and capital transactions, divergent trends would indeed initially lead to external imbalances among member countries; those with more restrained monetary and credit positions would have balance of payments surpluses vis-à-vis those with more expansionary policies. Ultimately, however, these imbalances would be corrected, through offsetting movements either in output and employment or in the exchange rate.
But in a union like the WAMU, with very few transactions among members, equilibrium within the Union does not automatically follow. Instead, the main impact of divergent monetary and fiscal positions will be on the individual member countries’ balance of payments with countries outside the Union. Nor will domestic costs and prices necessarily offset these trends; with little mobility of either labor or capital, and a rigid exchange rate, balance of payments deficits will not automatically produce lower prices and costs, as well as an eventual return to a balance of payments equilibrium in individual member countries. Thus, if price and cost differentials are persistent, they could put a strain on the common currency system. This is demonstrated by the data on prices, wages, costs, and the real effective exchange rates in the WAMU area.
Comparable detailed price data are not available for the six member countries of the WAMU for the period since the inception of the BCEAO in 1963. The most widely available data relate to the consumer price index, which, however, generally only reflects the urban cost of living. Even these data are not available as a continuous series and are heavily influenced by governmental controls on prices and by subsidies on consumer goods. The data on which Chart 1 is based are derived from two different sources, and cannot be linked, but they can give a broad idea of divergent price trends among member countries.
Chart 1.WAMU Members: Consumer Price Index, 1965–82
Sources: World Bank, World Tables (Washington) for 1965–74 data; and International Monetary Fund, International Financial Statistics (Washington: IMF) For data for 1975–82.
In both 1965–74 and 1975–82, Ivory Coast and Niger had relatively high inflation, and Benin and Burkina Faso low inflation. Inflation in Senegal was comparable to that in Ivory Coast in the first period, although it moderated in the second (especially until 1979) because of wide-ranging consumer subsidies. Relative price increases between the two groups of low-inflation and high-inflation countries were about the same in the two periods, with the maximum spread of about one third. However, in the first period the rate of inflation was moderate, between 3 percent and 7 percent, but it accelerated in the latter period to between 15 percent and 23 percent. Thus, while the price differentials in the first period could have been absorbed by productivity changes (or even explained by the qualitative differences between the indices), the price differentials in the second period are too large to be explained away and have caused significant divergent pressures on the balance of payments, with very different implications for future adjustment.
There are no comparable sectoral wage indices over time for the WAMU countries, nor is there a measure of average sectoral wages. However, each country has a minimum wage for industrial workers (salaire minimum interprofessionnel garanti) and agricultural workers (salaire minimum agricole garanti). The agricultural minimum is less than the industrial, but as most workers in agriculture are self-employed, the agricultural minimum wage has little scope to affect overall wages in the sector. The proportion of the industrial workforce actually receiving the minimum varies by country, and most labor contracts are negotiated between workers and management. Moreover, some countries have had different minimum industrial rates in different regions, with the highest rate applied to the capital city and its environs. (These differences no longer exist.) The link between the minimum industrial wage and other wages is either formalized through a system of coefficients, as in Ivory Coast, or relies on a demonstration effect on other wage settlements. The movements in the minimum industrial wage are useful indicators of general wage movements since in fact all wages eventually respond to changes in the minimum rate.
The changes in relative minimum industrial wages conform to relative price developments (Table 27). Thus, once again. Ivory Coast and Niger emerge with larger increases in wage costs. Relative wage differentials were also accentuated after the mid-1970s, probably with consequences for the balance of payments and adjustment policies similar to those caused by the divergent price movements.
As mentioned earlier, in a monetary union such as the WAMU, the relevance of exchange rates is not vis-à-vis the rates of member countries but rather vis-à-vis the rest of the world. In that context, if the import weights of member countries are exactly the same, their real relative (import-weighted) effective exchange rates will mirror the respective changes in the cost of living index. However, given that the individual member countries’ trade patterns are different, the relative effective exchange rates will also be affected by the changes in the cost of living in particular countries. Thus, divergent movements in real effective exchange rates of member countries would be caused both by changes in the local cost of living and by variations in living costs in their respective trading partner countries.
To show the movements in real effective exchange rates, 1974 is chosen as the base year, partly because until that year the rates of inflation in the member countries, as well as relative differentials, were low and partly because 1974 represents the year of transition in the monetary arrangements of the Union. Table 28 shows the marked relative appreciation of the real effective exchange rates since 1975 of Ivory Coast and Niger-—the two high-inflation countries as indicated by the changes in the cost of living. As mentioned, the Senegalese cost of living index is heavily influenced by consumer subsidies, without which the real effective rate would have shown a marked appreciation. The data do confirm that over the period, with a fixed nominal parity, real effective exchange rates have diverged significantly, thereby influencing differently the balance of payments of individual countries.
It is difficult to arrive at any conclusion regarding the appropriateness of the present exchange rates of member countries. However, given the importance of Ivory Coast in the Union, and the apparent downward bias in the calculation of the real effective exchange rate for Senegal, it would be safe to assume that the rate had appreciated significantly for the Union as a whole, at least until 1980; then it moved downward, in line with the depreciation of the French franc to which it is pegged.
