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Dual labor markets, public debt management, and exchange rate movements

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Dual labor markets, public debt management, and exchange rate movements

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Content DUAL LABOR MARKETS, PUBLIC DEBT MANAGEMENT, AND EXCHANGE RATE MOVEMENTS Copyright 2002 by Sheikh Shahnawaz A Dissertation Presented to the FACULTY OF THE GRADUATE SCHOOL UNIVERSITY OF SOUTHERN CALIFORNIA In Partial Fulfillment of the Requirements for the Degree DOCTOR OF PHILOSOPHY (ECONOMICS) December 2002 Sheikh Shahnawaz Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. UMI Number: 3093917 UMI UMI Microform 3093917 Copyright 2003 by ProQuest Information and Learning Company. All rights reserved. This microform edition is protected against unauthorized copying under Title 17, United States Code. ProQuest Information and Learning Company 300 North Zeeb Road P.O. Box 1346 Ann Arbor, Ml 48106-1346 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. UNIVERSITY OF SOUTHERN CALIFORNIA The Graduate School University Park LOS ANGELES, CALIFORNIA 90089-1695 This dissertation , w ritten b y U nder th e direction o f hfiS.. D issertation C om m ittee, and a p p r o v e d by all its m e m b e r s , has been p resen ted to an d a ccep ted b y The G raduate School, in p a rtia l fu lfillm en t o f r e q u i r e m e n t s fo r th e degree o f DOCTOR OF PHILOSOPHY r D ean o f I Dean o f G raduate S tu dies D ate U.e.cemher_.JL8.»_-2Q02 DISSER -it f l l w t Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Acknowledgements I would like to express my sincere gratitude to Dr. Herbert Dawid, and Dr. Selo Imrohoroglu for their incredible help and support. I would especially like to thank my chair and mentor, Dr. Jeffrey Nugent, without whose encouragement and guidance this dissertation would simply not have been possible. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Contents Acknowledgements ii List of Tables v List of Figures vi Abstract vii 1 Introduction 1 1.1 Dual Labor Markets and Public Debt 3 1.2 Inflation Stabilization 5 2 Dual Labor Markets and Public Debt: The Lebanese Example 7 2.1 Introduction 7 2.2 The Lebanese Economy in Historical Perspective 10 2.3 Lebanon After the War 15 2.4 The Political Situation 26 2.5 The Model 28 2.6 Conclusion 42 iii Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 3 An Empirical Study of Disinflation in a Small Open Economy 46 3.1 Introduction 46 3.2 Some Country Experiences 49 3.3 Inflation and Exchange Rates in Lebanon 55 3.4 Real Exchange Rate Models and Cointegration 57 3.5 The Empirical Model 63 3.6 Policy Implications 78 3.7 Conclusion 81 4 Conclusion 83 References 89 iv Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. List of Tables 2.1 Lebanon: Structural Change, Selected Years, 1950-1973, (.Percentage Shares) 13 2.2 Composition of Public Expenditure (Current Prices: % o f GDP) 19 2.3 Work Permits Issued to Selected Foreign Workers, 1993-2000 25 3.1 Johansen’s Trace Test (5 Variables) 66 3.2 Eigenvectors 67 3.3 Johansen’s Trace Test (4 Variables) 67 3.4 Eigenvectors 68 3.5 Choi’s LM Test for Stationarity 70 3.6 Cointegration Analysis (trace values) for p, p*, e, d, m, rer, tot, open, and r 71 3.7 Critical Values for Johansen’s Test at the 95 % Level for Lag Value 0 71 3.8 Results for the Main Inflation Model 73 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. List of Figures 2.1 GDP Growth Rate: Constant 1994 Prices 17 2.2 Total Government Debt: Current Prices, Percent of GDP 20 2.3 Real Interest Rates on Public Debt 21 2.4 Capital Expenditure in Selected Countries (Average 1991-2000) 28 3.1 Exchange Rate Depreciation and Inflation 57 3.2 Inflation and Real Exchange Rate 58 3.3 Equilibrium and Actual RER 74 3.4 Actual and Simulated Inflation 75 3.5 Actual and Simulated RER 75 3.6 Actual RER with 2 Simulation 77 3.7 Inflation Forecast when Change in Nominal Exchange Rate = 0 79 3.8 RER Forecast when Change in Nominal Exchange Rate - 0 79 3.9 Inflation Forecast with a Targeted Change in Exchange Rate 80 3.10 RER Forecast with a Targeted Change in Exchange Rate 80 vi Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Abstract Although the two essays included here focus on the economy of Lebanon, a country unique in the Middle East due to both its political and economic characteristics, the study is instructive even in the context of other developing economies. The first essay attempts to explain growing public debt and the influx of foreign labor in the face of high unemployment while essay two examines the role of exchange rates and their role in stabilization. The models developed are deemed useful for a more comprehensive understanding of the mechanisms that drive the economics of small and open economies thus contributing to improved policy formulation and implementation in the stated areas. The first essay tells a two-part story by developing models to explain high government debt and investment as well as the huge influx of labor from abroad even when there is significant domestic unemployment. The study is relevant to many developing countries that are characterized by the presence of various power vii Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. groups in the population. The model attempts to explain the somewhat surprising phenomenon of pervasive unemployment in Lebanon amongst its citizens while foreign workers continue to pour into the country to fill existing jobs. Also, the model employs game theory to functionalize a political explanation for rapidly increasing domestic debt and investment. The coalitional nature of the government is identified as the primary reason for high domestic debt and investment. A simple error-correction model is estimated in the second essay to study exchange rate based stabilizations in small open economies. Three considerations are taken into account in the development of this model. These are the gap between the actual and equilibrium real exchange rates, inertial inflation, and conventional factors like fiscal and monetary policy. The relative contribution of each of these factors to inflation is then examined. We find that only the initial appreciation following the stabilization program is attributable to inertial inflation. The rest is explained by difference between the actual and equilibrium real exchange rate. Finally, we use our model to show the usefulness of some proposed exchange rate policies. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Chapter 1 Introduction The important role of government in the growth and management of economies in the developing world is beyond debate. While misplaced government intervention can be extremely inimical for a developing economy, good policies and sound management in the form of limited but active government participation in the economic process can lead to rapid and sustainable growth with desirable economic fundamentals. This thesis studies some of the issues and puzzling phenomena that are presently of concern (or will be soon) to academics and policy makers. Although this study is done in the context of developing countries, it has important lessons for developed countries as well, particularly in light of the growing interdependence between the countries of the developed and developing world. The issues that are studied here include: Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 1. The migration of labor from its home country to other countries where domestic unemployment is rampant. 2. Insatiable government borrowing in the face of ballooning debt levels that threaten macroeconomic stability and therefore long-term growth. 3. The efficacy of nominal exchange rate anchors to stabilize the economy. All of the above are introduced in more detail later in this chapter. But before looking at the issues, it should be mentioned that this thesis examines them in the context of the economy of Lebanon. This choice is made for several reasons. First, Lebanon is one of the most dynamic economies in the Middle East region with a complex coalitional government structure. This study highlights the role of this peculiar political arrangement in the sort of economic outcomes that are not only observed in Lebanon but that have also been a feature in other parts of the world. Second, Lebanon has been well known for its laissez-faire and open economy with limited regulations impinging on the functioning of markets. In light of the thrust of many developing economies toward the free-market system, the choice of Lebanon as a case study is particularly useful due to the many policy lessons it holds for countries that are in the process liberalizing their economies. Third, following a civil war that spanned fifteen years, the Lebanese authorities have been engaged in the difficult task of simultaneous economic stabilization and confidence-building on the one hand, and postwar reconstruction and development on the other. This provides 2 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. us with a rich set of problems, both fiscal and monetary, that we can study in the context of only one economy. Finally, Lebanon has been a key economic intermediary between the developed economies of the West and the developing economies of the Middle East. Thus, intimate knowledge about the state of the Lebanese economy is not only crucial for the Lebanese authorities but also for countries that are engaged in trade with an increasingly important Middle East region. The following subsections present a broad overview of the issues to be examined. 1.1 Dual Labor Markets and Public Debt Many countries around the globe including those that are not part of the group categorized as developing countries often experience a significant influx of labor from their neighbors in the region. This problem is worth looking at in some detail especially given the pervasiveness of regional agreements that aim at intensifying economic cooperation between nations. Often such inflows of labor are in the face of rising domestic unemployment in the host country. This is also observed in the Lebanese case where, by some accounts, unemployment is as high as 25 percent and yet a sizeable labor influx from several countries in the region continues unabated. A classic study that has attempted to explain this paradox is Harris and Todaro (1970), who model migration behavior in the context of 3 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. urbanization policy and migration between rural and urban areas. They showed that the existence of a binding minimum wage in the urban sector can lead, even if the rural labor market is competitive, to a persistent wage differential between the rural and urban sectors and to the emergence of unemployment in equilibrium. Yet another feature of many economies worldwide is the burgeoning debt burden. Explanations for this phenomenon have ranged from the desire of governments to protect their economic rents at one end to their desire to protect their political rents on the other. Ethnic, religious, or ideological diversity in developing countries adds a new dimension to the issue of debt in developing countries. In such cases, we usually observe coalitional and power-sharing structures in government. Some examples include countries such as Brazil and Argentina with their populists, authoritarians, and democrats, South Africa with its mix of African, European, and Asian ethnicities. This form of government therefore holds much promise in explaining the dynamics of debt in not only developing countries but also in those nations where coalitions run the show. The case of Lebanon in the Middle East region is an especially good example. Despite high unemployment among the Lebanese citizens, a sizeable foreign work force is present in the tiny Mediterranean state. The model explains this apparent paradox of a the huge level of Lebanese public debt along with the decision of many Lebanese not to join the labor market—citizens opt not to work in view of the income they expect to earn through lending operations. So, although they are looking for jobs, they do not choose to work in just any position. Instead, 4 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. they opt not to work if a “good enough” job does not come their way. Also, the government plays an important role in determining government investment and debt. In Chapter 2, a political economy explanation is derived to explain the seemingly insatiable desire of the Lebanese government to borrow domestically. 