Leveraging Trade for Sustainable Growth: Lessons for Rwanda's Exchange Rate Policy

1. Using Trade to Grow: International Lessons (and Questions) about Exchange Rate Policy for Rwanda Richard Newfarmer International Growth Centre November 1, 2010 This presentation benefitted from research of Laura Collinson, Economist IGC -Rwanda

2. Main points… Rwanda has used donor finance wisely to build its much need infrastructure, and this has been a driver of growth… but over the long run Rwanda has to look for additional sources of growth. One potential growth source is export…but to date trade remains an under-exploited opportunity for Rwanda – trade ratios for goods are low, diversification across products and geographic markets is low, and new exports seem to die quickly International experience raises questions in several areas that might merit additional policy discussion (e.g., infrastructure, reducing trading costs, leveraging regional trade agreements) but one of the most important is management of real exchange rate.

3. Investment and rising consumption have been major drivers of recent growth Contribution to GDP growth Imports Source: Rwanda Statistical Yearbook and World Bank, unpublished manuscript

4. ….and development assistance has financed a large portion of investment… Source: World Bank, World Development Indicators. HP=16

5. … reflected in an expansion of services and, within industry, construction Composition of GDP Rw$T 2006 prices Contribution to GDP growth Services Services Industry Industry Agriculture Agriculture Source: Rwanda Statistical Yearbook and World Bank, unpublished manuscript Note: The adjustment has been equally divided and incorporated among the three sectors

6. … reflected in an expansion of services and other nontradables (with implications for the real exchange rate) Composition of GDP Rw$T 2006 prices Contribution to GDP growth Services Services Industry Industry Agriculture Agriculture But development assistance will eventually wind down..and before that Rwanda has to look for new sources of growth. Trade is one. Source: Rwanda Statistical Yearbook and World Bank, unpublished manuscript Note: The adjustment has been equally divided and incorporated among the three sectors

7. The EAC countries still have much to gain with trade integration – trade is below the predicted level

8. Rwanda trades less in goods than most other countries… so trade provides an opportunity for growth Trade as a share of GDP, av. 2007-2008 Qualifications: Services trade is not shown Informal trade is unrecorded… and investing in better data is a priority High performing countries were the fastest-growing in real GDP 1980-2006, and include Botswana, Burkina Faso, Cambodia, Chile, China, India, Indonesia, Korea, Malaysia, Mauritius, Pakistan, Singapore, Sri-Lanka, Chinese Tapei, Thailand, and Uganda. Source: World Bank, World Development Indicators. Average 2007-2008 values. Landlocked represents the average value across landlocked developing countries excluding Rwanda.

9. While most fast-growing economies have trade elasticities over 1.5, Rwanda’s is low even by African standards Source: Staff calculations and World Bank, WDI. Note: considering countries with data for the entire time series. The category “landlocked developing countries” excluded Rwanda and N=25. Sub-Saharan Africa=30

10. Rwanda is over-reliant on a few export products… Source: Staff calculation based on SITC rev3 from Comtrade database

11. …and this leads to volatility in terms of trade and undermines sustained growth Rwanda Source: World Bank, World Development Indicators.

12. Exports seem to “die young” …the probability that a Rwandan export product will survive into future years is lower than most other countries Year 2 only 70% of new products remain Tanzania Scope for export promotion efforts to sustain products? Rwanda We ran these numbers also with Kenya and Uganda and other countries, and Rwanda has among the lowest survival rates Source: IGC staff calculations and WITS comtrade database

13. From international experience, four determinants of success in trade beyond good investment climate… • Infrastructure is a major constraint in most countries • Lowering costs of trading is essential to rapid growth • Regional trade agreements have to be designed to promote deep integration… otherwise smallest members suffer • Managing the real exchange rate effectively is essential to maintain competitiveness In each area, these lessons prompt questions that Rwandan authorities might want to address… particularly management of the exchange rate

14. Haussman, et al (2004): Five findings about “growth accelerations” • First, growth accelerations – an increase in GDP growth rate of 2%+ per annum and sustained for 8 years -- are quite frequent. …more than 80 episodes since 1950 of rapid acceleration in economic growth that are sustained for at least eight years. • Second, growth accelerations tend to be correlated with increases in investment and trade, and with real exchange rate depreciations. • Third, political-regime changes are predictors of growth accelerations. • Fourth, other determinants determine whether the acceleration is sustained into the longer term or not. External shocks tend to produce growth accelerations that eventually fizzle out, while economic reform is a statistically significant predictor of growth accelerations that are sustained. • Finally, growth accelerations tend to be highly unpredictable: the vast majority of growth accelerations are unrelated to standard determinants such as political change and economic reform, and most instances of economic reform do not produce growth accelerations.

