AAMP Training Materials

1. AAMP Training Materials Module 2.3: Macro Effects on Smallholder Commercialization Shahidur Rashid, Nick Minot (IFPRI) s.rashid@cgiar.org, n.minot@cgiar.org

2. Outline • Macro and trade policy distortions • Importance of understanding distortions • Economics of distortions • Foreign Direct Investment (FDI) in Africa • Foreign exchange markets (exercise)

3. Macro and Trade Policy Distortions to Agricultural Incentives Information Supply (production + Import) Technological Capacity Commodity Price Infrastructure Demand Institutional capacity Macro-economic & Trade Policy Distortions to incentives refers to the changes in prices due to policies

4. Macro and Trade Policies • Fiscal policy • government spending, borrowing, taxes, subsidies • Monetary policy • money supply, interest rate, bank regulations • Trade policy • tariffs, quantitative controls • Exchange rate • import and export flows, FDI, pricing and quantitative controls

5. Importance of understanding distortions • More than two-thirds of the world’s poor live in developing countries; and a large share of them directly or indirectly depend on agriculture for their livelihood • Government policies can depress farm incomes through: • Anti-agricultural policies in developing countries • Pro-agricultural policies in developed countries, which lower international food prices and thereby some farm-gate prices in developing countries

6. Importance of understanding distortions • Poverty is alleviated by economic growth • Economic growth is enhanced when distortionary government interventions in markets are reduced • Gradual, phased trade reform in particular can contribute at little cost • Agricultural trade reform is likely to be pro-poor in aggregate, although some poor may lose

7. Importance of understanding distortions Applied tariff rates in Agriculture • Tariffs on agriculture have been historically high in developing country agriculture • Though declining recently, developing countries continue to have higher applied tariff rates than the MIC and HIC

8. Economics of Distortions P Consumer Gains So Producer gains Pd Pg D Q

9. Measuring distortions due to tax and subsidies • Consider the following notations: • Pf = Producer price • Pc = Consumers’ price • E = Exchange rate • P = the border price • tm = Import tax • te = Export subsidy • Tm = Transactions costs for imports • Tx = Transactions costs for exports

10. Measuring distortions due to tax and subsidies • If a tariff on imports is applied: NRA = (E.P(1+tm) – E.P))/E.P = tm and CTE = Consumers’ Tax Equivalent is tm (where tm<0 if it is an import subsidy) • The effects of an export subsidy, sx, are the same except sx replaces tm above (where sx<0 if it is an export tax)

11. Measuring distortions due to tax and subsidies Price S Import Tax Example Import tax revenue Trading costs D Quantity

12. Measuring distortions due to tax and subsidies • If a production subsidy is applied: NRA = (E.P(1+sf) – E.P)/E.P = sf and CTE = 0 where sf< 0 if it is a production tax

13. Measuring distortions due to tax and subsidies Price D S Trading costs Tax revenue Export Tax Example Quantity

14. Distortions from exchange rate misalignment • Inappropriate exchange rates are another distortion in the market • An overvalued currency makes export expensive, which makes firms less competitive • An undervalued currency makes export cheaper, which in turn promotes export (but at the expense of some other countries)

15. Distortions from exchange rate misalignment Ethiopia Coffee

16. Distortions from exchange rate misalignment

17. Foreign Direct Investment (FDI) • Offers one source of foreign exchange inflows • In any resource constrained country, FDI can contribute towards: • Promoting technology and institutional innovation • Building human capital • Creating jobs and increasing household incomes • Promoting overall development • Many emerging countries have benefited from increased flow of FDI (India, China, Brazil, South Africa) • Latin American countries had particularly benefited from FDI in promoting agricultural commercialization • Developing countries are receiving an increasing share of FDI

18. Trends in FDI to sub-Saharan Africa

19. FDI Trend in AAMP Countries

20. Trends in FDI to sub-Saharan Africa • FDI to Africa has increased in absolute terms, but has declined relative to growth in overall flow of FDI to developing countries. • Understanding this puzzling trend is subject of large body of research • The Challenge: How to attract more FDI to SSA?

