Sub-Saharan African countries emerged from the 1970s with large and unsustainable fiscal deficits, which stemmed from the increase in government spending in the aftermath of the two oil shocks. During the 1980s, the internal imbalance was exacerbated by a protracted decline in terms of trade.
To alleviate internal and external imbalances, these countries pursued two different strategies. Those in the western and central African monetary unions (CFA franc zone) retained the “internal” adjustment path by maintaining a fixed exchange rate parity with the French franc as a nominal anchor to ensure fiscal discipline and low inflation. Most other countries, pursuing an “external” adjustment strategy, relied on the exchange rate to alleviate the effect of external shocks.
This paper investigates a sample of 28 sub-Saharan African countries for which a fiscal data base was generated for the 1980-91 period. It finds that, in those countries where the tax base is highly dependent on imports and import substitutes, exchange rate movements in response to external shocks are critical for sustaining and improving fiscal performance. The paper uses statistical analysis to correlate the ratio of tax revenue to GDP with movements in the real exchange rate and the terms of trade.
The adopted adjustment strategies explain, to a large extent, the fiscal performance of sub-Saharan African countries in the 1980s. Fiscal deficits widened in countries with fixed exchange rates but were reduced in countries with variable exchange rates. Other indicators, such as the current or the primary balance, confirmed that the countries with fixed rates were not able to arrest the deterioration in their fiscal performance, particularly during the second half of the 1980s when a real effective exchange rate appreciation coincided with a deterioration in the terms of trade.
The major difference in the fiscal performance of the two groups of countries lies on the revenue front. The countries with variable exchange rates improved their ratio of tax revenue to GDP, and countries with fixed exchange rates experienced a significant decline. Both groups succeeded in reducing their government spending in relation to GDP. However, in countries with fixed exchange rates the effort was mostly concentrated in capital expenditures; the government wage bill, which should have been targeted for reduction in real terms under the internal adjustment strategy, actually increased in relation to GDP.
The paper finds that to the extent that an overvaluation of the exchange rate undermines the tax base, the internal adjustment strategy leads to a widening of the fiscal deficit when its purpose is to restore the real exchange rate to its equilibrium level through fiscal contraction. Those countries with variable exchange rates failed to achieve price stability, but exchange rate adjustment was critical in contributing to other macroeconomic objectives, particularly fiscal balance, competitiveness, and growth. Hence, presenting internal and external adjustment strategies as policy alternatives in sub-Saharan Africa is not meaningful. Rather, these two strategies must be complementary.