1.2 Inflation Stabilization There have been several approaches that have been used in an attempt to stabilize high inflation economies. While many countries have tackled the problem by directly intervening in the wage-price process, others have relied on more orthodox policies that attempt to get the fundamentals right. Such policies have involved using money and exchange rates to achieve their objectives. Targeting the exchange rate is a monetary policy with a long history. It can take the form of fixing the value of the domestic currency to a commodity such as gold, the key feature of the gold standard. More recently, fixed exchange rate regimes have often involved fixing the value of the domestic currency to that of a large low inflation country. A substantial literature has evolved over the recent past to study the use of exchange rates to bring inflation under control. Two broad approaches are found in this literature. While one of these approaches utilizes an equilibrium framework to examine exchange rate based stabilizations, the other highlights the importance of persistent high inflation as a significant factor in influencing inflationary dynamics. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. This was the policy that the Lebanese authorities implemented in 1992 following the end of the civil war. This policy has successfully brought down Lebanese inflation from triple digits to below 10 percent in recent years. In chapter 3, an empirical model of inflation that incorporates not only equilibrium and inertial factors but also the more traditional variables like fiscal and monetary policy is developed. In addition, the study acknowledges the reality that high frequency of data is crucial to the effectiveness of our model since we are concerned with stabilization episodes that, if successful, do not last for long periods of time. Unfortunately, obtaining high frequency data is often a problem when analyzing developing economies. Thus, we attempt to develop a model that is not rendered useless due to unavailability of data. In that regard, we utilize a model of the equilibrium real exchange rates that would allow maximum flexibility and not impede the analyses of developing countries due to an absence of requisite data. The model is estimated using Lebanese data and is then used to assess the contribution of the various factors described above to the excess of Lebanese inflation over foreign inflation (or to the real appreciation of the Lebanese currency) that occurred after the implementation of its exchange rate based stabilization program following the end of the Lebanese civil war in the early 1990s. 6 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Chapter 2 Dual Labor Markets and Public Debt: The Lebanese Example 2.1 Introduction The purpose of this essay is to develop a model to explain the link between the levels of public debt and unemployment observed frequently in developing countries. Various such nations around the globe are plagued not only by high levels of unemployment and government debt but also sizeable inflows of mainly unskilled workers pouring in, legally or illegally, from neighboring states. The situation can be aggravated by diversity, be it ethnic, religious, or ideological, of the country’s population that usually gives rise to coalitional and power-sharing structures in government. Many examples are available: Brazil and Argentina with their populists, authoritarians, and democrats, and, until recently, with a strong military 7 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. presence in political affairs; several nations in Africa but especially South Africa with its mix of African, European, and Asian ethnicities; Albania, Bosnia, Croatia, and Bulgaria with their rich ethnic mix; and countries like Uzbekistan and Afghanistan from the Central Asian region. Although economically at different stages of development, these countries are well known to be on the receiving end of foreign aid suggesting an aspiration for a strong economic future. The model presented in this paper hopes to help our understanding of the relationship between economic phenomena and the socio-political reality in such countries. The case of Lebanon in the Middle East region is an especially good example. Despite high unemployment among the Lebanese citizens, a sizeable foreign work force is present in the tiny Mediterranean state. The model explains this apparent paradox of a the huge level of Lebanese public debt along with the decision of many Lebanese not to join the labor market—citizens opt not to work in view of the income they expect to earn through lending operations. So, although they are looking for jobs, they do not choose to work in just any position. Instead, they opt not to work if a “good enough” job does not come their way. Also, the government plays an important role in determining government investment and debt. A political economy explanation is derived to explain the seemingly insatiable desire of the Lebanese government to borrow domestically. Some of the costs of such a policy, like the crowding out of private investment, are discussed in Shahnawaz (1998). Possible explanations for the puzzling behavior of the Lebanese government with regard to its borrowing may include its desire to protect (i) its economic rents, 8 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. an idea developed in various stages and different forms by Kuznets (1968), Mokyr (1990), Grossman and Helpman (1994), Krassell and Rios-Rull (1996), and Parente and Prescott (1997). These studies stress the role of economic gains that politicians can make by stealing or accepting bribes; (ii) its political rents, an idea introduced by Robinson (1997,1999), and Acemoglu and Robinson (2000), based on North (1981) and Acemoglu and Robinson (1999); or (iii) a combination of both. This paper takes the third approach due to its attention to both economic as well as political motives that politicians are likely to have in reality. The results on the labor market side obtained from the model reinforce the lessons learned from the seminal work on two-sector labor markets by Harris and Todaro (1970). This is an interesting result since the methodology employed in modeling here is quite different from that of Harris and Todaro. For the workers, we use a simple version of the more elaborate formulations of a search problem mainly delineated in Sargent (1987a) and Ljungquist and Sargent (2000) and based on the pioneering work of Stigler (1961) and McCall (1970). The results are also substantively in agreement with Hassler et al (1998), who also develop a model with labor market search and endogenous policy, and show that there may be outcomes with high unemployment and generous benefits or with low unemployment and less generous benefits. The layout of the paper is as follows: in Section 2, an historical picture of the Lebanese economy is presented in order to provide the reader with some background. This is important in order to be able to identify characteristics unique to Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Lebanon and to put policies being followed by the more recent Lebanese governments into better perspective. Section 3 then discusses the current situation of the Lebanese economy, therein delineating the features believed to be at the heart of the Lebanese conundrum. Section 4 briefly describes the political aspect of the story. This is followed by a presentation of the model in Section 5. We conclude in Section 6 with a discussion of policy problems and some suggestions to overcome them as obtained from our model. 2.2 The Lebanese Economy in Historical Perspective Lebanon has long been known for its laissez-faire economic system in a region otherwise characterized by pervasive regulations and tight government controls on economic activity. Before the Lebanese civil war that broke out in 1975, it had a strong currency, minimal direct taxation, and limited public spending on either development or defense. A policy of low tariffs and after 1956 a Bank Secrecy Law designed to attract foreign investment after 1950. These measures are argued by Shehadi (1987) to be a deliberate policy encouraging openness, not simply the result of inaction or inertia. Quantitative manifestations of these policies were a two-thirds share of national income for 1956 coming from banking, commerce, and other services, with only twenty percent coming from agriculture and thirteen percent from industry.1 1 Badre, Albert, “The National Income of Lebanon,” Middle East Economic Papers (1956). 10 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Not only was the self-propagation feature of this system useful for Lebanon but the post-war rise in oil revenues in Kuwait, Bahrain, and Saudi Arabia were also beneficial for the country. Lebanese merchants were quick to establish links with the Gulf elites who preferred to invest their new revenues with the help of Lebanese middlemen rather than Western bankers in London and New York. Owen and Pamuk (1998) quote a figure of almost two-thirds of the Arab oil surplus that found its way to Beirut between 1956 and 1965. Lebanon’s relative political stability in a tumultuous region qualified it as a recipient of capital in flight from coups and revolutions in countries like Syria, Egypt, and Iraq. After President Chehab’s (1958-1964) unsuccessful attempt to influence the country’s economic orientation, the crash of the country’s largest bank, Intra, in 1966, and the Israeli military victories of June 1967, Lebanon started a new period of rapid growth with oil revenues from the Gulf once again serving as the grease in the country’s economic wheel. While revenues from tourism increased, a new source of income during this period were from the remittances sent by the 150,000 Lebanese working in Saudi Arabia and elsewhere. Yet another feature was the arrival of foreign banks. The outbreak of Lebanese civil war in 1975 put an end to the nation’s economic glory. Destruction, forced migration, loss of trade and tourism, and the increasing division of the country into small separately controlled units caused a huge reduction in income and output. The war, that lasted 15 years, caused over one million people emigrate from the country. A significant proportion of these people 2 Owen and Pamuk (1998) quote these figures at LL110 million from Egypt, LL150 million from Iraq, and LL300-600 million from Syria, p. 173. 11 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. had professional and technical skills and included 22 percent of the country’s doctors.3 The result was a substantial reduction in the economically occupied population from 750,000 in 1975 to a little over 450,000 ten years later.4 In these trying times, there were three compensating factors. These were continued remittances, the money sent to support the rival militias, and most important of all, a dramatic increase in public expenditure which reached some 37.6 percent of GDP by 1982, approximately double the proportion of the early 1970s.5 This was a consequence of a larger government payroll as well as the price subsidization of necessities such as petrol, sugar, and wheat. Since the already low tax revenues were in a further sharp decline, this policy was sustained only by the inflationary process of borrowing more and more from the Central Bank. Prices, therefore, rose rapidly with inflation peaking at about 500 percent in 1987 before falling to around 50 percent by the end of the war and to single digits more recently.6 Lebanon’s growth during 1950-1964 had been quite impressive by the available range of estimates (5.2 percent to about 7 percent).7 Although the rate declined between 1965 and 1970, it picked up again in the early 1970s breaking into double digits. Prior to the civil war, banking and services were estimated to have 3 Al-Khalil, Yusif, “Economic Developments in Lebanon since 1982,” Beirut Review 3, 1992. 4 Owen and Pamuk, p. 160. 3 Saidi, Nasser, H., Economic Consequences o f the War in Lebanon, Papers on Lebanon 3, Oxford, Centre for Lebanese Studies, 1986. 6 Figures provided by the Research Department at Bank Audi. Also see al-Khalil, 1992. 7 The IMF’s International Financial Statistics claim the lower figure while independent economists like Badre who were associated with the American University in Beirut advocate the higher estimate. 12 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. contributed anywhere between two-thirds to three-fourths to the GNP, with the main change involving a decrease in the contribution of agriculture and an increase in that of industry. This is presented in Table 2.1 below. Table 2.1: Lebanon: Structural Change. Selected Years. 