External Shocks and Domestic Poverty Alleviation - AgEcon Search

63 Pages·2001·0.23 MB·English

The World’s Largest Open Access Agricultural & Applied Economics Digital Library

This document is discoverable and free to researchers across the
globe due to the work of AgEcon Search.

Help ensure our sustainability.

Give to AgE con Search

AgEcon Search
http://ageconsearch.umn.edu
[email protected]

Papers downloaded from AgEcon Search may be used for non-commercial purposes and personal study only.
No other use, including posting to another Internet site, is permitted without permission from the copyright
owner (not AgEcon Search), or as allowed under the provisions of Fair Use, U.S. Copyright Act, Title 17 U.S.C.
TMD DISCUSSION PAPER NO. 71

EXTERNAL SHOCKS AND
DOMESTIC POVERTY ALLEVIATION:
SIMULATIONS WITH A CGE MODEL OF MALAWI

Hans Löfgren
International Food Policy Research Institute

with
Osten Chulu, Osky Sichinga, Franklin Simtowe, Hardwick
Tchale, Ralph Tseka, and Peter Wobst

Trade and Macroeconomics Division
International Food Policy Research Institute
2033 K Street, N.W.
Washington, D.C. 20006, U.S.A.

February 2001

TMD Discussion Papers contain preliminary material and research results, and are
circulated prior to a full peer review in order to stimulate discussion and critical comment. It is
expected that most Discussion Papers will eventually be published in some other form, and that
their content may also be revised. This paper is available at
ttp://www.cgiar.org/ifpri/divs/tmd/dp.htm
Abstract

Two sets of issues loom large on the economic horizon of Malawi: poverty
alleviation and the country’s vulnerability to shocks emanating from the outside world. In
this paper, simulations with a Computable General Equilibrium (CGE) model of Malawi
are used to analyze aspects of these issues. The primary database that is used is a 1998
Social Accounting Matrix (SAM) for Malawi which in part is based on the recently
published Malawian Integrated Household Survey (IHS) 1997-98.
The simulations explore the effects of external shocks and domestic policy
changes aimed at poverty alleviation. The external shocks reflect episodes to which
Malawi’s economy has been exposed in recent times: changes in the international prices
of tobacco and petroleum products and fluctuations in the real exchange rate. Two types
of poverty-alleviating domestic policy shifts are simulated: a public works program and a
land reform program. The public works program may function as an absorber of negative
shocks elsewhere in the economy. The land reform program may introduce a structural
change in the distribution of factor incomes in favor of the poor.
The results for the simulated external shocks confirm that Malawi’s economy is
highly sensitive to external shocks of the magnitudes that the country has experienced in
recent years. The consequences are particularly negative for the non-agricultural
population. Real depreciation has a pro-rural bias and is a powerful tool for eliminating
balance-of-payment difficulties. Real appreciation protects the urban population (which
may be more powerful politically) and total household consumption. A more diversified
production and export structure would make Malawi less vulnerable to external price
shocks and reduce the pressures that lead to sharp exchange rate fluctuations.
Agricultural households are less exposed to changes in Malawi’s external environment
since their incomes tend to be more diversified with a substantial non-agricultural
component.
Assuming that it is self-targeted, the expanded public works program generates
significant gains for the rural poor but has a negative impact on non-agricultural
households, especially in urban areas. High administrative costs and mobilization of
workers that otherwise would have been employed elsewhere make the program less
attractive from an over-all welfare perspective. It becomes more attractive if resulting
improvements in infrastructure reduce distribution costs.
The results for the land reform simulations show that a tax-based land reform
program has the potential of generating substantial gains for the household groups that
receive the redistributed resources. The aggregate gains and the distributional effects are
reinforced if the new owners are able to maintain the production pattern of the estate
sector. Matching financing from the rest of the world can play a similar role by benefiting
the target groups.
Collaborative Research and Capacity Strengthening for Multi-Sector Policy Analysis in Malawi and Southern Africa

Table of Contents

1.0 Introduction ........................................................................................................................ 1

2.0 Background ........................................................................................................................ 2
2.1 Economic Structure ............................................................................................................ 2
2.2 External Shocks ................................................................................................................. 3
2.3 Domestic Poverty Alleviation ............................................................................................ 5

3.0 Model Structure ................................................................................................................. 6

