Academic journal article American Economist

The Effects of Domestic Policies and External Factors on the Real Exchange Rate and Economic Performance in Sub-Saharan Africa

Academic journal article American Economist

The Effects of Domestic Policies and External Factors on the Real Exchange Rate and Economic Performance in Sub-Saharan Africa

Article excerpt

I. Introduction

The past decade has seen an increase in focus on exchange rate policy, and the effects of real exchange rate misalignment on economic performance. This emphasis is evident in ongoing discussions about the causes of the debt crisis in Latin America, in which real exchange rate overvaluation has been blamed for current account deficits and capital flight. It has been suggested that countries such as Argentina, Mexico and the Philippines fell into the debt trap because of poor macroeconomic policies, while Indonesia. Korea and Turkey were able to avoid crisis by maintaining stable and competitive real exchange rates(1) The concern about real exchange rate misalignment has also featured prominently in current debates about the causes of agricultural decline in sub-Saharan Africa.(2)

In most of the discussions, real exchange rate misalignment and the associated balance of payments problems are attributed to policy mistakes in the developing countries.(3) Some of the "inappropriate" policies mentioned include unsustainable fiscal policies, inflexible exchange rates regimes and excessive government control of economic incentives. Given the underdeveloped financial markets and limited domestic savings in the developing countries, central banks are left with the major responsibility in financing government budget deficits. If deficits are financed by printing more money than the public wants to hold, prices will rise. Since many developing countries maintain inflexible exchange rate regimes, nominal exchange rates are not adJusted to account or the differences between domestic and foreign inflation, thus resulting in real exchange rate appreciation.

To date, only a limited amount of empirical work has been done on the role of the real exchange rate in economic adjustment in the developing countries. The most recent studies include Edwards (1988) and Cottani et al. (1990). These studies have addressed the issue of policy mistakes in some detail, and provided evidence on the negative correlation between real exchange rate misalignment and performance indicators for several developing countries. However, the studies are not suited to the experiences of the countries of sub-Saharan Africa. They do not distinguish between the effects of domestic policies and external factors on the real exchange rate, nor do they show the extent to which domestic policies are influenced by external economic events. It is impossible to understand fully the factors behind real exchange rate misalignment in sub-Saharan Africa without taking into account the adverse external environment of the 1970s. These factors are still in evidence in the 1990s, with the Gulf Crisis, and the continuing volatility in commodity markets. External shocks such as these have served to augment domestic inflationary pressures, thus reducing domestic policy options and contributing to real exchange rate misalignment.

The purpose of this paper is to examine the relative contributions of domestic and external factors to real exchange rate changes in six sub-Sahara African countries during the period 1960-91. In addition, the relationship between real exchange rate misalignment and economic performance is examined for the six countries. The study uses a vector autoregression (VAR) analysis to examine the interrelationships between the current account, the budget balance, and the real exchange rate in the six countries. The countries are divided into two groups: Cameroon, Cote d'Ivoire and Senegal belong to the CFA zone, and Ghana, Nigeria and Sierra Leone are former members of the Overseas Sterling Area. The economies of CFA zone are unique in having a common monetary policy, a convertible currency and a fixed exchange rate with respect to the French franc. Ghana, Nigeria and Sierra Leone also maintained fixed exchange rates from the 1960s to the mid-1980s. In principle, these countries possess a wider range of policy tools than the CFA countries. …

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