1950-1973. (Percentage Shares) 1950 1955 1960 1965 1970 1973 Agriculture 19.7 16.2 14.1 11.6 9.2 9.0 Industry 13.5 12.7 12.1 13.1 15.9 21.0 Construction 4.1 4.3 3.5 5.7 4.5 4.5 Transportation 4.1 5.4 3.9 8.2 8.2 8.5 Trade 28.8 28.8 32.0 30.6 31.4 33.0 Finance and Insurance 3.8 5.1 6.3 3.4 3.4 4.0 Real Estate 9.2 8.4 11.0 7.6 8.8 10.0 Government 6.9 6.0 7.8 8.0 8.7 10.0 Other Services 9.6 12.0 9.2 11.3 9.9 - Source: Owen, Roger, and Sevket Pamuk, A History o f Middle East Economies in the Twentieth Century, p. 258. Between 1950 and 1974, there was a major reduction in the labor force in agriculture, going down from close to 50 percent of the total to about 20 percent. This was accompanied by a movement away from the cultivation of cereals toward higher value crops like fruit and vegetables. In the industrial sector, there was an increase in investment, employment, and output from1950 to the early 1970s. Complex processes involving the working up of imported raw materials or spare parts were also introduced, bringing Lebanon into the vehicle assembly and pharmaceuticals industry while it continued to participate in the manufacture of such traditional goods as textiles, clothing, and shoes. During the early 1970s, a 13 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. significant stimulus to the expansion in activity was the opening up of new markets for Lebanese manufacturers in the Gulf. Banking and trade were the main drivers of growth in the services sector. From 1950 to the mid 1960s, the number of individual banks (of Lebanese, foreign, or mixed ownership) increased from 17 to 93, while the ratio of deposits to national income went up from 20 to about 100 percent.8 Following the Intra bank crisis of 1966, the Superior Banking Council was established and laws were tightened, creating the conditions for the entry of large Western banks. The other main contributor to this sector, trade, provided nearly a third of GDP from 1950 to the early 1970s.9 The size and profitability of the services sector has been blamed for the unequally distributed fruits of economic growth. An illustration of this can be gleaned from the figures provided by Owen and Pamuk (1998): while 23 percent of the working population was employed in commercial, financial, and other services, they produced 47 percent of the national product in the late 1950s. This is in sharp contrast to the meager 16 percent of GDP controlled by an agriculture sector that employed almost 50 percent of the population. Thus, the outbreak of civil war in 1975 was not a complete surprise. Saidi (1986) estimates the fall in national income by the end of 1976 to be nearly half its pre-war level. It did, however, recover gradually to about 80 percent 8 Owen and Pamuk, 1998. 9 Nasr, Salim, “Backdrop to Civil War: The Crisis of Lebanese Capitalism,” MER1P Reports 8, 10, 73, 1978. 14 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. of its pre-civil war level by 1980-81. But the volatile intensity of the war up until its end took its toll on GDP and by the end of the prolonged tragedy, GDP was down to about a third of its 1974 level in constant prices according to World Bank estimates. Agriculture and industry suffered the largest reductions in contributions to GDP, from 17 and 9 percent to 14 and 7 percent, respectively. Poverty and unemployment increased, while wages lagged behind inflation. At the same time, public and professional services in areas such as education, health, housing, transport, water, and electricity fell drastically. Even something as basic as personal security no longer existed. 2.3 Lebanon After the W a r Only recently has Lebanon started to emerge from the consummate destruction inflicted upon it during its fifteen-year civil war. As described in the previous section, economic progress suffered and, consequently, a good part of the country’s best and brightest minds left for abroad in search of better opportunities. More than 200,000 professional and skilled workers had emigrated by 1991.1 0 However, many professionals stayed giving rise to under-1 1 and un-employment. The civil war came to an eventual halt in the early 1990s, Syria finally being able to 1 0 Eken, Sena et al, Economic Dislocation and Recovery in Lebanon, IMF Occasional Paper 120, 1995. 1 1 Many professionals were forced by the situation to work below their qualifications as job availability became rare. This phenomenon continues to this day, although at a much reduced scale, as the drive for reconstruction in the post-civil war period has only become stronger. 15 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. assert its dominance in the tiny nation thanks to 35,000 troops stationed on Lebanese soil charged with maintaining control. Coupled with the fact that Lebanon has historically served as a land of opportunity for many in the region, this explains to a large extent the conspicuous presence of a nearly 250,000-strong Syrian labor force in Lebanon.1 2 However, in contrast with their Lebanese counterparts, an overwhelming number of these workers are unskilled which means that their greatest influence is on the informal sector of the Lebanese economy. We will come back to this later. In the last several years Lebanon has enjoyed a respectable growth rate. The end of the war allowed households, firms, and the government to return to normal conditions of production and consumption, which, in conjunction with the rebuilding of residential and business structures, the productive capacity of enterprises, the stock of consumer durables, and the government-led reconstruction program to build infrastructure, had the expected strongly positive effect on growth. Although projected by the World Bank at 3.1 percent for 2000-04, the growth rate steadily declined from its level of close to 8 percent in the early days of the reconstruction drive.1 3 This is illustrated in Figure 2.1 on the next page. The growth rate slowed to 4 percent in 1996 due to bombings in April and the decline in construction activities because of the excess supply in some segments of the real estate market. The rate of growth has stayed at these levels since then. 1 2 The Economist, various issues. Alternate estimates are going to be presented and discussed later in the paper. 1 3 Gessani and Page, 1999. IMF estimates put average annual growth rate of GDP during 1991-97 at an impressive 9.7 percent. 16 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Figure 2.1: GDP Growth Rate (constant 1994 prices) 9 8 7 6 5 4 3 2 1 0 1992 1993 1994 1996 1997 1998 1995 Source: Gressani, Daniela and John Page (1999). “Reconstruction in Lebanon: Challenges for Macroeconomic Management,” MENA Working Paper Series No. 16, The World Bank, Washington, DC, p. 4. Another feature of the Lebanese economy since 1991 has been the government’s overzealous efforts targeted toward recapturing the country’s past eminence as an economic and financial hub to the Middle East. Thus, the government has played a prominent role in reversing the civil war legacy in the hope of again attaining Lebanon’s post-independence stature as an economic powerhouse. Total damage to physical assets was estimated at US $25 billion at the end of the civil war.1 4 The government formulated first the National Emergency Reconstruction Program and then the Horizon 2000 Program. The objective of each of these two programs was to rapidly rehabilitate and enhance the country’s severely 1 4 Eken, et al., 1995. 17 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. damaged infrastructure. Public investment spending has, therefore, been targeted to the reconstruction and upgrading of existing infrastructure, in part to catch up with countries at similar levels of development. As one would expect, the government has acquired very high levels of debt in the process. This has resulted in calls from concerned circles for concentrating policy efforts toward fiscal adjustment. According to the original ten-year plan, public spending is scheduled to be around US $12 billion, a figure that is close to 11 percent of GDP per year and front-loaded to around 13 percent of GDP during the earlier years.1 3 Although the reconstruction program was mostly viewed as appropriate for post-war Lebanon, some, including the World Bank, found its size and phasing to be excessively ambitious and likely to lead to macroeconomic imbalances. Thus, due to the acceleration in the growth of government capital expenditure (the program has largely been financed on commercial terms with private participation limited mostly to the management and provision of infrastructure), the large and expanding current expenditure (particularly interest payments on domestic debt), and the slow recovery of the revenue-generating capacity, Lebanon is suffering from sizable fiscal imbalances. Although the deficit fell from 16 percent of GDP in 1991 to 8 percent in 1993, it rose and has remained high since then.1 6 Gessani and Page (1999) report that, since the launch of the program in 1993, public investment has hovered around 7 percent of GDP during the 1993-98 period. The sheer magnitude of the budgetary 1 5 Gressani, Daniela, and John Page, Reconstruction in Lebanon: Challenges fo r Macroeconomic Management, World Bank Working Paper Series, No. 16, 1999. 1 6 For example, in 1997, government deficit was reported by the IMF to be 26 percent o f GDP. 18 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. effort has led to larger budgetary deficits (about 15 percent of GDP) and faster domestic debt accumulation than was originally expected. A widening budget deficit increases the inflation rate and the interest rate, and hence discourages the participation of the private sector. The deficits have been mostly financed through the issuance of government bonds (with maturities of up to two years) denominated in Lebanese pounds and held primarily by the domestic banking system. During 1993-2000, gross public debt increased from 49 percent to 109 percent, and net public debt rose from 38 percent to 97 percent. Rapidly accumulating debt has, however, helped Lebanon achieve some favorable macroeconomic outcomes like low inflation, a stable exchange rate, and growing foreign exchange reserves (Figures 2.2 and 2.3 on the following pages). But, the high level of debt keeps interest rates up and paying the interest on such debt absorbs an ever-increasing share of public revenues. Table 2.2 below presents the composition of public expenditure. Table 2.2: Composition of Public Expenditure (Current Prices: % o f GDP) 1992 1993 1994 1995 1996 1997 1998 Current Expenditures 21.8 20.0 25.8 25.7 29.4 31.0 20.0 Interest on External Debt 0.4 0.3 0.3 0.7 1.1 1.1 1.2 Interest on Domestic Debt 5.0 5.7 9.4 9.7 11.9 13.9 13.0 Consumption 14.8 14.0 14.5 14.1 15.5 15.7 15.0 Subsidies 1.5 - 0.6 1.2 1.0 - - Wages and Salaries 6.9 9.9 11.2 10.4 11.1 10.7 - Capital Expenditures 1.5 3.4 9.3 9.4 8.5 5.5 5.5 Source: Extracted from Eken, Sena, and Thomas L elbling, “Back to the Aiture: Postwar Reconstruction and Stabilization in Lebanon,” IMF Occasional Paper No. 176, p. 87. 19 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. It should be noted that, historically, initial recovery through reconstruction has not been a guarantee for sustained growth for countries emerging from, war (Gressani and Page, 1999). For example, macroeconomic stability and strong private sector recovery were achieved in post-war West Germany and Japan largely by pursuing tight fiscal policies and ensuring wage restraint. A two-tier approach to fiscal restraint addressing the problem of external imbalances and wage restraint focusing on firm profitability and retained earnings was used. Figure 2.2: Total Government Debt (Current Prices; percent of GDP) Source: Banque du Liban, Quarterly Reports, Vols. 29-35. 20 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Figure 2.3: Real Interest Rates on Public Debt (In percent) 40 20 -40 -60 -80 -100 Source: Banque du Liban, Quarterly Reports, Vols. 28-37. These experiences indicate that, external deficits are difficult to avoid in the early stages of reconstruction and are not necessarily harmful; yet, the fiscal policy stance is crucial for ensuring that external deficits are kept under control and eventually eliminated; and labor market developments are critical for achieving public-sector led reconstruction that is accompanied by a strong private recovery. The sheer size of fiscal imbalances in Lebanon endangers the reconstruction effort itself by raising the prospect of macroeconomic instability, thus undermining the prospects of robust growth beyond the early reconstruction phase. 