This paper will analyze the impact of relative prices on the non-oil trade account. The analysis will primarily focus on the effectiveness of the exchange rate adjustment of November 1978 in promoting non-oil exports and restraining imports. The importance of fiscal and monetary policies in supporting an exchange rate action is indicated by Indonesia’s experience. On November 15, 1978, the rupiah/dollar exchange rate, which had been fixed since 1971, was depreciated by 33 percent. After this devaluation, a stable link of the rupiah to the dollar re-emerged. During the first year after the devaluation, tight fiscal and monetary policies were successful in retaining the improvement in relative prices stemming from the devaluation. Domestic inflation was reduced to international levels within six months and remained at that level for the next six months.
However, with the additional foreign resources made available by the second round of oil price increases, domestic expenditure began to outstrip domestic productive capacity and to generate pressures on prices and imports. By mid-1981, the relative price of domestic to foreign goods in domestic currency had returned to the level existing prior to the 1978 devaluation; export volume began to stagnate, and import volume expanded rapidly. The rupiah’s close link to the dollar was broken in 1982, when the currency was depreciated by almost 8 percent.
Nevertheless, the competitive position of the non-oil sector deteriorated because of the sharp appreciation of the dollar against major currencies and the relatively high domestic inflation. Conditions in the international oil market progressively weakened during 1982 and early 1983 and strained the balance of payments. Following the Organization of Petroleum Exporting Countries (OPEC) agreement in early 1983, Indonesia’s oil prices were reduced and a production ceiling imposed. In response to lower oil revenue and in order to improve the competitive position of non-oil exports, the rupiah was depreciated by 28 percent on March 30, 1983; this devaluation returned the real exchange rate to about the level it had reached immediately following the November 1978 devaluation.
The paper is organized as follows: the first section reviews the background to the 1978 devaluation, the developments that immediately followed the devaluation, and the events leading to the exchange rate action of March 1983—in particular, the consequences of the second round of oil price increases for the competitiveness of the non-oil sector; the next section attempts to quantify the impact of the exchange rate adjustment on the non-oil trade account by estimating import-demand and export-supply equations and then simulating these equations under alternative exchange rate policies; and the final section summarizes the findings.
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)| false Magee, Stephen P., and Ramesh K.S. Rao, “Vehicle and Nonvehicle Currencies in International Trade,” American Economic Review: Papers and Proceedings of the Ninety-Second Meeting of the American Economic Association( Nashville), Vol. 70( May 1980), pp. 368– 73.
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Mr. Kincaid, Senior Economist in the Asian Department, holds degrees from the University of California at Los Angeles and Columbia University.
The author has benefited from the comments of Fund colleagues but is naturally responsible for any remaining errors.
The profitability of exporting manufactured items was also enhanced after the devaluation by an export certificate scheme under which eligible exporters received a rebate of import duties.
In 1980/81, the greater domestic budgetary deficit was more than offset by the increase in the foreign budgetary surplus; thus, a larger overall budget surplus resulted. In 1981/82, however, the increase in the foreign budgetary surplus fell substantially short of the expansion in the domestic deficit and the overall fiscal position turned to deficit. The swing of 3.4 percentage points in the overall fiscal position was equivalent to about half of the change in the external current account between 1980/81 and 1981/82. The decline in the foreign surplus in 1982/83 was not offset by a similar contraction in the domestic deficit; consequently, the overall deficit expanded by almost 2 percent of GDP, which, once again, was equivalent to about half of the deterioration in the external current account.
Due to data availability, the import and export equations were estimated only through 1981.
For an extremely useful presentation of the empirical issues related to estimating export and import functions, see Morris Goldstein and Mohsin S. Khan (1984).
A variable representing abrupt changes in relative prices was also included when the equation was estimated. This variable attempts to measure the impact of large changes in relative prices; some economists have argued that the relative-price elasticity would be larger for large price changes than for small price changes.
Capital imports associated with government projects average about 75 percent of capital-goods imports. Moreover, through the Board of Investment, the Government regulates foreign and domestic investment, which account for the remaining 25 percent.
One example is Bijan B. Aghevli, Mohsin S. Khan, P.R. Narvekar, and Brock K. Short (1979). In that paper, real income was defined as real gross national product, whereas in this paper it is defined as real gross national income (GNY), which includes the gains from the improvement in the terms of trade. During 1971–81, gross national income grew, on average, 50 percent faster than real GDP. Consequently, it would be expected that the long-run income elasticity for real money balances reported using real GDP would be 50 percent higher than the one using real GNY. In fact, the reported elasticity in their paper was 1.85, or 50 percent higher than the value given in the text.
In the simulation exercise, only the results using the real-balance equation are presented; however, both equations were simulated, and the results were nearly identical. This is not surprising, given that the relative-price coefficients are the same and that there is a close relationship (described in the text) between income and real balances.
Indonesia’s shares in world production of coffee and tin were only 5 percent and 10 percent, respectively. For natural rubber, Indonesia’s share of the market was more substantial—averaging 25 percent—during 1971–81. However, the share of natural rubber in the market for both natural and synthetic rubbers was only about 32 percent; therefore, Indonesia’s share of the larger market was limited to 8 percent.
The World Bank has estimated that the adjustment of tin, rubber, and coffee supply to higher prices requires 3, 7, and 7 years, respectively, which accords with this result.
A reduction in the adjustment coefficient for the import equation of the same absolute amount would only change the long-run elasticities by 15 percent, because this adjustment coefficient is much further from the upper bound.
The simulation for the maintained real devaluation scenario begins in the third quarter of 1979, because until then the relative price of exports was improving. Consequently, export supply under Scenario II and under actual relative price developments are the same from the fourth quarter of 1978 to the third quarter of 1979. This also explains the absence in Chart 10 of any additional export earnings until the fourth quarter of 1979.
To quantify the impact of Indonesia’s export supply on its export prices, a price elasticity for export demand was calculated as a weighted average of price elasticities for each commodity. This elasticity indicates that a 10 percent increase in export volume would reduce export prices by between ½ and 1 percent. Thus, as a first approximation, maintaining export prices constant appears workable for simulation purposes, although the results obtained would be somewhat overstated.