Algeria-The Real Exchange Rate, Export Diversification, and Trade Protection

24 Pages·1999·1.14 MB·English

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Policy Development and Iteview Department

Algerin—The Real Exchange Rats, Export Diversification, aud Trade Protection
Propared by Pritts Sorsa?
‘Authosized for distribution by Robert Sharer

April 1999

Abstract

Given the tendeny oF fhe vil seclar ln appreciate the equilibrium real exchanye rate
(RER) in Algeria, trade Ibcralizasion with its deprecioting impact on the REI is important
fos diversification of exports. This paper shows that reductinn in Irade procection would
dapraciate the ROR in Algeria, whish in mca would imprave competitivences of, and
incenlives wo inves in, non-cil exports. The paper then discusses cxitng levels of
protection in Alycria and directions for refoum

JRE Classification Nusahers: FI, Fa
Keywords: Protection, growth

Author's E-Mail Address: Psorsadimong,

"The author is grates! to Heuri Ghesquire, Karim Nashashii, Philip Swacel, and
‘Natalia Tanirsa for helpfil comments,
Contents

AL Trtroduetion
AL Thy Determinants of the Real Cxchange Rate (RER) in Algeria
MW, Estimation Ronulls

TV Nature of Protection in Algeria
A. Algeria's Trasic Regine in Goods

Series Bacriow
©. nvestent incentives

Vo Conusions

Tables

1 1 #, Selected Oil Praducers (1996'1997)
2. Unit Root Tests

3. Fahanven’s Masiunim Likelytood Test of Cointegration

Ja, Regression Retults—Long-term Relationship

4b, Regreaviom Resalts—Short-sorm Relationship

5. Summary Indicators of Tariff Protection and Duty Collection in Algeria

& Average Tac in Selected North Afican ané Eastern European Counties
7 acy of Main Barticrs in Trade in Services

1. Algeria: Evolution of the Real Exchange Rate
2. Growth in Expos vs, Growth in GDP, Average 1993-197

References

Page
T. Introduction

‘the oil scetor hus been a sominan. ealute of Algeria's ecanumy for decades making it
vvulncrable to changes in world oil markets. Depencenes on ot and related prenlue.s is striking
ever when compared Io a number af ather eibesporting countries (Table |} hydrocarbons ia
Algeria uovounled for 95 perecer of exparis, GO percent of goveanment revenue. ond

30 pereent of GPP in 1997, Therefore, che reduction in the dependence on oi and ether
inydrecarbons including the development of albee expars, and the eeation af a sustainable
bass for growth has beea the unin long tern objectives af the government's adjustment
cflbitsinoe 1994, Put despite mecesshil stabilization inthe past fows years, progress in the
Sructural areas has buen slower. The pickap of gowth inthe nonbydrocarbon sector and
exports bas not yet maletalzed. or example, non-oil exports in 1998 seve sil oly

5 percent of taal,

Diversification of expr isa way to adrevs number of problems in the Algerian economy.
First, dependence on oil inereases the vulnerability of Algeria to external shucks. This can
have important cass in rerms of mstabify of the maeroeconcmmic framework, whieh ean
effect investment decisions and growth As cil seveuues are also a large share of overall
‘govsinment revenues, chaugcs in ol pricus aso lead to large chanyes in fiscal balances.
Second, in Algeria the vulnerability vo changes i ul pices is exe cerhated by the high burden
fof both domestic and Loceign debs, which reduce the room for mmeuver in economic policies.
‘Third, the high unemployttent 4 Algeria ut necely 39 percent and Ihe expacted large mummber
lof news eniranls 19 the labor force cequire aubstantial growth rates in the nenoil eecnarny (0
sorb the unemployed. ‘This is unbcsy ta be achieved without substandal growth in exports
FFourrh, the dovelopraent of nonliydrocarhon exports is ikely wo have positive externalities [or
the rest of the economy in tems of learning-by-dving. This has beoa underlined in reecnt
Titerature on endogenovs growll (see, eg,, Sachs and Warner, 1995)