21 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Although high public consumption does increase future growth and, therefore, repayment capacity,1 7 and significant operations and maintenance expenditures can increase the return on public investment, it is debatable whether this actually is the case for the majority of current expenditures in Lebanon. Interest payments on public debt and the government’s wage bill represent one of the largest components of current expenditures, as has been shown in Table 2.2 already. It is interesting to note that interest payments and the wage bill each exceed the public investment budget. As Table 2.1 shows, a distinguishing feature of the Lebanese economy is its heavy reliance on the service sector rather than industrial activities as the main source of export earnings. The occupational distribution of the country’s labor force of about 1 million plus as many as 1 million foreign workers is evidence of this reliance: while 62 percent of the labor population is employed in the services sector, only 31 percent and 7 percent of the labor force work in the industrial and agricultural sectors respectively.1 8 Table 2.3 presents these shares since 1975. Also, relative to the resident population, a large expatriate population represents a source of transfers and capital inflows, as well as skills that are generally unavailable to other countries in Lebanon’s position. In addition, the tiny nation of 4 million has access to a large supply of unskilled labor from other countries in the region, especially, as mentioned earlier, 1 7 Expenditures on health and education have particularly been shown to have a potential positive impact on economic growth in the medium term. 1 8 CIA World Factbook, various issues. 22 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. from Syria. This influx of Syrian labor has increased unemployment among Lebanese nationals to an estimated 18 percent,1 9 and placed a heavy burden on Lebanon’s social security system. As a result of this influx, Lebanon is transferring approximately $3 billion a year to Syria.2 0 This figure constitutes the largest (or second largest, depending on the current price of petroleum) single source of income for Syria. The situation has given rise in Lebanon to nationalistic groups like the Citizens for a Free and Independent Lebanon (CFIL) that have launched a series of terrorist attacks against Syrian civilian workers. The types of jobs that foreign workers usually undertake are the traditional, dirty, dangerous, and difficult jobs characteristic of the secondary labor market. In particular, since the civil war, Lebanese nationals have been less likely to undertake such jobs because the jobs have been “tainted” by the low status of foreign workers in the country and because they are less prepared to suffer the indignities of degrading work, low pay, and insecurity. Syrian workers had been a significant part of Lebanon’s expatriate workforce prior to the outbreak of civil war in 1975, but their presence had been strictly subject to Lebanese laws. The growing Syrian influence in Lebanon since 1991, however, led to the official removal of most travel restrictions between the two countries. As Lebanon’s post-war reconstruction boom gained steam in the early 1990s, a variety of subsequent agreements were implemented which made it possible for Syrians to cross over the border virtually undetected, making Syrian workers a nearly 1 9 Many experts believe the rate to be between 25 and 30 percent instead. 2 0 World Bank estimates. 23 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. ubiquitous presence in the streets of Beirut. The Lebanese newspaper, Al-Nahar, in October 1994 and July 1995, cited figures obtained from Lebanon’s General Security Directorate that put the number of Syrians entering the country at 1,435,991 in excess of the number who departed Lebanon. Marwan Iskander, a Lebanese economist and former adviser to Prime Minister Rafik Hariri, has estimated that the number of Syrian workers in Lebanon remains about 1.4 million.2 1 These figures are considered to be conservative since they don’t take into account undocumented migration into the country. In addition, the estimated 35,000 Syrian soldiers stationed in Lebanon often have jobs to supplement their meager pay. According to Lebanese economic experts, the Syrian labor force is roughly distributed as follows: construction (39%), seasonal agriculture (33%), municipal and sanitation jobs (20%), 'j'j services, including street venders and taxi drivers, (8%), and industry (2%). It is interesting to note that in 1999, according to the Ministry of Labor, only 530 work permits were issued to citizens of Syria, implying that the vast majority are employed in the informal sector. Table 2.3 below further provides annual data from 1994 to 2000 on the number of work permits issued to different Arab and Asian nationals.2 3 2 1 Note that this figure is in conflict with the one o f 250,000 reported earlier in the paper and that was obtained from The Economist. 2 2 Figures obtained from the United States Committee for a Free Lebanon. 2 3 As mentioned earlier, the number o f work permits issued, however, is not an adequate measure o f the number o f these foreign workers employed in Lebanon. They include new and renewed permits but do not include those who entered the country illegally, or the “illegal” employment o f those whose permits have expired and have not been renewed, those who are working with only tourist visas, and those who are unemployed. There are no reliable figures. 24 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 2.3: Work Permits Issued to Selected Foreign Workers. 1994-2000 1994 1995 1996 1997 1998 1999 2000 Syrians 2502 1056 834 1061 691 530 449 Palestinians 357 354 449 460 358 350 304 Sudanese 477 429 384 507 565 495 418 Egyptians 15557 11602 8972 10788 20083 18051 14365 Jordanians 546 313 266 278 259 230 182 Iraqis 298 129 105 100 79 103 117 Other Arabs 203 91 122 139 148 139 126 Total Arabs 19940 13974 11132 13333 22183 19898 15971 Sri Lankans 13274 14253 12552 23668 23516 22917 22430 Filipinos 3689 4344 4304 5501 5315 5788 6436 Indian 3727 4659 4758 6881 6974 7196 6217 Others 2269 2218 2187 3138 3610 4348 4614 Total Asians 22959 25474 23801 39188 39415 40249 39697 Source: Ministry of Labor, Lebanon. The influx of workers into Lebanon is driven to a large extent by the availability of jobs that have been created due to the massive government program for the reconstruction and rehabilitation of the country. Since Syria’s per capita GNP is less than a third of Lebanon’s,2 4 Syrian workers have been readily willing to work for wages that are extremely low by Lebanese standards. For example, a Syrian taxi driver in Beirut can earn up to $200 per month2 5 2 6 —around twice the salary of a university professor in Damascus. Lebanese employers prefer to hire 2 4 World Bank estimates of per capita GNP in 1999 in Lebanon and Syria are $3720 and $1010 respectively. 2 5 In a 1998 study on the economic internal rate o f return ofVocational and Technical schools funded by the World Bank, the Bank estimated the average hourly rate o f unskilled workers to be $1.79 and in the range between $1.53 and $2.22. The hourly rate for skilled workers in Lebanon (these were taken to be graduates ofVocational and Technical schools) was found to be $3.08 with the range of between $2.50 and $3.61. 2 6 It is widely believed in Lebanon that the government stipulated minimum wage of LL 300,000 per month, which is about $200, lies far below the basic family needs calculated by any standards, even if one adds to it family allowances (unemployed spouse and children) and transportation and education allowances. 25 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. unskilled Syrian workers over their Lebanese counterparts because the transaction is off the books, allowing them to avoid paying the required minimum wage, evade the social security system, and demand long working hours of the workers. However, the effect on the Lebanese labor force of this influx has been inimical. The 18 percent unemployment rate cited earlier is for the Lebanese labor force as a whole but this figure is probably higher for unskilled workers. It is not uncommon for those who get jobs to accept low wages and dismal working conditions, as well as to forgo health insurance and other benefits.2 7 According to the results of a study by the Development Studies and Projects Center that was published in a Lebanese newspaper, Lebanon’s labor force is expected to grow at an average of 2.3 percent in 28 the next decade, compared to an average of 1.5 percent worldwide. The Lebanese government, therefore, needs to implement policies that encourage growth and currently lacking private sector participation. 2.4 The Political Situation According to a complicated compromise, the government in Lebanon is made up, of the three main religious factions, the Maronite Christians, the Sunni Muslims, and the Shi’ite Muslims. According to the arrangement, the leaders of the three 2 7 Lebanon stipulates a minimum wage of LL 300,000 per month. However, the law is not enforced effectively. In theory, the courts could be called upon to enforce it but, in practice, they are not. 2 8 Al-Sqfir (Beirut), 29 January 2001. 26 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. factions assume the role of President, Prime Minister, and Speaker of the Parliament, respectively. The three political figures are also known as the Troika. The relationship among the Troika is generally characterized by tension and rift. Currently, Emile Lahoud is the Maronite President, Rafik Hariri is the Sunni Prime Minister, and Nabih Berri the Shi’ite Speaker of the Parliament. Though historically the Maronite President was the leader of the Troika, post-civil war arrangements have shifted power to the Sunni Prime Minister. In the Parliament for 2000-05, out of 135 Members of Parliament, 34 were ■ J Q Maronites, 30 were Sunni, while 28 were Shiite. Other significant minorities are 18 Greek Orthodox and 9 Druze. The remaining members belong to small minority groups. This distribution points toward the need for coalitions in the government in order for it to work smoothly. In particular, out of the three main groups, two have to be aligned for the government to be able to pass and implement public policies. The contention of this paper is that this coalitional structure directly contributes to over-investment on part of the government. This is illustrated in Figure 2.4 below where a cross-country comparison of capital expenditures is presented for several countries in the region over the recent past. It is interesting to note that average capital expenditures in Lebanon are above those in these other countries in the region. All these countries are either ruled by monarchs or by regimes that have not been based on fragile coalitional arrangements.3 0 This is in agreement with a claim 2 9 These proportions hold true for the Parliament in other post-war periods. 3 0 We include Israel in this list based on the observation that, apart from a brief period o f a Labor- Likud coalition, its government’s have been fairly homogeneous ideologically. 27 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. made by the model presented in the next section of this paper. According to the model, coalitional governments are more likely to engage in over-expenditure resulting in higher government investment. Figure 2.4: Capital Expenditure in Selected Countries (Average 1991-2000; In percent of GDP) I I Israel Jordan Kuwait Egypt Lebanon Source: Gressani, Daniela and John Page (1999). “Reconstruction in Lebanon: Challenges for Macroeconomic Management,” MENA Working Paper Series No. 16, The World Bank, Washington, DC. 2.5 The Model Consider an endowment economy with endowment Yt = C, + G, at time t where C{ and Gt are the consumptions of the agents and government respectively. 28 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The model is divided into two parts: we first look at the worker’s problem followed by an exposition of the politician’s problem. The model consists of two sectors—one formal, the other informal. Two types of agents make up the total labor force: the Lebanese, who have the option of working in either of the two sectors or to not work at all, and the foreigners who can work only in the informal sector in Lebanon or back in their home country. These conditions are imposed to capture the fact that the Lebanese workers are mostly highly skilled and trained while the foreign job seekers are largely unskilled. The model remains unchanged if we allow for unskilled Lebanese workers provided that they do not have access to jobs in the formal sector.3 5 The Worker’s Problem: We consider a simple two-period model. Each domestic worker maximizes: ui co>lo) + flEuic^ , /j), 0 </?