Whether this recent depreciation of the CFA franc has restored international competitiveness to the WAMU countries is not examined here. Rather, a more general question of importance to the future adjustment policies is considered. Assuming that the overall exchange rate needs to be adjusted in a union such as WAMU (either because the relative movements between member countries are causing specific payments difficulties in specific member countries or because the rate has become overvalued for the union as a whole), should the change in the rate alleviate the balance of payments difficulties of the union, should it meet the needs of its strongest member (in terms of its relative international competitiveness), or should it restore the competitiveness of its weakest member?
It is, of course, evident that if a union as a whole experiences persistent balance of payments deficits that cannot either be financed or corrected by other acceptable adjustment policies, the exchange rate must change to ensure an overall equilibrium. But if the new rate does change to meet the needs of the union, what policies should individual member countries, whose rates may then be either overvalued or undervalued, pursue? If an individual rate is overvalued, the country will continue to have overall deficits, offset by the surpluses of the countries with undervalued rates. The external deficit in the former would be deflationary, while the surplus in the latter would he expansionary, unless credit policy is so designed as to permit an appropriate monetary expansion in each country, to maintain an overall balance of payments equilibrium in the region. Such a policy, in effect, would mean a system of “internal compensation” whereby the resources of the surplus countries would be continually made available to the deficit countries (with the credit expansion in the latter representing an income transfer).
When the exchange rate adjustment corresponds to the needs of the strongest (or most competitive) member country, the union would experience persistent balance of payments difficulties equal to the cumulative deficits of other members, which would need to be financed by external assistance or corrected through internal policy adjustments in the deficit countries.
Finally, if the rate is adjusted to make the balance of payments of the weakest country sustainable, the union would experience a surplus, no internal income transfers would be needed, and the surplus countries would ultimately (or immediately, if the national authorities so desired) experience increases in incomes (and prices) to adjust to the new (initially undervalued) rate.
The choice of an exchange rate policy among the three alternatives would depend upon political consensus within the union. In the first case, the authorities of the surplus member countries must maintain income transfers to the deficit countries; in the second, some permanent external arrangement would be necessary if the deficits are to be financed; while in the third, the relatively stronger countries would have to be willing to accept the immediate inflationary consequences of a greater devaluation than their own situation would justify. However, an essential condition for the success of any of the solutions is that member countries adopt (and coordinate) their policies to avoid the re-emergence of disequilibria for the union.
A concern has been expressed that, in the context of the programs of the Fund with member countries of the WAMU, common monetary arrangements may hinder the pursuit of appropriate adjustment efforts and policies—in particular, the use of interest rate and exchange rate policies—in individual countries. Furthermore, the use of the common pool of external reserves and the access to the operations account at the French Treasury could induce a member country to delay implementing an appropriate adjustment effort.
An adjustment effort could, of course, be undertaken independently of a program with the Fund. Indeed, the statutes of the BCEAO enjoin its members to implement specific monetary actions when external reserves fall below critical levels. However, this section will discuss the adjustment efforts made in the context of Fund programs, which in general encompass fiscal and monetary measures, and policies to stimulate production. All six member countries of the BCEAO have had stabilization programs with the Fund since 1974, either in conjunction with the use of the resources in the Trust Fund (a highly concessional facility that operated between 1976 and 1981) or within the framework of stand-by or extended arrangements.
The first question is whether these countries have tended to delay an adjustment program. The Fund has had stabilization programs in Senegal since October 1977 with virtually no interruption. Two large successive groundnut crops and sizable exports meant that Senegal was able to contain its external imbalances in 1975 and 1976, while in 1962 to 1971 its imbalance had been lower, averaging 14 percent of GDP. Ivory Coast entered into an extended arrangement with the Fund in early 1981, following the emergence of a large deficit in its external current account equivalent to nearly 15 percent of GDP (compared to a deficit of 3 percent of GDP in 1977). A stand-by arrangement was negotiated with Togo in 1979 (and again in 1981), when the external current account deficit, as a proportion of GDP, nearly doubled to 28 percent. Membership in a monetary union has clearly not impeded these countries from embarking on stabilization programs. (This is, of course, a separate question from the one on whether the actual implementation of the program was successful—an issue not dealt with here.)
Another question is whether the policy instruments used in the adjustment programs were appropriate. In the more recent Fund programs with these countries, the immediate cause of the balance of payments difficulties was identified in general as expansionary fiscal policies, though the financial imbalances of state enterprises and, occasionally, large credit expansion to the private sector were important contributory causes. In addition, in some cases, inadequate incentives to the export sector were identified as a factor leading to external imbalances.
Thus, the Government of Ivory Coast continued massive consumer subsidies in 1977 and 1978 (increasing them by 83 percent and 43 percent, respectively) even after the earlier boom in the export prices of cocoa and coffee (the country’s two major exports) had subsided. The subsidies were financed by external borrowing. Since public expenditures continued to rise, the overall balance of the public sector shifted from a small surplus in 1977 to a large deficit, equivalent to 15 percent of GDP in 1980, and the debt-service ratio rose to 29 percent in 1981.