One constraint to enpatt diversification isthe “natural” appreciation of the real exchange rate
in Alacra from the presence of the ail sotoe. Much of it is unavridable and refleors many of
the findamenials in Algeria, ualoss the rate af zesource extraction is slowed down This is
unlikely, given the government's development needs, and the high debl burden. A key issue
fox policy then becomes whether there are other ways to slow down ihe real appreciation. Any
‘oliey aiming at manipulating the noranal rate by doveluations would lead ta macroeconomic
<isoquilibria and consequent problems in mansging the economy, and have ne real effects in
the long run Thus the answer to the above qvestion has to fi in some factors ivfuencing the
fiandamentals. A key pofcy in tis ean be trae liberalization, In addition, trade berstization
hias well-known beneficial eflects on the efficiency of resource allocation

20ne uplivn in deal with this isue is ta cu the dicovt Tink fra oll revenues ta the budget by
Increasing olher sources of rovenoes ar hy establishing an oil und to manage revenues ftom
the il sostor, Anather option is to cneourage diversification of the economy
‘this paper argues that reduction in made protection in Algeria would tend 10 depreciats the
‘equilibrium real exchange ratc, which in ura would improve competitiveness of and wneertives
for investing in noa-oil exports, Hirst, the imponlance of trade protection asa determinant of
tha real exchange rate in Algeria is snuly2ed and estimated. Second, present irade policies are
discussed and a reloee program proposed.

AL ‘Yhe Determinants of the Real Exebange Rate (RE) in Algeria

‘The links ofa resource seotor with the ret af ee economy and the real exchange rate have
hhoen uch studied ie the Herature of the so called Durch disease (Comden, 19%4, edwards,
1992; and Gelb, 1988), The word “disease” mainly means that the presence of a rexource
socuor va its rendeney to apyresiate the equilibria zea exchange rate makes macrocconmic
management more difisult ad reduces competitiveness of other exports. ‘The appreciation
team Lake place via a munber of channels such as an increase in perraauent income, spending on
nontraded goods or increase in expital inflows

Codertansting of the dynamics of the real exchange tate cat help in devising policy responses
to deal with the eal appreciation, Thus, we estimate the determinants ol the RER for Algcria
“this relies hewsily om the metoda‘ogy developed in a vember of reven! papers fr ether
developing countries (Febwards, 1992; Mlbadaw, 1994: and Baffes and others, 1997), which
nave used single cquation techaiqnes to estimate levels and determinants af real exchange
tates. The model for Algeria relies on a model developed by Edwards (1992) tor Venezacla,
another oll-oxporting coualy,

“The above saidics point oul. thal an analysis of real exchange sates needs to make a
fisxinctinn between the equilibrium level ofthe rate and doviations irom that rate. The former
‘eproscnts changes ia Fundamentals, while (he llterrepresant often temporary effects of
macrocconomic disequilibia on the roel oxchany rate Polloveing the analysis of Lewarés
(1992), the various determinants of the REK can be represented by cecomposing changes in
the real exehauge cae inta its sadamental and monctary determinants

lege, = Blower, -Ioge,)+ pliog Miya M+ ODER, 0)
“Thus changes ia the RER wil respond co thre Zoces: differences betveon the euliiumt
ER (o*,) and its lagged zeta (@,); macrozconomic dxeyulbium (ference
‘between supply (Mt) and demund for money (M}, and nominal devaluation (DEV); 8, p, and
‘ae positive parameters

‘Adjustment inthe fundamental thal effect se equilibrivm real exchange rate (e., increased
spending trom an increwss in oil production, changes in import protection, or changes in che
terms of rade) to either an excess eupply or demand take place via adjustments in prices and
‘wagos, which wil gradually bring the RER closer ta its equilibrivor level. Monetary pressures
(eg, from an inerease in seserves fram higher oil exports) an the other hand Lend to cause
real appreciation by increasing the aupply of money vi-i-vis demand. Changes in the nominal
cxchange rate atoet the KER only it is nor in equilheuan, Thus, manipulating the exchange
rate wil have no long-run impact om the equilibrinay rate,