<!, (2.5.1) s.t. a, < R(a0 + w0.(l - 1 0) - c0), and c, < w1(l-I1) +a}. Also, Lt +lt = 1, for t=0, 1. 3 1 This would make sense due to the lack o f requisite training and qualifications o f the unskilled Lebanese workers to be able to find employment in the formal sector. 29 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Here, ct and lt are, respectively, consumption and leisure at time t, and Lt is the amount of time spent doing work at time t. The total time endowment is taken to equal 1 . The wage, wt, varies depending on in which sector the worker is employed and whether the worker is working or not. Thus, if the worker is in the formal sector, the wage is given by wf , if employed in the informal sector it is given by wr , and by wa if the worker is employed outside of Lebanon.3 2 We make the plausible assumption that the unskilled wage in Lebanon is higher than that available in the foreign worker’s home country. Obviously, the wage is zero if the worker is unemployed. The variable at represents each agent’s asset position at time t. Subscripts are used to signify the sector to which the agent holding the assets belongs, just as was done for the case of the wages. Further, wages and interest rates are taken as given by both the agents as well as the government. We now proceed with our analysis with the assumption that preferences are additively separable and linear. The worker gets w °f in period 0 but searches for a new job in period 1. The probability of finding a job is given by a and is a function of the size of the Lebanese labor force, Lx, the amount of capital being employed in the se c to r,^ , and the asset position of the agent in period 1. The probability of getting ajob decreases as the size of the labor force increases but goes up as the capital being employed in the sector rises. The asset position of the agent affects the probability of finding ajob positively in the sense that an agent with a higher asset 3 2 The time subscript is dropped for simplicity 30 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. level is assumed to have a higher social status that increases his likelihood of finding ajob through social connections. If he succeeds in finding a new job, he gets a wage of wl f . If the worker does not find a new job, however, he retains his job from period 0. The worker also makes his optimal leisure choice: this is denoted by Ifl when he gets a new formal sector job in period 1 and moves from his older formal sector job and is given by lf0 when he stays in his older formal sector job in period 1. On the other hand, it is given by when a worker moves from the informal sector in period 0 to the formal sector in period 1. In the case where he is in the informal sector in period 0 and stays in that sector in period 1, it is given by l#0. In the same manner, lu l is the leisure choice made when a worker who is unemployed in period 0 moves to the formal sector in period 1. The problem faced by the worker in the formal sector is then given by: max— — +a° +w°f(l— l0)+l0 + fr R am ,K f ,al f )Wf (l-ln )+al f +lfl\ +(1 -a(al f ))[w °f (l-lf0)+al f +lf0\ (2.5.2) The worker in the informal sector as well as the unemployed worker in period 0 also searches for a formal-sector job in period 1. Thus, the problems faced by these two agents are given respectively by: 31 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 4 R max— £ + a0+ w°(l - 1 0) +/„+/?• A T y ,^ ) [W y (l l y ^ + U y + l l f l ] + ( 1 - a ( d y ) ) [ W y {\-/ro) + 4 +V o i (2.5.3) and m ax-“ +a0 + !+/?• R a(i1 ,r / ,4)[^/ (l-/al)+4 +^,] + ( i - « ( 4 ) K + i ] (2.5.4) Note that we distinguish between the period 1 asset levels of the agents by using the appropriate subscripts depending on their period 0 employment status. This is because decisions regarding period 1 asset levels are going to be affected by which sector the worker belongs to or whether he is employed or not in period 0. We now solve for two reservation wages, one for a worker who has an offer from the formal sector as well as the informal sector in hand in for period 0, and the other for a worker who has an offer from the formal sector for period 0 in hand and the option of not working at all. First, using (2.5.2) with (2.5.3) we solve for the reservation wage between working in the formal versus the informal sector; and second, we take (2.5.2) with (2.5.4) to solve for the reservation wage between working in the formal sector versus not working at all. This is done by differentiating the objective functions with respect to the appropriate asset levels and equating, (i) informal-sector agent’s solution to that of the agent in the formal sector; 32 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. and (ii) unemployed agent’s solution to that of the agent in the formal sector. This yields, respectively: Rp + Wtf - w jff (2 .5.5) and RP + l = w, Ilf (2.5.6) The variable wiff is the reservation wage of moving from the informal sector into the formal sector and wuf is for moving from being unemployed into the formal sector. We can see that as R goes up, w also increases in both cases. The above analysis shows the effect of a change in interest rates on reservation wages and, thus, labor participation. We have concluded that high interest rates would discourage Lebanese nationals from working in the formal sector. A similar kind of analysis can be conducted to study the decision problem of the immigrant workers. To do this, we can look at the maximization problem of the foreign worker that is given as follows: m ^ l ^ p i > { L 2,K ¥ )wl v ^ P { l - ^ K ¥ ))wa,wa{l + P)} (2 .5.7) 33 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. A worker searching in the informal sector has a probability of finding ajob given by 4(L2 ,K if). Here, L2 is the part of the labor force seeking a job in the informal sector while Kv represents the amount of capital being employed in that sector. The unskilled wage in the worker’s home country is assumed to be time invariant. Note that the foreign worker does not care about leisure and has no assets. The former is because most unskilled foreign workers are interested mainly in maximizing earnings for themselves and their families back home. The latter can be explained as a consequence of the worker’s economically weak status as well as a result of the fact that such workers usually end up spending any savings or assets in order to get to the country of work. We assume that if the worker goes back to his country in period 0, he can never come back. This is based on the fact that moving away from their home countries in search of jobs involves prohibitively high costs that render the possibility of fluid movement across borders infeasible. This is a common feature in the Levantine region where a significant proportion of unskilled workers often do not return to their home countries even for visits for extended periods of time once they have moved abroad.3 3 Now, to get the reservation wage for this case, we equate the two available options to the agent to yield: ^~ = wa- M £ 2,Kv ) [ 4 - w a] (2.5.8) 3 3 See, for example, Goldberg (1996), Hollister and Goldstein (1994), and Lockman (1994). 34 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Note the relationship in probability < f > of the reservation wage condition above. < j > is a function of capital in the informal sector and the labor force eligible to work in this sector. Thus, as the amount of capital in the sector goes up (for example, when the government targets its investments toward reconstruction efforts), the reservation wage falls. This implies that more workers would be likely to accept jobs in this sector. On the other hand, however, as the potential candidates for available jobs increase due to this fall in reservation wage, the probability of finding ajob also decreases, thereby pushing up the reservation wage again and thus contributing to a rise in unemployment.3 4 3 4 Note that the reservation wage o f the foreign labor is lower than that o f the domestic labor. To show this, we invoke the Harris-Todaro contention that wages in the host country are higher than those in the home country and this provokes migration—expected wages might tell a different story. Given this, if we look at the expression for the reservation wage o f foreign labor, we can say that: - fi< j> { L z,Kif)[ w ] f - wj < w l¥ - /?#(.L 2,Kv){ w ] f - w V ], since w a < . This implies that the reservation wage o f the foreign worker is less than w^ . But j notice that the comparable reservation wage o f the domestic worker is greater than shown below: + w )f >w)f 1 1 The term in the square brackets above is positive since which means that the slope o f a is less for a l f . And since ^ , the first term in the square brackets is larger than the second making the square bracket positive. Therefore, since the reservation wage o f domestic labor is higher than Wy which in turn is higher than the reservation wage o f foreign labor, we conclude that the reservation wage o f domestic labor is higher than that o f foreign labor. 35 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The Government: To complete our model, we introduce the government into our analysis. The operative assumption here is that the Lebanese government is coalitional. This is because of the constitutional arrangement of the government discussed earlier whereby politicians have to share power. Subsequently, we compare the results (regarding investment levels) obtained from this approach to the case where the government is constituted as a single ruler. The coalition consists of two politicians who play a Stackelberg game. This means that the junior coalition partner (politician 2) has the power to destabilize the government and bring it down unless he receives a payoff equal to or more than some reservation level. The senior coalition partner takes this into account when he solves his maximization problem. Politician 1 solves his maximization problem taking the monetary rents, i.e., q, and investment, K, of politician 2 as given. More specifically, the level of q and K of politician 2 is what is needed to give him his reservation utility. The maximization problem for politician 1 when the government is a coalition can be stated as: max where s-t- (?<+u + Q t+ 1,2) + (^/,i + 2) ^ Dt (2.5.9) and Dt <maft + nctg j , 36 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. while nx is the utility that politician 1 obtains if politician 2 decides to destabilize the government and make it fall. Also, qM 2 and Kt 2 are the minimum levels of monetary rents and investment that make politician 2 indifferent between accepting the status quo and destabilizing the government. In addition, a politician maximizes his or her expected utility in the next period.3 5 p ( ) is the probability of re-election and is an increasing concave function in K and the GDP to debt ratio, 1/D. In addition, Qt + 1 are the ego-rents that a politician gets from staying in office while D, represents government borrowing in period t. This is constrained by the amount in the economy that is available to be borrowed, i.e., assets available in the formal and informal sectors with m agents in the formal sector and n agents in the informal sector. Moreover, we let the interest rate, R, depend linearly on the debt level as R = R + bD, where R is the international interest rate and b Is a constant. Also, Kt i + Kt 2 = K t is the sum of the money that each of politicians 1 and 2 use for investment, while qt+ u + qt+ 1 2 = qM is the sum of the monetary rents that each of politicians 1 and 2 appropriate for themselves at time t. Notice that the money diverted by the politicians to their own pockets has the time subscript t+1. This is to convey the point that the stealing of funds has some inefficiency associated with it and is not a cost-free exercise. Funds stolen today can only be accessed tomorrow, 3 5 In practice, he politicians make investments and do not give capital to any sector. But we use an abstraction, i.e , K represents the capital that each sector gets as a result o f that investment. 37 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. i.e., there is a lag of one period before the sum of money earmarked by the politicians for themselves is available to them. Solving this problem yields the following useful first-order conditions: and RQ = Pkx (2.5.10) R R \ Yt y - y 2 Qt+lPa f and (2.5.11) R 1- R - Y‘ n j y 2 Q 1+ 1 P a As K rises, pK i falls, which implies a higher level of R. Given this context, we have a plausible explanation for both the high interest rates as well as the extraordinary participation in terms of government investment of the public sector in the country’s post-civil war reconstruction effort. Our FOC suggests that the observed level of interest rates and government investment in recent times can be ascribed to the politicians’ desire to maintain office and thereby maximize their expected benefits. 