4.0 Simulations ........................................................................................................................ 8
4.1 External Shocks ................................................................................................................. 9
4.2 Elasticity Simulations ...................................................................................................... 12
4.3 Public Works Program and Transaction Costs ................................................................ 12
4.4 Land Reform .................................................................................................................... 14

5.0 Conclusions ...................................................................................................................... 16

References
Appendix
External Shocks and Domestic Poverty Alleviation: Hans Löfgren / IFPRI
Simulations with a CGE Model of Malawi
1.0 Introduction1

Two sets of issues loom large on the economic horizon of Malawi: poverty alleviation and the
country’s vulnerability to shocks emanating from the outside world. In this paper, simulations
with a Computable General Equilibrium (CGE) model of Malawi are used to analyze aspects of
these issues. The simulations explore the effects of external shocks and domestic policy changes
aimed at poverty alleviation. The external shocks reflect episodes to which Malawi’s economy
has been exposed in recent times: changes in the international prices of tobacco and petroleum
products and fluctuations in the real exchange rate. Two types of poverty-alleviating domestic
policy shifts are simulated: a public works program and a land reform program. The public
works program may function as an absorber of negative shocks elsewhere in the economy
whereas the land reform program may introduce a structural change in the distribution of factor
incomes in favor of the poor. Selected simulations are carried out under alternative assumptions
to clarify the role of different elements in determining the effects.

A major advantage of our modeling approach is that it provides an integrated and detailed
framework for analyzing changes at the micro and macro levels, including a wide range of
government policies. The current model is characterized by a relatively fine disaggregation of the
household sector, permitting assessment of distributional effects of simulated changes in the
economy. The primary database that is used is a 1998 Social Accounting Matrix (SAM) for
Malawi (Chulu and Wobst 2000) which in part is based on the recently published Malawian
Integrated Household Survey (IHS) 1997-98 (NSO 2000).

We will proceed as follows: Section 2 provides a background on the issues that are addressed in
the simulations. Section 3 briefly presents the CGE model and its data base.2 Section 4 is devoted
to simulations, while Section 5 presents conclusions.

2.0 Background

2.1 Economic Structure

This section provides a snapshot of the structure and state of Malawi’s economy in 1998 and
recent growth performance, covering both macro and micro aspects. The main purpose is to help
us better understand the impacts of the different policies and exogenous shocks that are
simulated later in this paper.

Tables 1-4 summarize Malawi’s growth performance in the 1990s and its macroeconomic
balances in 1998. The 1998 data were extracted from the project SAM (Chulu and Wobst 2000).
With the exception of growth data in Table 1, all data are expressed as shares of GDP at market
prices.

1 Various colleagues have commented, assisted with the analysis or provided information used in the paper; we
would like to thank Todd Benson, Jennifer Chung-I Li, Moataz El-Said, Ahmed Kamaly, and Sanjukta Mukherjee.
2The model is presented in detail in Löfgren (2000).
1
External Shocks and Domestic Poverty Alleviation: Hans Löfgren / IFPRI
Simulations with a CGE Model of Malawi
Table 1 shows that domestic absorption (the sum of private consumption, government
consumption and investment) exceeds GDP by around 10%, by definition reflected in a trade
deficit of identical magnitude. The investment share (13%) is lower than in other low-income
countries.3 Compared to these, Malawi’s economy is relatively open, with the sum of exports and
imports representing 75% of GDP. In US dollars, GDP per capita in 1998 was US$160. Since
1990, aggregate annual growth has been close to 4%, in excess of population growth. Among the
absorption components, private consumption has increased while investment and government
consumption have declined. On the supply side, agriculture has outperformed the other sectors.

The current account of the balance of payments (Table 2) shows that agriculture has a strong
trade surplus whereas industry and, to a lesser extent, services record significant deficits. The
current account deficit (foreign savings) is smaller than the trade deficit due to a net transfer
surplus. On the income side of the current government accounts (Table 3), taxes contribute
around 75% with the rest covered by transfers (grants) from the rest of the world. On the
spending side, the main item is government consumption. The surplus (government savings) is
close to the value of foreign transfers received, i.e., current government revenues are just about
sufficient to finance current operations. The bulk of investment is carried out by the government
(Table 4). Given that government investment exceeds government savings, there is an over-all
deficit in the government budget. All but a small part of investment is financed by the outside
world, either explicitly (as foreign savings) or implicitly (as grant aid to the government).4