An Algeria, the exuilbvinm exchange rate is likely te be determined hy che following
mndamentals

loge*,= Xo Aylogp.r Aslogz, | Ayloga, + Aalngttade. — @)

in which p= real price of ol, “= volume of oi or hydrovatbon production, 2 ~ goverment
cxpenditure on nomradable goods, and wade = level of protection. Its expected tha lf the
coulficients are positive, Other impartant determinants ofthe RER can be the ratio of debt
servive La expoits® or capital inflows, These were nor sigeificant for Algeria and were thus lft
out

iy combining the above tn ouations the dynamics af sho real exchange rate equation
become

loge, 4) hep. + aloyy, elope. + u log trade, +p (log Mt.
alg 4.) ODEV, © a; loge. + €, o

hore tip Oy: Bay jm Ohy :ey— Oh, ; aud oy

-0). & the error term,
“The following are the expected ellects ofthe various variahles of the real exchange rate

Oil price aus ail deposits or production—she spending and resource effects. Given the
large share of cl in &gera’s economy changes in the price of oll have impertant effects on
overall spending, Discoveries of new ol reserves or gna depenila cau aso affect nverall
spending overtime by incressing permanen|. income.‘ Sinilarly, datines in oil prices should
‘result in lower spending with corresponding cffecls on relative prices. The impact on
‘permanent inoome of ehwaes in oil prices is likely 4o be smaller can that of ol production as
Ine later isin general perceived to be of a more permanent nature (Edwards, 1992). hn
addicion, the increased dernaad for nontraded woods by the government wail tend Co increase

8

¢ a pages on Txypt by Mengardivi (1997),

“rhe real appreviation can take place cither via nominal appreciation (Pexchange rates are
flexible} of via increases in domestic prices, As the increased income is spont domestically
‘mostly on nanteaded goods, and iCthe goods" mackets arc in equilibrium, the excess demand
‘will tend to increase the price nontradables. The increase in prices on noptraced yoods can
be mitigated ia large share ofthe lho force in unemployed, The increased profisblity ia
‘umn of the noniraced goods sector will end Io altact tesources from tradables goods sectors
‘The teal appreciation wil also tend to reduce the competitiveness of other exports
wages in these sectors and attract resources from the traded goods sevios, This resource
cffoct will in uur contsbute to the real appreciation ofthe exelunge rate, and make
evelopment aPuther exports more difiull

Jin Algerin, where the ol sector is government ovined, mich of the spending effect is ikely 19
tke ple via govevmument budgets given that 60 percent of government reventes are frors the
cil scolar, The effect of changes in il prices on demand for traded yoods (or the current
account) in Algeria has been small, asthe spending by che government is mostly on nontraded
goods.’ Thus loal government spending can be 2 good proxy for expenditure on nontraded
‘goods. Given the present high unemploymaem levels Ihe ampact of charges in ol pices on
wages inthe nonmraded gowda sector and daze on the real appreciation is hkely to be smaller
than expected by thoory. These elles are measured by OILPRICK, which is the WEO price
ol ol dellated by U §, CPT; and TTYDROPRO, which is the volume of production of
Inydsocarbons in Algeria.

‘Teade restrictions, High tradc barriers wil tend to appreciate the real exchange rate, An
increase in protection tends to inorsaso the raltive price of importables. which tends ro divert
more speruling to nansradables incroasing ther pice The sssosiated real appreciation in tum.
val tend to reduce the competitiveness of exportables and import competing industries
Depending on the strenylh of ese effets import competing and nouttadsble industries we
likely to hecome mare profitable attracting resources fram expostables produetion, Thus
protection wil hit esportailea iwc.

‘Trade polisy restrietivemesa here is measured by an inex of Irude restiitiveness, The lack of
appropriate measures for a ccunkiy'sLrade policy stance has been a Frequent problom in punt
suis assessing the impact al trade policies on other economic variables. Most studies have
cused various openness indicalws such as share of exports and impos in GDP (Edwards,
1992; Elbadavis, 1994, Baffey and oilers, 1997, and Mongardini, 1998) 2s proxies to measure
the degree of retrictiveness of cous trade policies. Far Algeria the openness indicator is
a particularly biased raeasuire af trade vestrctiveness because ofthe dominant presence a cil
in total exports and GRP. The index used is a composite measure of the restrictiveness of
country’s trade policies iuking imo account both tariff and nontasil barriers (NTB3)

(for details, see Sharer and athers, 1997). 1c takes values berwoen I (open) and

10 (restrictive), Yaris fll into five entegaries* end NIB into three,” The index is a weighted
average a these Lo measurcs of protection, wilh aBigher weight assigned to NTBS duc ¢0

Cthanges in the fiscal balance can also effect overall sponding sia is impact on the real interest
sate and thereby on the current cebu.

