Emeritus Professor of Economics and Fellow of King’s College, Cambridge
Since the early 1970s, acute external payments difficulties have become widespread among developing countries, necessitating borrowing from both official and unofficial sources. In large part, these deficits were the counterpart of the large balance of payments surpluses of some of the oil producing countries, amounting to over US$100 billion in 1980. The rise in oil prices that generated these surpluses might have been expected to affect various countries according to their share of world oil imports. In fact, however, the current account of some of the less developed countries deteriorated to a disproportionate degree, owing to measures adopted by developed countries to protect their own balances of payments; the fact that the non-oil producing developing countries (unlike the industrial countries) were not able to supply many exports to the oil exporters; and, among other reasons, because of the inadequacies of their own domestic policies. The most common causes of the latter difficulty—at least in the view of some authorities—were excessive pressure of demand, often resulting from overspending by governments financed by budgetary deficits, and increases in money wages even in the absence of a state of excess demand. These demand and cost pressures led to inflationary increases in prices as well as to external imbalances.
The prescription, generally recommended by the Fund, to improve the current account in such cases is a program of phased financial retrenchment, the liberalization of foreign trade, and, to make all this possible, substantial devaluation. The latter is recommended not only, or even mainly, to improve a country’s trade competitiveness—for the foreign balance may be insensitive, at least in the short run, to changes in the exchange rate—but to supplement budgetary measures to reduce domestic demand and consumption. A devaluation, by making all imported goods (and their substitutes) dearer in relation to wages, causes a decline in real wages that would in itself tend to reduce consumption and shift the internal distribution of income more effectively than any domestic (fiscal and monetary) measures.
The main objection to this approach is that it assumes devaluation is capable of changing critical price and wage relationships that are the outcome of complex political forces and that could not be changed by domestic fiscal and monetary policies. But it is more likely that a large-scale devaluation will end up by reproducing much the same initial price relationships at the cost of a great deal of additional inflation. This outcome is, of course, particularly likely in developing countries, where the gap in the standard of living between the urban and rural population is large and where modern industry (or the so-called “organized” sector of the economy) extends to only a segment of the population.
Moreover, the determination of the appropriate rate is a far more complex problem than would appear at first sight, since the standard textbook principles (such as purchasing power parity or cost parity with other countries) may not work. In fact, since devaluation is invariably attended by some additional inflation in the developing country, there may be no unique appropriate rate of exchange.
The import substitution case
A typical balance of payments problem that devaluation cannot solve without causing acute hardship is the severe inflation and disruptions in production resulting from the chronic shortage of foreign exchange characteristic of countries pursuing strategies of import substitution mainly by protective tariffs. Import substitution in the early stages of development often has the effect of raising industrial production and employment at a very rapid rate—as it did in Latin America, for instance, between 1950 and 1974. But this was achieved with the aid of import restrictions of various kinds, while the percentage of industrial output exported actually declined from its initially low level.
Low export shares in manufacturing output are not conducive to self-sustaining industrial development. Manufacturing output is an addition to the total productive activities of the country (and not a substitute for other activities) and sets up additional import requirements that are partly temporary—to supply plant and equipment—and partly recurrent—to meet continuing needs for raw materials or semiprocessed goods. The natural source of finance for these continuing imports should be manufactured exports. They could, of course, be financed out of surpluses earned from exports of primary commodities. But food exports, the most common primary export of these countries, are less likely to provide such surpluses because industrial development seems to lead to a decline in agricultural exports, even to the country becoming a net importer of food.
Contrary to a widespread view, exchange devaluations would not have been capable of solving the problem of a chronic shortage of foreign exchange in these situations, unless perhaps they were combined with the complete abolition of import restrictions and a deflationary policy sufficiently severe to make it possible to keep the exchange rate stable. In this case, however, industrial development would have been sacrificed in the process and the scope for urban employment would have been greatly diminished.
A dual exchange rate?
All industrial countries developed their industries through import substitution, secured by protection; the successful industrializers were those who managed to develop an export capacity once the protected industries attained an adequate level of efficiency. This required (1) that the initial measures should be carefully selected so as to foster the most promising industries; and (2) that the level of wages in the import-substituting countries should be low relative to that in the countries whose markets the newly industrializing country hoped to penetrate.
Given a strategy of this kind, industrialization in developing countries would probably create jobs more slowly, but with less pressure on the balance of payments and hence less need for import restrictions. For it is the severity of the balance of payments constraint that causes violent inflation—no country that was not compelled to restrict imports for balance of payments reasons as distinct from protectionist reasons suffered from major inflation.