Table 5, which is also derived from the project SAM, provides a more disaggregated perspective
on the structure of production and trade, complementing the information in Tables 1 and 3.
Agriculture is dominant in terms of employment and exports. The sector represents 87% of total
employment but a smaller share, 36%, of GDP (i.e., its labor-intensity is above the economy-
wide average). In addition to the disaggregation along product lines in Table 5, the agricultural
crop sector may be disaggregated into small-scale (68% of agricultural value-added) and large-
scale (32%) sub-sectors. Close to 70% of total exports are agricultural, with the lion’s share for
tobacco (representing close to 50% of total exports, including services, and close to 60% of
merchandize exports). Virtually all tobacco production is exported. On the other hand, exports
are much smaller or negligible for maize, non-crop agriculture, and industry. Agricultural
imports represent a small share of total imports (8%) and of total domestic agricultural demand
(11%). For non-agricultural commodities as a whole, imports constitute a much more significant
share of domestic demand (30%), in particular for non-food manufacturing and other services.

Table 6 shows selected data for Malawi’s households, disaggregated on the basis of socio-
economic characteristics. Some 87% of Malawi’s population lives in rural areas. In 1998, the
poverty rate was 61% in rural areas and 51% in urban areas. In the rural areas, the majority of the
population belongs to the category of agricultural households with land holdings of less than two

3 NEC (2000a, pp. 6-7) makes the same observation. In 1999, more government investment raised the investment
share to 20%. However, even this higher share may note be sufficient to generate GDP growth at levels sufficient to
significantly reduce poverty.
4 There are obvious links between Tables 1-4. Table A.1 restates this information in a condensed, aggregated SAM.
This format has the advantage of making the links between the different accounts explicit and impose consistency
between information from different sources.
2
External Shocks and Domestic Poverty Alleviation: Hans Löfgren / IFPRI
Simulations with a CGE Model of Malawi
hectares. The data indicate that there are substantial welfare gaps, both in terms of urban to rural
average per-capita income and within each area.

These income differences are largely driven by an unequal distribution of factor assets and
associated incomes.5 The importance of different factor incomes in the income of each household
is indicated in Table 7, while Table 8 shows how incomes from different factors are distributed
across households. In general, the agricultural – non-agricultural household distinction is
reflected in the different sources of factor incomes for the different households. The low-income
households primarily rely on their labor whereas those who are better off rely more on land and
capital. A substantial share of total agricultural resource incomes accrues to urban households
whereas rural households earn a large part of the non-agricultural labor income. The rural
households do not control any urban capital.

In sum, this snapshot of Malawi’s economy paints the picture of an economy that is closely
linked to the outside world and vulnerable to external shocks (with a single commodity
dominating merchandize exports and investment being largely financed by the outside world).
The potential repercussions of negative shocks (from external or internal sources) are severe as a
large part of the population lives below the poverty line.

2.2 External Shocks

As mentioned in the Introduction, our simulations will address three types of external shocks:
changes in the international prices of tobacco and petroleum products and variations in the real
exchange rate. Figure 1 shows the evolution for these variables since 1990 (with both commodity
prices measured in constant US dollars and all variables indexed to 1990=100).6 For all three, the
variations have been substantial. The tobacco price declined by 50% between 1991 and 1994,
increased by 66% between 1994 and 1998, and declined by 25% between 1998 and 2000. The
long-term prospects for tobacco prices may be negative (World Bank 1998, p. 35). The
international price of petroleum products, which in 1998 accounted for 7% of total imports, has
also fluctuated substantially: between 1996 and 1998, the average price fell by more than 40%
whereas, between 1998 and 2000, it more than doubled.

In the mid-1990s, Malawi attained current account convertibility. Since that time, the value of
the Kwacha has been determined by market forces subject to Reserve Bank interventions aimed
at smoothing out seasonal fluctuations. Relative to other African countries, Malawi’s real
exchange rate fluctuations are among the highest: the year-to-year changes in the index for the
real effective exchange rate were above 25% in 1994, 1996, and 1998, without any perceptible
trend since 1994.7 The reasons for these sharp variations include budgetary crises, pegging of the
nominal exchange rate at unsustainable levels, the seasonality of Malawi’s export earnings, and
unpredictable foreign aid flows (IMF 1997, p. 14; World Bank 2000a, p. 220).