38 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The other FOC implies that as the debt to GDP ratio rises or, in other words, as the GDP to debt ratio falls, we have an ambiguous effect on R. This is because a Y decrease in the output to debt ratio causes p af (and p av) to go up but makes % ° Y down. Thus, R will go up if the decrease in is greater than the increase in p Uj. To make our conditions clearer, we state them with the assumption that the probability function for re-election above is given by: 1 P ( K ^ ~ 7 t ) = - i D, a l + e * - y , Then our first order conditions become: _D+ A y . RQ 'M K l( l + eK « T ‘f and (2.5.14) RQ M V 1 D, l A 39 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. We get the second condition above when we maximize with respect to af or a#. Note that the sum of these two variables is equal to D that appears in the above expressions. To emphasize the point that the coalitional nature of Lebanon’s government structure contributes to high domestic interest rates and government investment, we compare the case above with that of a single-ruler form of government. Assuming that the politician cares about his image in all constituencies, we can write:3 6 p i(Ki) = p(2KJ) (2.5.15) where pt{) is the probability that politician i faces while p ( ) is the probability that the politician gets re-elected. Differentiating (2.5.15) with respect to K, gives: ri{K,) = 2p?{2K,). But we can use (2.5.10) (or (2.5.13)) to substitute for the probability that the K politician gets re-elected, and since K t = — , we have: 3 6 We drop the second argument o f the probability function here for rotational simplicity. 40 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. p;(K,) = 2pXK)= 2 RQ Therefore, Pi 2 1 > — . (2.5.16) RQ RQ Thus, in the case where there is a coalition as opposed to single-entity rule, the K optimal level of investment is K* = K, >— , i.e., it takes more investment in the coalitiona! set-up to reach the same probability of re-election that a somewhat lower investment level would make possible in a single-ruler framework. Again, this brings forth Lebanon’s government structure as a reason behind high government investment that has led to an explosion in the public debt level in post-civil war times. We can also get to this conclusion if we look at our national income identity given by C+G=Y where Y is exogenous. Thus, if G is higher in the coalitiona! case than in the single-party government case, it would mean that private consumption is going to be lower in the coalitional government scenario as compared to the case of single-party government. This means that a coalitional government diverts more resources from the consumer than does a single-party government. The preceding analysis of the worker’s decision problem and that of the coalitional government contribute to our understanding of the dynamics of the debt 41 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. and unemployment situation in Lebanon. High interest rates have several significant impacts in our model. First, they explain the high levels of unemployment amongst the Lebanese workers. Our model fulfils the expectation that higher interest rates would cause more and more workers to opt for a work-free life. A reason why this happens is the increased attraction of earning income on assets that the agents own. While high interest rates discourage private investment and increase the amount of lending by agents, politicians use them as a policy variable that directly affects their expected utility. The nature of the politicians’ preferences implies a greater likelihood of re-election with high levels of investment concomitant with higher interest rates. The reconstruction drive in Lebanon has been progressing at a very healthy pace with relatively little help from the private sector. The model provides a self-interest maximizing explanation for the Lebanese government’s spearheading of this effort that in turn has most significantly added to the mounting levels of public debt in the nation. 2.6 Conclusion Unlike the recovering economies of West Germany and Japan in the 1940s and 1950s, Lebanon has the advantage of being different in several key respects. The most important of these is that Lebanon is a much more open economy and is part of a world that is integrated closely with regard to trade and capital flows. In 42 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. addition, Lebanon has access to significant pools of capital because of its large expatriate population. Together with the availability of expatriate savings, Lebanon can therefore finance a much l arger portion of aggregate spending than would have 07 been possible for West Germany or Japan. A faster recovery of investment and consumption could be generated from higher foreign savings. In the recent past, Lebanon has been able to finance a resource balance deficit in excess of US $6 billion (equivalent to around 40 percent of GDP) using private capital inflows. This option is most feasible, especially in the medium term, because it does not require a drastic restructuring of the political set-up and institutions, which is a difficult and long task. However, this does not mean that changes in the political structure would no longer be needed. This approach is favorable because it does not impede the correction of current macroeconomic imbalances and buys time for a possible de linking of borrowing and investment decisions from re-election prospects of the politicians. In general, there is interaction between three variables related to monetary policy. These are the interest rate, the exchange rate, and real wages. At medium and long runs, high interest rates and overvalued currency tend to decrease real wages and exacerbate poverty and inequality of incomes. Thus, a restructuring of the political set-up that leads to interest rate determination becoming independent of the politicians’ maximization problem would improve welfare by having a positive 3 7 Giersch, Paque, and Schmieling (1993) and Hamada and Kasuya (1993) note that despite the foreign aid these two countries received following World War II, West Germany received less than 2 percent o f GNP in support from the Marshall Plan, and Japan’s total external transfers never exceeded 6 percent o f GNP. 43 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. impact on the level of real wages. In addition, our model suggests that lower interest rates would increase private sector investment A recent opinion poll reported by the Lebanese Ministry of Industry reports that Lebanese industrialists identified the high level of interest rates as the greatest difficulty they faced. Lower interest rates would therefore accelerate private investment and thus increase the rate of job creation and hence reduce unemployment. Also, asset holders would find working at the new higher real wages more appealing particularly after the returns on their assets decline as a result. Without a significant reduction in the fiscal deficit and real interest rates, macroeconomic stability will be endangered by rising public debt. The sustainability of the reconstruction effort depends on expanding the range of profitable private investment opportunities in addition to keeping domestic interest rates near international levels. The motivation behind this strategy would be the conviction that minimum wage should provide the average family with enough household income to meet the basic needs of the family. Thus, an interest-rate focused policy could contribute to the solution of two very acute problems. Not only would lower interest rates encourage private sector participation in Lebanon’s reconstruction, but also viably address the persistent problem of unemployment. This would happen firstly by making participation in the labor market more attractive for the Lebanese relative to depending on their assets for income, and secondly by rapidly expanding capital availability in both the formal and informal sectors, thus creating more jobs. It would improve macroeconomic 44 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. stability by relieving the government somewhat from its tremendous debt-servicing burden that has accounted for nearly a third of the budget in recent years. In short, although much needs to be done to put Lebanon back on the path of rapid development that it followed prior to the civil war, the authorities need to address the more pressing short-term problems before shifting their attention to the requirements of sustainable growth. This is because long-term growth can effectively be targeted only if short-term prospects are first made viable. In order to do this, Lebanon needs to move swiftly to check its macroeconomic imbalances. Rising public debt and unemployment levels threaten not only the country’s macroeconomic stability but also its political future. This paper suggests focusing on interest rates as a policy tool to ameliorate the situation by reducing interest rates. This would not only encourage private sector participation—which would reduce unemployment through the creation of more jobs and relieve the government of some of the burden of the country’s reconstruction—but also provide breathing space to the government by decreasing the currently immense load of debt servicing. 45 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Chapter 3 An Empirical Study of Disinflation in a Small Open Economy 3.1 Introduction High rates of inflation have been a persistent problem in developing countries. Latin American countries have been infamous for their excessively high levels of inflation and have therefore been the focus of studies that have looked at policies and programs that have been implemented in order to address this issue. Countries in Africa and Asia have also received some attention with regard to this issue. Inflation rates over 10 percent and even periods with sustained inflation over 25 percent have not been uncommon. While many countries (most of which are in South America) have experienced what is now commonly labeled as “chronic” high 46 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. inflation (Pazos, 1972), many other developing countries have suffered from high inflation associated with large changes in terms of trade of political instability. Several approaches have been used in attempting to stabilize this high inflation. While many countries have tackled the problem by directly intervening in the wage-price process, others have relied on more orthodox policies that attempt to get the fundamentals right. Such policies have involved using money and exchange rates to achieve their objectives. A substantial literature has evolved over the recent past to study the use of exchange rates to bring inflation under control. Two broad approaches are found in this literature. While one of these approaches utilizes an equilibrium framework to examine exchange rate based stabilizations, the other highlights the importance of persistent high inflation as a significant factor in influencing inflationary dynamics.1 It should be noted, however, that the two hypotheses outlined above have seen few attempts to directly test them. There have been various efforts to develop numerical simulation models to study the equilibrium approach Predictions from these models have been compared against actual trends in economies undergoing exchange rate based stabilization. Research in this area includes Reinhart and Vegh (1995), Rebelo and Vegh (1995), and Mendoza and Uribe (1996). However, these studies mostly rely on calibrated parameters to tally broad features of model 1 For a discussion o f the equilibrium approach, see Rebelo and Vegh (1995), Kiguel and Liviatan (1992), and Vegh (1992). Early work on this approach can be found in Rodriguez (1982) and Dombusch (1982). For a discussion of the role of inflation persistence and the reasons behind considering it, see Edwards (1993), Calvo and Vegh (1994), and Dombusch and Werner (1994). These reasons include overlapping contracts, imperfect credibility, and backward looking expectations. 