There can be no doubt that a regime of universal free trade, far from causing participants to approach the same or a similar level of economic well-being (as the classical theory of comparative costs suggests), tends to accentuate the differences between “rich” and “poor” nations. This is because only the industrially developed countries are capable of securing full employment and a high real income per head. Moreover, any initial advantage in industrial development is likely to be enlarged mainly as a result of the existence of economies of scale in the manufacturing industry and the increasing returns gained from learning and experience in terms of improved know-how, marketing, and managerial ability. As a result of these, any newly industrializing country is bound to be under a severe handicap in competition with industrially more developed countries, in terms of the comparative productivity of both men and machines as well as such nonprice factors as quality of design and technical reliability. The fact that the newly industrialized country will normally possess the advantage of lower wages (in terms of a common currency) is unlikely to afford more than a partial compensation for these handicaps.
Protection is essential for promoting the industrialization of the developing countries, but a combined system of import protection and export subsidization is preferable to import protection alone, since it serves to offset the adverse effect of protection on domes-He costs not only in home but also in foreign markets.
Devaluation is often looked upon as a combination of a flat ad valorem import duty and an equivalent ad valorem subsidy on exports. Yet devaluation applies to all imports and exports; it does not permit the adaptation of the existing structure of domestic costs necessary for making selected domestic goods competitive with foreign goods. The chief obstacle to the industrialization of the developing countries is not that their costs are in general too high (though that might be true as well) but that their costs of producing manufactured goods are high in relation to their costs of producing primary commodities. Consequently the exchange rate that would be necessary to afford adequate protection in the home market for manufactures and an adequate incentive to exports to foreign markets would be strongly inflationary in terms of foodstuffs and other primary products. Such an exchange rate would be feasible only if the level of wages in manufacturing in terms of wage goods (or foodstuffs) could be reduced to the point at which the structure of domestic costs would be aligned to the relationship of world prices.
However, a system of dual exchange rates with a low exchange rate applicable only to exports and imports of manufactures is an appropriate instrument for industrial development. It could, in principle, be pursued as well through a combined system of input tariffs and export subsidies as through a system whereby exporters of manufactures would be entitled to sell their foreign currency proceeds at a special rate while importers of manufactures would be required to buy foreign currency at that rate. From an administrative point of view the imposition of import duties and equivalent export subsidies, payable in local currency at the point of export, may be more efficient than the alternative method via multiple exchange rates.
A case for general devaluation?
The introduction of a dual rate would confine general devaluations to those cases in which, as a result of internal inflation, the cost of production of a country’s staple exports (whether they consisted of cash crops, tropical or temperate foodstuffs, or mining products) had got seriously out of line with world prices, expressed in terms of local currency at the prevailing rate of exchange.
Since the main element of costs (or of that part of costs that enters into the “value added” by domestic operations) is the cost of labor, this amounts to saying that a general exchange rate adjustment may be called for if, and only if, the labor cost per unit of output (including a certain allowance for profit) of a country’s main export product exceeds its world market price at the official rate of exchange. If a currency becomes overvalued in this sense, protective measures for industry might be unable to prevent an erosion of a country’s potential to export primary products.
It is often suggested that the price-cost relationship in the primary sector is not important from the point of view of a country’s exports, and hence would not justify a general devaluation. This is partly because the domestic elasticity of supply of such products is small and unresponsive to changes in export prices; and partly also because the export price in terms of foreign currency will be the same, irrespective of the exchange rate, so that devaluation will not stimulate world demand for the product. However, these propositions are likely to hold only within certain limits. It is often suggested, for instance, that the supply of cash crops—particularly of tree crops such as coffee, cocoa, and so on—is wholly inelastic in the short run since any increase in production presupposes an increase in the area of cultivation (or at least the replanting of trees), which requires a number of years before it leads to an increase in production. However, the real price received by farmers can fall so seriously that they no longer find it worth their while to harvest the full crop. It may also become more advantageous for a farmer to spend less on the cultivation of cash crops and devote more to subsistence farming.
But one must be careful to ascertain that it is the overvalued exchange rate that is responsible for reducing the profitability of the agricultural sector before concluding that devaluation will solve the problem. A number of African countries south of the Sahara have pursued policies that were detrimental to the production of their export crops and have landed in balance of payments difficulties, necessitating severe curtailment of imports. There was also a general overvaluation of currencies resulting from rapid rates of domestic inflation. In most of these cases, however, the inflation was the result of a redistribution of income from the rural to the urban population through the imposition of low prices for agricultural goods. This meant that the local currency price of the export crops, delivered to a marketing board or cooperative, was well below the local currency equivalent of the net export proceeds even at the official overvalued rate of exchange. A devaluation would have increased the local currency proceeds, no doubt, but there is no guarantee that the increases would have gone to the producers unless there had been a political consensus that previous trends in the distribution of income should be reversed so as to favor the farmers.