5 Factor incomes accounts for more than 90% of total incomes for every household category in the SAM except for
the urban, non-agricultural households with low education (representing less than 1% of the total population); for
this group, factor incomes account for 66%, with the balance represented by transfers from the government.
6 The data underlying Figure 1 are presented in Table A4.
7 The real effective exchange rate is from the IMF: it is a weighted average of nominal exchange rates for selected
countries adjusted for differences in inflation.
3
External Shocks and Domestic Poverty Alleviation: Hans Löfgren / IFPRI
Simulations with a CGE Model of Malawi

The simulation analysis in this paper will assess the impact of these external shocks on selected
indicators, including the distribution of gains and losses across different household groups and
producing sectors.

2.3 Domestic Poverty Alleviation

Public Works Programs

To alleviate domestic poverty, Malawi’s government is pursuing a variety of policies. The Public
Works Program (PWP), which is carried out by the Malawi Social Action Fund, is becoming
more important. According to plans, the Expanded PWP will employ the equivalent of 250,000
full-time workers (5% of the total labor force but a larger share of the targeted labor segment) at
a daily wage of US$0.35 (KW11 at 1998 prices) (NEC 2000a and 2000b).

In the short run, it may dampen the negative impact of shocks on the poor. A major attraction of
PWPs is that, by offering wages that are below the lowest market rates, they can be self-
targeting, attracting only the poorest at times of slack in the regular labor market. This obviates
the task of administratively identifying the poor to which the benefit is targeted and may assure
that labor is not diverted from other productive activities. However, to some extent it may be
difficult to avoid the latter outcome given that rural, basic wages are very low. In 1999, reports
convey monthly wage figures that are KW200 or less than US$5 (NEC 2000a, p. 67; World
Bank 2000b), i.e., below the rate of the PWP. Another potential drawback of PWPs is large
administrative costs relative to the benefits that are distributed.

In our simulations of the Expanded PWP, we address the following questions: What welfare
improvements will the program generate? How does its impact differ depending on whether the
program absorbs surplus labor or ends up diverting workers from employment in other activities?
How sensitive are its effects to the level of administrative costs?

Land Reform

In Malawi, cultivable land is scarce and inequitably distributed, a situation that has generated
intense land competition and conflict.8 The sector is dualistic, consisting of a large number of
smallholders and an estate sector that, as a result of government policies, tends to occupy the best
land (Lele 1989). In 1998, the estates accounted for 32% of value-added in crop agriculture (with
tobacco as their dominant crop) in spite of the fact that they represented only 9% of the
cultivated area.

The general rationale for land reform rests on that it can reduce poverty, increase efficiency, and
add to economy-wide growth. Efficiency gains (measured by total factor productivity) are likely

8 Summary data of the inequality of land distribution in Malawi are not available. As an indicator of the prevailing
inequality, according to the 1998 SAM and population data, the average annual per-capita income from agricultural
land and capital varies from US$1.6 for rural agricultural households who are landless or own less than 0.5 ha
(representing 20% of Malawi’s population) to US$2,360 for households with 10 ha and above.
4
External Shocks and Domestic Poverty Alleviation: Hans Löfgren / IFPRI
Simulations with a CGE Model of Malawi
given that evidence from many developing countries suggest that small farms are more efficient.9
Through greater linkages to the rest of the economy, higher incomes for smallholders tend to
support more rapid economy-wide growth (van Zyl et al. 1996, pp. 4-5; Binswanger 1996, pp.
20-21).

Different approaches to land reform are possible. Compared to reforms that are imposed on the
landowners, market-assisted land reforms have the advantage of being based on voluntary
agreements between buyers and sellers. The government may provide grants that finance the
bulk of the cost of land and additional production-related investments for selected beneficiaries.
Supplementary financing is provided by other sources, including an agricultural credit system.
Such market-assisted land reforms may be carried out at costs comparable to those of other
government interventions and may impose less of a burden on government capacity than reforms
that are imposed from above. (For a discussion of this type of land reforms, see Deininger 1998).

The land reform simulations of this paper implement a simplified version of a market-assisted
land reform. The government makes payments to eligible beneficiaries to finance their land
purchases. These payments are financed by a tax that is a fixed share of estate incomes (defined
as the return to estate land and capital, i.e., the sales revenue net of the costs of intermediate
inputs and labor), possibly supplemented by grant aid from the outside world. Such a reform
approach spreads the burden that is imposed on estates evenly across the sector; no additional
burden is imposed on the estate owners that give up their land since this is the outcome of a
voluntary transaction.