21. What will Attract FDI to Africa? • The simplest answer to the question is “ possibility of profitability” • What determines the FDI profitability? Consider the following: • Economic openness • Size of the economy • Political stability • Infrastructural development • Institutional capacity • Regulatory environment

22. Trends in FDI to sub-Saharan Africa • One way to analyze why FDI vary by country is to compare a common indictor. World Bank produces such an indicator, called “the ease of doing business”. It ranks countries based on the following indicators: • Starting a Business • Dealing with Construction Permits • Registering a property • Getting credit • Protecting Investors • Paying taxes • Trading across borders • Enforcing contracts • Closing business

23. Trends in FDI to sub-Saharan Africa • None of the AAMP countries ranks worse than BRIC countries • Rwanda and Zambia rank better than any of the four BRIC countries • Are these results puzzling?

24. FDI Exercise • Open Excel workbook and click the [Ex. 1 – FDI Exercise] sheet • Examine the example: Zambia v. Brazil • What do you notice? • Copy and paste rows of data from [FDI Inflows] sheet for further comparison • Compare SSA countries with BRIC countries

25. Model of foreign exchange (Explanation) • Characteristics of Excel model [Ex 1 – Forex Market] • One “product”: foreign currency • Supply and demand of foreign exchange • “Price” of foreign exchange is exchange rate • In model, you can shift fixed exchange rate, supply for foreign exchange, demand for foreign exchange, and income • Output shows effect with fixed exchange rate and market (floating) exchange rate • How to use the Excel model • BLUErepresents cells you can change to calibrate model • YELLOW represents cells you can change to simulate a shock • GREEN shows the output cells, which should not be changed • Table shows “before” and “after” simulated shock • Solid lines represent “before”, dashed lines “after”

26. Model of foreign exchange (Discussion) • What factors determine supply of foreign exchange? • Exports of products • Exports of services (e.g. tourism) • Foreign direct investment • Inflow of international remittances • What factors determine demand for foreign exchange? • Imports of products • Imports of services • Speculative demand

27. Model of foreign exchange (Exercises) Open Macro Effects on Smallholder Commercialization.xls and open [Ex 1 – Forex Market] worksheet • Suppose there is a burst of economic growth and income rises 20% • If exchange rate floats, what happens to exchange rate? • Who benefits from this change in exchange rate? • Who loses from this change? • If exchange rate is fixed, what happens to exchange rate? • What happens to excess demand?

28. Model of foreign exchange (Exercises) • Suppose the cost of imported goods rises dramatically, causing a 50% increase in demand for foreign exchange • If exchange rate floats, what happens to exchange rate? • If exchange rate is fixed, what happens to excess demand?

29. Model of foreign exchange (Exercises) • Suppose the price of the main export rises, causing a 40% increase in inflow of foreign exchange • If exchange rate floats, what happens to exchange rate? • What does this do to other exports? • Concept of Dutch disease • If exchange rate is fixed, what happens to excess demand? • Suppose oil is discovered in a country, causing a surge in foreign direct investment • If exchange rate floats, what happens to exchange rate? • If exchange rate is fixed, what happens to excess demand?

30. Resources http://www.doingbusiness.org/ http://unctadstat.unctad.org/TableViewer/tableView.aspx http://economics.adelaide.edu.au/newsletter/agdis.html Beginners guide to the economics of foreign exchange markets ( http://economics.about.com/cs/money/l/aa022703a.htm) Wikipedia article on foreign exchange markets (http://en.wikipedia.org/wiki/Foreign_exchange_market) Gaucan, 2010. “Introduction to the foreign exchange market” http://www.scientificpapers.org/wp-content/files/1120_Introduction_to_the_foreign_exchange_market.pdf