There are other cases, too, in which the general criteria for devaluation are not really adequate to establish a case for it. The most common of these is where balance of payments difficulties result from an unfavorable change in a country’s terms of trade, due to world overproduction of its principal export product relative to demand. Devaluation by any one country does not change the world price of its export commodity, but will stimulate its domestic production. If all other major exporters of the same commodity devalue, production would be stimulated even further and lead to a further deterioration of the terms of trade. In such cases, devaluations are likely to aggravate the producing countries’ problems and the proper remedies must be sought in commodity agreements that serve to eliminate overproduction and restore remunerative prices.
In addition, it is sometimes suggested that if the balance of payments difficulties of a country are due to external causes, such as a sharp deterioration in the terms of trade from a rise in the price of some essential import such as oil, currency devaluation may aggravate the loss of real income by making the deterioration in the terms of trade even larger. It is, of course, sometimes unavoidable that a country should suffer a loss in real income due to an unfavorable change in the terms of trade, or the failure of its main export crop, and in such cases it might be inevitable that the real consumption of the country would have to be reduced. But there are limits to the decline in real income that should be expected of a country seeking to restore external balance. The declines in real wages of the order of 30 to 40 per cent that were experienced in a number of developing countries during the 1970s were excessive and disruptive of social order and development. A country should be entitled in such cases to explore alternative remedies to devaluation, such as the limitation of nonessential imports that might not involve the same additional loss of real income.
On closer inspection it appears, therefore, that the number of cases in which there is a general presumption in favor of devaluation as a remedy for a country’s balance of payments problems is even more limited than appeared from the preceding discussion. Nevertheless, a residue will always remain. There will always be cases where the official rate of exchange has moved so far away from anything that could be called “purchasing power parity”—that is, the general level of costs in the primary sectors of the economy has moved out of line with costs in other countries at the prevailing rate of exchange—that only a significant change in the exchange rate could succeed in aligning internal and external prices and restoring the profitability of staple exports. It will be found, however, that such large overvaluations usually occur only as a result of prolonged inflation, generally due to structural causes. Consequently, devaluation could not provide a lasting solution, since it would not deal with the underlying factors responsible for the external imbalance.
Finally, in the case of primary exporters, any effective devaluation involves a redistribution of income within the devaluing country from urban wage earners to rural producers, since the former group is more likely to suffer, and the latter to benefit, from the resulting rise in food prices. It then generates strong pressures to reestablish the previous income distribution through a rise in urban wages, which leads to inflation and tends to cancel the benefits of the devaluation. This possibility must always be borne in mind, however justified the exchange rate adjustment appears on paper. It points to the fact that the basic requirement is political and social reform, involving the creation of a consensus on income distribution. This would prevent the kind of situation arising in which a country’s export capacity is impaired by the unduly low share of income accruing to those whose efforts are critical in the maintenance of external balance.
REJOINDER: For a different analysis of the considerations—and choices—underlying a devaluation in the. context of an adjustment of the balance of payments, the reader is referred to the article by Karim Nashashibi that appeared in the March issue of Finance & Development. In response to Kaldor’s article, however, a few specific points may be made. First, the exchange rate is a very important policy instrument, and a devaluation is often necessary to help restore a sustainable balance of payments. This contrasts with Kaldor’s view, which seems to be that devaluation is only justified when currency overvaluation has become so large as to leave no other recourse. Second, exchange rate policy can be effective only in concert with other policies; it has never been advocated as an isolated policy measure by the Fund or by any responsible economist (although in circumstances characterized by sustained high inflation, devaluing the exchange rate on a continuing basis would at least help to minimize distortions). Inadequate economic policies are often behind the disequilibrium in the balance of payments and the overvaluation of the exchange rate. Hence, in the absence of supportive monetary, fiscal, and other policies the benefits of a devaluation would soon be frittered away and one would be back at square one. Third, Kaldor refers to the proposition, prevalent in much of the literature, that supply elasticities are low in developing countries and that, consequently, exchange rate policies have a limited role to play. But there is a great deal of empirical evidence to suggest that supply elasticities are, in fact, much higher than had been supposed. Fourth, there is no general rationale for a system of dual exchange rates such as the one advanced by Kaldor. Apart from the serious practical problems of implementing such schemes, it is not clear that the economies of developing countries have the two sector characteristics that Kaldor assumes.