To simulate this type of land reform, it is necessary to determine an approximate level for the
average land price at which buyers and sellers will arrive through their negotiations. A piece of
land (and the capital that comes with it) may be viewed as an asset that is expected to yield a
perpetual income stream (the return to land and capital net of any taxes). According to economic
theory, the price (in present value terms) of such an asset is the annual net income (after
deducting any taxes and an allowance for capital consumption) divided by the interest or
discount rate (Chiang 1984, p. 464). This formulation captures an effect that is often observed in
the real world: the imposition of a tax on an asset (or its income) reduces the market price of that
asset.10

Our analysis is based on the assumption that the land sellers receive a fixed annual payment
(indexed to the domestic inflation) during a period of 10 years; the present value of the payment
stream is scaled to assure that it is identical to the present value of the asset (calculated in the
manner described above). In practice, the land transactions would be facilitated if a third party,
for example a foreign government, guaranteed the payments. The simulations test the sensitivity
of the required annual payment per land unit during the 10-year period to alternative discount
rates. The amount of land that is transferred is defined as the resources available (from the land
tax and foreign grants, net of administrative costs) divided by the annual payment required

9 The fact that, in Malawi, yields (output per land unit) are higher on estate lands does not negate this since the
estates are relatively intensive users of capital and intermediate inputs and have benefited from long periods of
government interventions in its favor.
10 In Malawi, substantial estate lands are unutilized. When a land tax is imposed, it is possible that some estate
owners prefer to turn over the land to the state, thus freeing up more land for redistribution (Chulu 2000).
5
External Shocks and Domestic Poverty Alleviation: Hans Löfgren / IFPRI
Simulations with a CGE Model of Malawi
during the ten-year period. In the simulations, the land is transferred, on an equal per-capita
basis, to the lowest-income, rural, agricultural, household groups (the three rural agricultural
groups with less than two hectares, representing 57% of the Malawi’s total population).

Major questions revolve around the technology and the cropping pattern that will prevail on the
redistributed lands. In the simulations, two extreme alternatives are tested: the redistributed land
either retains the characteristics of the estate lands or takes on the characteristics of smallholder
lands.

The purpose of the simulations is to draw a general picture of the likely impact of a tax-based
land reform and its sensitivity to various assumptions. The analysis will address the following
types of questions: How large a land area can be redistributed? What is the impact of any given
reform scheme on aggregated and disaggregated household welfare? How is this impact
influenced by the productivity and production pattern of the land-reform beneficiaries?
Complementary analyses of various micro-level aspects could cast light on important aspects
such as the selection of beneficiaries, production issues, and mechanisms for arranging land
transactions (including financing of part of the land cost through the banking system).

Before turning to the simulations, we will first give a brief overview of the model structure and
the database.

3.0 Model Structure and Database

The simulation analysis of this paper is based on a CGE model of Malawi. To the best of our
knowledge, this is a first for Malawi. Since the model is presented in detail in Löfgren (2000),
we will here only provide a brief verbal overview.

CGE models may be defined as economy-wide models the solutions to which depict a
simultaneous general equilibrium in all markets of the economy. CGE models are widely applied
to policy analysis in developing countries and have a comparative advantage when there is a
need to consider links between different producing sectors, links between the macro and micro
levels, and the disaggregated impact of changes in policies and exogenous shocks on production,
and household welfare. The current model is structured in the tradition of trade-focused CGE
models of developing countries described in Dervis, de Melo, and Robinson (1982). Its
distinguishing features include a detailed treatment of households and the division of the
agricultural crop sector into small-scale production and estates.

Figure 2 provides a bird’s-eye perspective on the model, highlighting the links between its major
building blocks: producers, factor markets, commodity markets, households, the government,
and the rest of the world. The arrows in the figure represent payment flows. For payments other
than taxes, transfers, and savings, real flows (a factor service or a commodity) go in the opposite
direction. In the model, all blocks except the government and the rest of the world are further
disaggregated; Table 9 shows the full model disaggregation. In Figure 2, the block labeled
“Households” represents all domestic non-government institutions that are listed in Table 9 (i.e.,
all households and all enterprises).
6