“These are below 10 percent; 10-15 percent; 15 20 percent; 20-25 pereenl; and above
25 pers

ONES aover up Wo | percent, betwecn | and 2S percent, of sbove 26 persent of trade,
their assumed bigher distortion costs, Wiile the index captures large changes in countries
trade policies and is ely tobe superior to various statistical measures of openness, iis
subject to a nunber of caveats ‘No account is taken of aif dispersion or exempions in
increasing the dstonivencs ofa counlsy's trade regi, In the case of Algeria, these caveats
cei mioderac, bowever. Given the iepertant changes inthe eounly’stkade regime rom
nearly central planing io moderacecestrctvencss (from an inex cag of 10 to 7 during the
1990', see below) the indox seems to captate relative well the major changes in policies
iawever, the impact of high dispersion in rates in Algeria and the importance of eamptiom

ji not captured

‘Monetary expansion and nominal devaluation, Jn fhe short ran, chauges in ol pices are
‘alo likely to lead so eiunyges in monetary conditions, which muy alfec the Teal exchange ral
vi yesorve acoumalation, An increase in ceserves unless scrilized will increase the money
supply, which muy exeved money demsad related tothe price change. This is lkely to increase
demand for both tradables and nontradables. Ifthe price of wemtradables increases there wil
be a real appreciation, Tovever, the expansionsry effec ik reduced in ezonomies where the cil
sector iy government owned, in whish there will by two opposing effects (Eciwvards, 1992)

‘The bigher revervex will end to increase money supply while Ihe lower goverument burrowing
requirements from higher revenues ill tend to reduce the demand lor credit by the
‘government. ‘The condicons in Lay money market (log MI’, - log MI") aze measured by
share of broad money to GDP and nominal devaluation (DEV) by the percentage change in
‘the nominal dellar exchange 970

"Veansition issuen, Aputt [Eom the above vatisbls transition zelaled issues may have an
independent impact on the seal exchange ratc ir, Algoria, Although the country was never
‘erly a centrally planned ezonomy, economia management yi he eally 1990s was very
slutlar to certral planning wilh yoverameat contals on production and prices. Thus the
subsequent adjustment w a more market based economy has made Algeria face sinilar issues
as centrally planned econersies A number aC sues (see, 2.g., Rosenberg an Saavalainen,
1997) have shown that cransition from cantral planing loa market-based economy tends 10
have an independeet effect on the real exchange rate. Iutially, the imroduction of market
prives and correction ofthe ancinal exchange rate is likely ze lead Io undervaluation of the
exchange rate, ‘This is becuse nt the tact of transition demand for forcign aasetz tends t0
bypass its supply leading 10 a Tasye depreciation, as maccoeconomi¢ imbalances and inflation
expectations cause a flighe Un Faneign assets. As asser markers adjust Cuter than goods markers
oversioating of the real exchange rule can take place. Over tims administrative price
adjustments, producivity growth, and expla inllows tead co lead to neal uppreciation. In
Algeria, dratie adjustments have taken place belween 1994 aud 1998 and the exchange rate
way have intially heen overshooting dowawards, and some of the subsequent appreciation
may be duc ta productivity geowth and administative price adjustrent

“Trowever. in practice tariff disporsion is likely la he higher in countries with higher average
tavitfs
THE Estimation Results

‘The estimarion procedure allows closely che methodology described in Eibadawi (1994) and
Ballos and ethers (1997) The esimation is constrained by a rclalively small sample sire

(8 obyervations), as 9st of the daln are available only in annua! series. The estimation
sreridl chasen was [980-1997 For the availability of data