In Niger, the growth in financial resources generated by the uranium sector between 1976 and 1979 allowed an escalation of investment and current public expenditures. When in 1979–80 uranium prices declined, large investment expenditures “bunched,” and the consolidated government budget (including extrabudgetary expenditures) turned into a deficit equivalent to over 5 percent of GDP, compared with an average surplus equivalent to 6 percent of GDP in the previous four years. In Senegal the authorities’ expansionary policies regarding public wages, consumer subsidies, and other expenditures had resulted in spiraling public finance deficits, including substantial deficits of state enterprises, particularly the crop marketing agency. ONCAD. Most of these deficits tended to be financed by external borrowings. Furthermore, wage, income, and pricing policies resulted in a sharp increase in consumption, which rose to 97 percent of GDP in 1978 and exceeded GDP in the subsequent two years. The internal terms of trade moved against the agricultural sector, as producer prices for groundnuts were not allowed to increase in line with the rate of inflation. Finally, the debt-service burden also escalated.
In Togo, the origin of balance of payments difficulties was a sharp rise in budgetary expenditures, initially financed by resources from the export (cocoa and phosphates) sector, which experienced temporary increases in prices, but financed later by external borrowing and domestic bank credit as the terms of trade moved against the country.
In these circumstances of almost universally large public sector deficits and a growing external debt service in member countries of the Union, the Fund’s stabilization programs invariably included fiscal adjustment as a crucial instrument. In the three-year program with Ivory Coast (1981-84), emphasis was placed on strengthening budgetary management and discipline, and guidelines were formulated for public investment expenditures. A Committee for Financial Coordination and Investment Control was set up to monitor, coordinate, and supervise the financial operations of public agencies and to review the monthly and quarterly data on the consolidated operations of the public sector. A major review was also conducted of the lax system, and structural improvements in the fiscal system are being implemented. In addition, as happened in other BCEAO countries, interest rates were raised substantially in May 1981 and again in April 1982.
The extended Fund facility program agreed with Senegal in 1980 also included a significant increase in producer prices for cotton and groundnuts, and the abolition of ONCAD, in an attempt to improve the marketing of groundnuts; a reduction in consumer subsidies was also effected. A reform of public enterprises was initiated through the mechanism of concluding contractual programs between them and the Government. To improve the international competitiveness of domestic industry, a modest system of export subsidies for nontraditional exports and import surcharges was introduced. In a subsequent one-year stand-by arrangement, which replaced the extended facility program (whose objectives appeared no longer attainable), a series of price and tax measures, accompanied by specific actions to contain the growth of public expenditures, were taken to reduce the deficit of the public sector. Simultaneously. Senegal obtained a rescheduling of its external debt repayments. As in Ivory Coast, the Government took a number of institutional measures to monitor public sector arrears, consolidate its accounts, establish realistic targets for recruitment, and restore the profitability of the agricultural sector.
The stabilization efforts in Togo have also concentrated on improving the fiscal situation. Various methods have been used: the consolidation of expenditures into a single budget to help increase the control of expenditures; a more vigorous application of credit policy through the imposition of monthly ceilings on central bank rediscounts and advances to banks and other financial institutions; monthly norms for these institutions; the encouragement of the use of their own resources; and a more vigorous use of the preauthorization requirements. Togo also obtained debt relief through the official rescheduling arrangements of the Paris Club.
Stabilization programs would, therefore, appear to have been designed to reach the causes of disequilibria (though this is not to claim that the intended policies were in fact faithfully applied or were successful in achieving their objectives). The fact that these countries were members of a monetary union did not adversely affect the elements of the programs that related to the required fiscal adjustment or the limits on credit expansion, whether to the public or to the private sector. The use of specific fiscal measures to reduce expenditures or increase revenues was tailored to the circumstances of individual countries.
In general, the interest rate and the exchange rate were not used as tools in these programs, in part because any change in these two rates requires agreement by all Union members. Interest rates were nevertheless, as mentioned earlier, raised as a result of independent considerations affecting the Union as a whole. But no Fund program in these countries has included an overt exchange rate action, in recognition of the common currency arrangement. This may have resulted in a more contractionary program than would otherwise have been designed. On the other hand, to the extent that the expectation of a fixed exchange rate may have attracted external capital, the contractionary consequences of the fixed rate could have been mitigated. A stabilization program can, nevertheless, introduce fiscal proxies for the required exchange rate change—as the program for Senegal did—but the experience with these proxies is limited and their effectiveness is not proven.
In conclusion, the root cause of the recent external imbalances in the member countries of the WAMU seems to be their increasingly large public sector deficits, accompanied by deteriorating terms of trade. A reduction of these deficits to sustainable levels is fundamental to any adjustment process. Analysis shows that the present monetary arrangements determined by the Union have not overly restricted the choice of appropriate adjustment instruments. Even though individual countries cannot use interest rate and exchange rate policies as adjustment tools, tailoring them to their particular situations, the broad movements in these variables in the Union during the period of adjustment have been on the whole in the right direction.