15. Management of the real exchange rate: Important to facilitate export drives • Avoiding overvaluation : Early success at exporting (or mobilizing donor finance) can drive up currency value – and raise price of exports. • Aghion (2006): overvaluation leads to slow productivity growth • Maintain competitiveness: Competitive exchange rate may foster growth learning by doing associated with productive activities for exports • Hausmann, et al (2004): 80 “growth accelerations” of 2 % points – 8 years; real devaluation was signifcant predictor • Country experiences: Korea (1964-mid-1970s), Chile 1982-92, China post -1994 • Conclusion: Answer is not obvious, not easy and not cost-less: Appropriate policy mix depends on objectives and situation; REER targeting difficult; increasing reserves can be costly • Eichengreen, 2008: “The real exchange rate is best thought of as a facilitating condition: keeping it at competitive levels and avoiding excessive volatility facilitates efforts to capitalize on these fundamentals…” (that is, education, savings, investment and institutional capacity to assimilate technology)

16. Successful export drives have maintained a competitive real exchange rate… Impact of 50% Real Undervaluation on GDP per Capita Growth Impact of 50% Real Undervaluation on Exports to GDP Ratio Source: Haddad, 2010

17. China is one example of using a competitive real exchange rate to export and grow…(perhaps to excess) China: Level of Real Exchange Rate, 1992-2007 (Up = real depreciation) Source: Eichengreen, 2008

18. …and exchange rate volatility is negatively associated with GDP p.c. growth… Volatility (= the absolute value of the percentage change of the real effective exchange rate of the preceding years) Source: Eichengreen, 2008

19. …is there room for a better alignment between monetary and trade –growth objectives? …Rwanda may wish to undertake its own analysis

20. Global “currency wars” make watching the exchange rate more important: real exchange rates have shifted competitiveness since the onset of the Great Recession …and Rwanda may wish to track these developments to anticipate external exchange rate surprises Source: J.P. Morgan, October 21, 2010

21. Conclusions… Rwanda’s objective of using trade to power growth is well-formulated …and the government has identified all the right issues… from infrastructure to trading costs to regional integration. But price incentives will determine success or failure of any export drive… …and arguably the most important price in the economy is the rate of foreign exchange. Hence understanding the recent historical role of exchange rate determination and exploring ways the government might maintain a competitive real effective exchange rate – especially in light of a prospective EAC monetary union -- is crucial.

22. The IGC Program in Tanzania: Towards Monetary Integration • Joint research plan for monetary union developed by Monetary Affairs Committee of the East African Community. Bank of Tanzania / IGC-T lead agency on: • –Exchange rate regimes and convergence • –Monetary transmission mechanism • –Money demand • Money and Monetary Policy Issues • BoT--along with rest of EAC –targets inflation using a monetary anchor (M2), with reserve money as the operational target but RM programs might be losing effectiveness • Research Papers • Money demand [complete –on line ] • Liquidity management and the money multiplier [complete –final review] • Dollarization and currency substitution [complete –final review] • Food prices and the dynamics of inflation in Tanzania [in progress] • Financial architecture and the monetary transmission mechanism [2010 Q4] The IGC would be pleased to sponsor a greater participation of BNR in this research

23. References cited Aghion, Philippe, Philippe Bacchetta, Romain Ranciere and Kenneth Rogoff, 2006. Exchange Rate Volatility and Productivity Growth: The Role of Financial Development. NBER Working Paper No. 12117. Eichengreen, Barry, 2008. The Real Exchange Rate and Economic Growth. Commission on Growth and Development. World Bank: Washington, DC Haddad M., and C. Pancaro, 2010. Can Real Exchange Rate Undervaluation Boost Exports and Growth in Developing Countries? Yes, But Not for Long. Economic Premise No. 20. World Bank, Washington, DC International Monetary Fund (IMF), 2010. Rwanda: Request for a Three-Year Policy Support Instrument. IMF: Washington DC Hausmann, Ricardo, Lant Pritchett, and Dani Rodrik, 2004. Growth Accelerations. NBER Working Paper No. W10566. Levy Yetati, Federico Sturzenegger Eduardo and I. Reggio, 2003. On the Endogeneity of Exchange Rate Regimes. Unpublished manuscript, Universidad di Tella. Spence, Michael. 2008. The Growth Report: Strategies for Sustained Growth and Inclusive Development. Commission on Growth and Development. World Bank: Washington, DC Winters, L. Alan, 2004. Trade Liberalization and Economic Performance: An Overview. The Economic Journal, 114 (February): Oxford

24. Using Trade to Grow: International Lessons (and Questions) about Exchange Rate Policy for Rwanda Richard Newfarmer International Growth Centre November 1, 2010 This presentation benefitted from research of Laura Collinson, Economist IGC -Rwanda