‘Yo determine the estimation mcthod for the equation of che equilibrium veal exchange rate the
data of the RFR and is “fundaraentals" were frst ested for stationarity. The results (ablc-2)
show that al variables have unit roots, but are salionary in first differences, Although the test
statisties are slightly helo the crcial valne the small size cl the sample makes it dflicult ro
reject scavionarity at First dillerence fevel given that the values are any slightly below the
critical umes, ‘The next stop was -» test Ibr colntesration bebween the vatiables to establish»
lg-iun :elaionship berivesn the RER and its tandamentals To save degrees of freedom the
Jag length was made to |, The Tohaasen test showed support for eviuteptation, and that tae
rank of the aystem would be I mening thal there wold be one coinlegrating vector “Ihe test
su udjusied fora small sample bits (Table 3), which conditms the rejection of the nll
hypothesis far no cointegrmion. Tawever, the test is weaker Por the hypotlesis of only one
‘eointegratiug vector

‘To estimate the long.run parameters two methods were used. Following falles and ochers
(1997), the longe-turm celationship was estimated by OLS with te levels of RER and the
undermenals in a atic repression, Otaer options considered were the use of firs dillerences
and a lagged dependent variable to estimate the equalina hy OLS, and the Johansen aiethod to
estinare equations with cointegration for a discussion, see Balfes and others. 1997). These
‘were rejected as the firs method ia likely to Jeave out amch infoeavation and the sceond i not
‘well suited Zor small sample estimates. Thereafter the dynamic model was esimated with the
‘esos covrection method (ECM), The above authors note that bath the static regression and
Une TICM deliver consistent estimates of long-run multipliers when cointegration is prescnt.
Table 4a gives estimates of the determinants of ibe fang-ran equilbrive real exchange rate,
‘while Table 4b gives the resulls fiom the nurestriosed FCM. The cesidusis ofthe stale
repression wore tesla for unc roots to conginw the presence oF cainteasation. The Dickey-
Tuller test suggests that the residual we stationary,

All dhe evelicients in the static long-run repression are significant. ard have the expected
‘igs, The LIYDROBRO verse representing the amount of production of hydrocarbons was
roped lecmn the equation ta save degrees of treedom as it proved to he noasignicant The
results indicate Uat wade protcetian has nn important impact on the equilitviuin real exchange
rate, Thus trade Hbevalization would deprociets the ROR. The other two de:econnants
included in the equation, public expeusltuce and the real price of ol, sve also significant witha
‘ane period lag. Thus an inceease in ail prices ued public cxpendieure would appreciavs the real
xchange rate, As discussed carlicr the [ranston related factors van also be important
determinants of mavements in the equiibriyin real exchange vate, and are wot captured by the
coefficients, Figare | shows the estimation results forthe lang-rum equation and the evolution
29.

‘a the trade opentess nd the ol prices. Given the senall sraple problems the rewuls should,
however, he veated with some easton. But asthe purpose of the exercise is to palms a
frcetion of fnlluence betwecn tric Hberulizaion sad the real echanye sate and not to obtsin
peevive parameter estimates, the roxulty em robust for tis goa

‘The ere correction specification SCM usp vanlieas the predictions of theory. All four
determinants al the equilibrium REK have the expected signs ‘The short-run effets of the
Fundamentals (lade restricivencas, yovsraatent expenditure, and oi prices) aave the sumac
‘ign a8 the long-term variables. but iy the Lrade poticy variable has a Significant cocPEcient
‘Among the olher short-run variables (devaluation and monetary equilibrium) che coeficien,
for the nominal devaluation i significant, but smatl. ‘the coefficient forthe monetary
conditions is not sigrilicant perhaps reflccting the rifizatian of foreign cachange receipts in
Atgetia, Devalnation could alsa have some transitory effects in the short-man on the RRR,
Again the celablty ofthese etimalen is seduced by the problems related to che small sample
bias, Bul the results do sygyest that cade liberalization has an imporvaal short and long-run
inwpact on the real exchange THe,