47 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. simulations with predictions of particular theories. On the other hand, Dombusch and Werner (1994) contribute to the examination of the inertial inflation hypothesis by focusing on the example of Mexico. They estimate a model of Mexican inflation to illustrate that fixing the exchange rate in the face of high inflation gives rise to sizable real exchange rate appreciation This is because inflation is slow to adjust. However, their work does not consider the possibility that an appreciation of the real equilibrium exchange rate is responsible for the slowness of inflation to decline to international levels. The objective of this paper is to develop an empirical model of inflation that incorporates not only equilibrium and inertial factors but also the more traditional variables like fiscal and monetary policy. In addition, the study acknowledges the reality that high frequency of data is crucial to the effectiveness of our model since we are concerned with stabilization episodes that, if successful, do not last for long periods of time. Unfortunately, obtaining high frequency data is often a problem when analyzing developing economies. Thus, we attempt to develop a model that is not rendered useless due to unavailability of data. In that regard, we utilize a model of the equilibrium real exchange rates that would allow maximum flexibility and not impede the analyses of developing countries due to an absence of requisite data. The model is estimated using Lebanese data and is then used to assess the contribution of the various factors described above to the excess of Lebanese inflation over foreign inflation (or to the real appreciation of the Lebanese currency) 48 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. that occurred after the implementation of its exchange rate based stabilization program following the end of the Lebanese civil war in the early 1990s. The plan of this paper is as follows. In Section 2, we discuss the stabilization experiences of Chile in 1978, Israel in 1985, and Argentina more recently in the 1990s. Section 3 then gives a brief overview of the Lebanese case and provides some initial information on exchange rates and inflation that would serve as the basis for our analysis later. Before we conduct our analysis and estimate our model in Section 5, we provide an overview of some relevant empirical literature in Section 4 that deals with the issue of real exchange rates and inflation. Section 6 discusses some policy implications and Section 7 concludes. 3.2 Some Country Experiences Exchange rate based stabilization programs had their intellectual origins in the monetary approach to the balance of payments, which was popular in academic thinking in the late 1970s.2 This approach advocated the belief that purchasing power parity held more or less continuously. Under continuous PPP, the domestic price level would be determined by the exchange rate. This translated into the requirement of slowing down the rate of depreciation of the exchange rate to stabilize inflation. A program originating from this line of thought would include a 2 Presentations of this approach can be found in Frenkel and Mussa (1985), Kreinin and Officer (1978), and Wilford (1986). 49 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. predetermined exchange rate path, and fiscal and structural readjustment. In this regard, trade liberalization would have an important role to play because the adoption of low and uniform tariffs would not only promote economic growth but would also support the price stability objective through the influence of the law of one price. The Experience of Chile Chile adopted the exchange rate approach in early 1978 following the disappointingly slow reduction of inflation despite the stabilization efforts taken to bring it under control. A succession of'“tablitas” — schedules of pre-announced exchange rate changes—were instituted to determine the path of the exchange rate in advance, thus using the exchange rate as a nominal anchor for domestic prices. The rate of devaluation was set below the inflation rate in the previous month and was set to steadily decline until it converged to zero in June 1979. At this time, the rate would be fixed. Although the monetary approach to the balance of payments maintains that domestic variables should converge rapidly to their international counterparts, this did not happen in Chile after 1978. Although domestic interest rates fell, they still remained above devaluation-adjusted foreign rates. This was despite substantial capital inflows through 1982. The inflation rate also came down but remained above international inflation plus the rate of devaluation. This resulted in a strong 50 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. appreciation of the real effective exchange rate despite the strong depreciation of the US dollar. Between early 1978 and mid-1982, the cumulative appreciation was close to 30 percent.3 A sharp contraction in domestic credit during the first quarter of 1981 succeeded in sterilizing capital inflows and contracting the monetary base. By the third quarter Chile started to experience a rapid fall in net capital inflows. Nominal interest rates increased in Chile during 1981 which, coupled with slower inflation, caused ex post real interest rates to rise significantly. A financial crisis in the second half of the year led to a large central bank bailout financed through credit expansion. By the end of 1981, real output growth had become negative. In the middle of 1981, the exchange rate policy was changed and after devaluing the Chilean peso by 18 percent against the dollar, it was set to depreciate by 0.8 percent per month against a basket. However, capital flight prompted the adoption of a floating exchange rate two months later. The use of exchange rate as a nominal anchor was finally given up after continued depreciation despite central bank intervention and an imposition of restrictions on foreign exchange transactions. The Experience o f Israel Triple digit inflation in Israel at the end of the 1970s is explained by Fischer (1987) as a consequence of the receipt of large-scale US military aid, the adoption of a crawling peg, and financial liberalization which had made greater access to foreign 3 Vegh (1992). 51 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. currency and foreign, exchange-linked deposits possible. During the early 1980s, Israel experienced a period of high inflation, slow growth, and successive external crises. The monthly inflation rate in consumer prices remained over 8 percent on. average during 1980-84, rising to 15 percent in 1984 and remaining at 14 percent in early 1985. The overall public deficit in 1980-84 was over 1 .0 percent of GDP and 13 percent in 1985. The exchange rate was indexed through a PPP-based rule for the crawling peg.4 The receipt of $1.5 million in grants from the US over 1985-86, conditional on the adoption of the stabilization program, helped the credibility of the exchange rate. This inflow of external resources amounted to about 3 percent of GDP. In addition, the competitiveness of the new Israeli shekel was given a boost by the depreciation of the dollar. Also, favorable movements in Israel’s terms of trade during the early part of the program eased the external constraints in the economy. The program announced a devaluation of the shekel by 19 percent and was frozen at 1.5 shekels to the dollar. The stabilization program reduced the monthly inflation rate from 14 percent per month to 2.5 percent on impact and to the 1 to 2 percent range by the end of 1986 (Liviatan, 1988). Fiscal performance changed significantly. Over the first year of the program, fiscal deficit fell by 9 percent o f GDP. The public sector deficit had been eliminated by the fourth quarter of 1986. Also, real public sector spending declined over the third and fourth quarters of 1985. The trade surplus that had existed prior to the implementation of the program grew even more and led to a 4 Cukierman (1988). 52 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. current account surplus with the help of the external assistance mentioned earlier. Sizable capital inflows helped this process even more and led to a reserve accumulation that contributed to money growth. Monthly nominal bank lending rates also experienced a decline from 20 percent before the program to 5.5 percent by the end of 1985. There was some real appreciation of the shekel in 1986. This, together with high private consumption resulted in the deterioration of the current account. In August of 1986, the shekel was pegged to a five-currency trade-weighted basket replacing its peg to the dollar. The objective was to bring down the inflation rate to the OECD level during a period of dollar depreciation and reduce the rate of increase of import prices. In January 1987, the shekel was devalued by 10 percent against this basket of currencies to correct for the real appreciation accumulated over the past year. Still, the average price increase in the first quarter following this devaluation was lower than that in the last quarter of 1986 and the inflation rate remained stable for the rest of the year.5 Following this devaluation, the shekel remained fixed for almost two years. The inflation rates attained by Israel during the latter half of 1985 proved to be durable and the annual inflation rate came to stay around the 20 percent level. 5 Cuikerman (1988). 53 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The Experience o f Argentina Argentina implemented a money-based stabilization program in. 1990 that, although it produced spectacular results in bringing down inflation (from 95 percent in March 1990 to 11 percent in April, failed to make inflation converge to international levels. In order to achieve this goal, a new stabilization program, the Convertibility Plan, was implemented in March 1991. The key element of this plan was a fixed exchange rate. The exchange rate was fixed at 10,000 Australes per dollar and future exchange rate changes were required to be authorized by congress rather than left to the discretion of the central bank. The currency was made fully convertible for both current and capital account transactions. In addition, the US dollar was legalized as a unit of account and means of exchange. In addition, the government could not count on the central bank for credit as the bank was legally enjoined from printing money for this purpose. The Convertibility Plan had an immediate impact on inflation. By mid-year, inflation was in the vicinity of the 1-1.5 percent per month from its earlier level of 1 1 percent in March Annual inflation reached single digits by 1993 reaching international levels by 1994 when the rate dropped below 4 percent.6 A sharp drop in nominal interest rates following the implementation of the plan suggested that the program was viewed as credible. However, the failure o f inflation rates to approach international levels meant a sizable real appreciation given that the nominal exchange rate was fixed. This coupled with a booming economy led to large trade 6 Agenor and Montiei (1999). 54 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. deficits that reached 5 percent of GDP by 1994. The situation further worsened when world interest rates rose creating reductions in capital inflows and strained Argentina’s financial system, ultimately leading to a severe credit crunch. The government, however, adhered to the Convertibility Plan. Credit expansion measures were undertaken but were not enough as domestic interest rates rose rapidly from. 11 percent at the end of 1994 to 22 percent in March 1995. The economy rebounded by the second quarter of 1996 with high growth rates and a virtually stable CPI. Adherence to the plan helped Argentina achieve price stability while it experienced rapid growth and weathered an extremely severe external shock. 