Av. Natu

of Protection in Algeria

Given the inorlance af trade liberalization as a detecmiuant ofthe RER, cis section
ddescrines in more detail the nature of presear trade relicics in Alyeria 8 discussed above
trade liberalization via its impact on tho RAR aul va ineeetives beoween producing for
‘exports and jmpeit substitution can have er important impact on the divensfiection of exports
Frade policies ere are defined in 4 broad xense covering those with an impact on trade in
both gourds and services, Ax services aro un increasing shave of national ineome in many
coumtries and an portant input in exports or in producing goods ina ylobwizing warld
economy, eBicien: provision of services at competitive prices is becoming increasingly

portent for the cowpetitiveness of exports? Thus liberalization of services becomes an
important element of the modern Irade polizy fiamework as well. Furthermore, the diseunsion
also includes investment policies, as these in Algeria can influence incentives of investing in
‘various soctora Ttis shown thar despite sowoc trade Mberafization since 1994 present levels of
protection renin high, and that trade and investmen! policies ace biased aguinst the
development of nenhydrccarbon exports, ‘Thus further efforts inthis aren are important if
expodt diversification isto be achieved.

AL Algeria's Tradde Regime in Goods
At the star ofits suuetural adjustment program i the early 1990s Algeria made rapid

progress in ciemanling tade barriers despite ame teve/sal in 1998 Many NTs were removed
aud tarifs were loweretIninging Algeria from a 10 in the index of trade estrictiveness to

*S9e Tonos and Kiutzkowski (1960).
s10-

Toerween 1991 and 19107 (Figuee 1). However, progres since fas bean very slow and
incentives for the production af uoa-hyérocatbou exports remain distorted.

Currently Lar protection in Algeria remains high! and dispersed leading Lo uneven.
incentives between sectors. In 1998 avoraye urls were about 25 pervent. Nominal protection
‘was highawt on consumer aud food products, many of which are taxed at te maximum rake oF
AS percent (Table 5). The cost of tne protection is thus aainly borne by Algerian consumers ia
higher prices for thei defy consumption baskets and can help explain Ihe zelatively ow share

‘of eonsumor youd in tral iaspars (1 percan!). Main benetisiaries are enterprises producing
these goods, which until receutly have boon maatly state-owned Average alatutory protection
‘om most inputs and capital goods is relatively high at 15 percent.

‘The disvorions ervatal hy the tant regime can be measured by effeetive protection rates
(ERPS) that compare value-added ofan gctvity at domevic twitCinclusive prices in relation
to international prices PRPs in Algeria indicate a high dispersion in protection levels and the
existence of an aati-export bia especialy in labor-intensive gooda, In 1996, for veh most
recent ERD estimates are available, the rates were estimated to range between.

20-110 percent" amang main sec.ors of te eaoaomy. with the highest rates in ood praducts
(110 percent), and textiles and clothing (1 percont), Fapecially the latter soctor tes to be
Tabor-inteasive, and in many developing, counties has been the basis of export success. Wrile
sotne of the highest nominal rates have been reduced sinco the abnve study was undostaken,
the high dispetsion af incentives buween sectors reanains ws the struct of tariff rates has
fo. changed! The nurubers suggests thar effective protection is high in Tubor-intensive sectors,
rentles and many Good products, in which Alyeria unay potentially have a comparuive
advantage in experts, Development af labor-intensive exports can be an important source of
cemplaymenc creation so salve Algeria's ehvoaie unemployment problera

Dispersion of protection in Algeria iv increased and its transparomey reduced by duty
‘exetplious.” About a third of imparts paid lower chan stavntory duties (Table 8), which
amounted toa loss of customs tevenae ef about DN 25% billion per year or 3 percent oF

"Between 1994 and eatly 1997 cho masimora twill was loviered from 60 puroent 10
45 percent. The unweighied average cariff at present is 22 pereeal. with 6 bands (0. 3, 15, 25,
440, 45) compared to 24 porcont in 1996. In addition, here is » 2 percent customs fee and
04 percent addicional customs foc on wll imports bringing the total average of customs dutios
to 24.8 percent.

paved on a World Bank srdy reflecting 1996 tavitts, which had seven bands (0, 3, 7, 18, 25
40, axel 60),

The weighted average of customs duties wae about 17 percent, and cevenue eoflection Bom
customs duties way dons 14 percent ofthe value oF impavis in 1986, The latter measures
indica high dispersion af rates louting tu important differences in incentives between sectors