3.3 Inflation and Exchange Rates in Lebanon Unlike most countries, Lebanon has had a flexible exchange rate system since 1948. After the Lebanese civil war, the government embarked on a stabilization plan in 1991. The authorities, while not officially fixing the exchange rate, in effect attempted to link the Lebanese pound to the US dollar without any formal commitment to maintaining a fixed exchange rate. In the first half of 1992, Lebanon experienced capital outflows that put intense pressure on the exchange rate. This depreciated the average exchange rate from LL 879 per $ 1 in January 1992 to 55 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. IX 2527.8 per $ 1 by September 1992, and inflation soared.7 However, the government aimed to stabilize the economy by adopting a policy using exchange rates as nominal anchor led to a return of confidence. Attractive interest rates on Lebanese government securities and favorable prospects in other sectors of the economy all led to a surge in capital inflows, which put upward pressure on the exchange rate.8 Here, the authorities intervened in the foreign exchange market to moderate the appreciation of the Lebanese pound and to increase the foreign exchange reserves. Nevertheless, the Lebanese pound appreciated by about 30 percent against the US dollar between October 1992 and March 1994. Exchange rate volatility also declined starting in 1993. The monthly growth rate (log change) of the Lebanese CPI is plotted in Figure 3.1 below against the rate of depreciation of the Lebanon-US bilateral exchange rate. We can see that inflation gradually drops from its very high level at the beginning of 1993 in response to the stabilization program. Figure 3.2 presents monthly CPI inflation against the log of the real bilateral exchange rate. Following the drop in inflation in the early part of the period under consideration, we see that the two series move very closely together, providing prima facie support for the view that inflation reflects an adjustment of prices to the deviation of the level of the real exchange rate from its equilibrium value. 7 IMF, International Financial Statistics. 8 Although data for capital flows for Lebanon are not available, changes in the foreign exchange reserves of the Bank of Lebanon give us some idea about the size o f such flows. In 1993, reserves increased by about 50 percent to about $ 2.2 billion according to the IMF. 56 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 3.4 Real Exchange Rate Models and Cointegration While the PPP approach has often been used to estimate the equilibrium real exchange rate in practical policy applications, research in relation to developing countries has acknowledged the use of real fundamentals. There are two major strands in the research that uses the single-equation approach. One consists of traditional reduced form studies while the other is based on the estimation of a cointegrating equation linking the real exchange rate to its fundamental determinants. Figure 3.1: Exchange Rate Depreciation and Inflation Inflation Depreciation 20 1993 1995 1997 1999 2001 Source: Banque Audi Research Department and Bunque du Liban, Quarterly Reports, Vols. 30-38. 57 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Figure 3.2: Inflation and Real Exchange Rate RER Inflation 160 140 120 100 40 -20 1993 1995 1997 1999 2001 Source: Banque Audi Research Department and Bunque du Liban, Quarterly Reports, Vols. 30-38. Two studies that use the traditional approach are Edwards (1989) and (1994). The latter uses panel data for 123 developing countries over a period of two decades to estimate a regression in which the actual real exchange rate was the dependent variable while the set of independent variables included the rate of growth of total factor productivity, the terms of trade, the share of government consumption in GDP, a measure of the openness of the trade regime, and a measure of the severity of capital controls (all of the above being potential fundamentals). The author uses his estimated equation to calculate estimates of the equilibrium real exchange rate. These estimates seem to incorporate changes in real fundamentals. 58 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. A more recent study in the same spirit as Edwards (1994) is done by Razin and Collins (1997) who estimate reduced-form real exchange rate functions for a large country panel that included explanatory variables such as the terms of trade, the value of net long term capital inflows, a proxy for the exogenous component of the trade balance, and the excess of money growth over GDP growth. The authors show that favorable terms of trade movements and increases in long term capital inflows are associated with an appreciation of the equilibrium real exchange rates. In recent years, unit root econometrics has been increasingly used in international finance and has been applied to the problem of estimating equilibrium real exchange rates. Initially, the thrust of this research had been in the direction of testing the PPP. Some studies had not been able to show convincingly the existence of unit roots in exchange rates or of the non-cointegration of the exchange rates and the price ratio. These studies include Adler and Lehman (1983), Baillie and Selover (1987), Corbae and Chilian's (1988), Enders (1988), and Mark (1990). An emphatic exposition of the bilateral exchange rate-price relationship using cointegration techniques is provided by Kim (1990) who uses the United States and five other countries: Canada, France, Italy, Japan, and the UK. Kim finds evidence of cointegration between exchange rates and price ratios with a cointegrating coefficient close to one. Another study in a somewhat similar spirit is the one conducted by Fisher and Park (1991) who test purchasing power parity under the null of cointegration using price and exchange rate data from eleven industrialized countries over 15 years and find evidence of non-stationary exchange rates. 59 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. More recent studies have attempted to detect cointegration among real exchange rates and a variety of underlying fundamentals. One such study is ' Elbadawi (1994) who uses annual data over roughly two decades for Ghana, China, and India on the level of net capital inflows relative to GDP, a measure of openness as a proxy for commercial policy, and the share of government spending in GDP among others to develop a model of the long run real exchange rate. He identified all of the fundamentals in the model as non-stationary and cointegrated. He used time series techniques to estimate permanent values of the fundamentals and substituted them into the cointegration equations to determine the long run real exchange rates over the sample period. This approach is extended in Elbadawi and Soto (1994) who actually distinguish between long-term and short-term inflows. They found that short-term inflows were stationary and dropped them from the cointegrating equation. Another recent study similar in its emphasis on the influence of government spending on real exchange rates is Espert and Maino (2000) who explain the appreciation in the exchange rate in Argentina. They develop a cointegration model to explain the equilibrium value of the exchange rate by incorporating fundamentals from the supply side. Data from 1991 onwards was used for the purpose. In some sense similar to the Alberola and Lopez study discussed above, Espert and Maino use the relative productivity differential of the manufacturing sector in Argentina against its main partners as a measure of Argentine productivity. Other fundamentals include the terms o f trade and public expenditures. The authors 60 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. emphasize the role of public expenditures by arguing that policy makers, although not able to influence real variables, can affect them in the short run using instruments like public expenditures. A recent application of cointegration methodology to the determination of real exchange rates is Alberola and Lopez (2001), who compute the real exchange rate for the Spanish peseta over two decades using quarterly data. They consider the stock of foreign assets and the evolution of sectoral prices to be the fundamentals of real exchange rate. A cointegration approach not only sidesteps any difficulty that might arise from these series being non-stationary and therefore leading to spurious results under OLS estimation, but also tackles the problem that arises from the fact that we only observe actual and not equilibrium values of the relevant variables. They conclude cointegration in their system at the 10% level that implies about a 3% appreciation in the equilibrium exchange rate with a 10% change in the stock of net foreign assets and a 4.2% appreciation in equilibrium exchange rates with a 10% change in the relati ve price of non-tradable goods. Cardenas (1997) estimated Colombia’s equilibrium real exchange rate using a methodology similar to that of Elbadawi and Soto. He uses quarterly data spanning over 12 years and considered fundamentals such as average labor, total factor productivity in the traded and non-traded goods sectors, the terms of trade, and government spending as a share of GDP. He found mixed evidence for the Balassa- Samuelson hypothesis: an increase in TFP in the non-traded goods sector was 61 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. associated with a real depreciation but so was an increase in TFP in the traded goods sector. Calderon (2002) is an example of panel cointegration techniques applied to the problem of explaining real exchange rate behavior. This study is different from those discussed above because it uses a panel of 67 countries and thereby has a somewhat differing objective. Rather than focusing on exchange rate movements in a particular country, it sets out to study this relationship in a much more broad and general context. However, for our purposes, this study is relevant because of its choice of variables that are included in the estimation of the cointegrating relationship. These include the ratio of net foreign assets to GDP, the relative home to foreign productivity of the traded and non-traded sector, and the terms of trade— the author concludes that there exists a relationship between these variables and real exchange rates. A possible critique of this approach, however, comes from the previously discussed study by Kim (1990) who finds that there were no common trends between each set of exchange rates and prices. The cointegration-based estimates of the equilibrium real exchange rates are promising in at least two respects. First, cointegrating relationships are often found between equilibrium real exchange rates and a broad class of fundamentals suggested by theory. Moreover, estimated impacts of the fundamentals on the equilibrium real exchange rates generally prove to be consistent with theory. Second, estimated real equilibrium exchange rates are often capable of reproducing historical episodes of overvaluation as judged by other means. This type of confirmation supports the 62 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. reliability of approaches to the estimation of equilibrium real exchange rates based on unit root econometrics. We therefore use this approach and a combination of fundamentals not previously used in the literature to estimate a cointegrating relationship for equilibrium real exchange rates. This set of fundamentals is feasible in that researchers would likely not run into the problem of an absence of requisite data even in the cases of developing countries notorious for a lack of data availability. It is also attractive because of the quality of results obtained that is at least comparable with studies conducted previously. 3.5 The Empirical Model We develop an empirical model linking Lebanese inflation to the gap between the actual and the equilibrium real exchange rates. We first operationalize the definition of equilibrium real exchange rates that we use in our estimation of the model.9 This definition would also allow us to overcome the issue of the dearth of data for developing countries that often impedes researchers in conducting their analysis. Since many macroeconomic variables contain unit roots and are non- stationary in nature, recent focus in applied work has emphasized cointegration as a useful feature in the modeling of these variables. Testing for cointegration among 9 We use the term equilibrium real exchange rates in the sense discussed by Isard (1983) who estimates that two to five years are required for it to be reestablished after a disturbance. 63 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. economic variables allows us to assess the empirical support for the equilibrium of economic behavior. This approach provides not only an estimation methodology but also explicit procedures for testing a relationship among variables that is suggested by economic theory. The intuition behind cointegration is that it allows us to capture the equilibrium relationships dictated by economic theory between non-stationary variables within a stationary model. We first search for a linear combination of such variables such that this combination is stationary. If such a stationary combination exists, the variables are said to be cointegrated which means that even though they themselves are not stationary, they are bound by an equilibrium relationship. We should not, however, discount the analysis conducted in this paper due to the limited span of data we use. One reason for this is simply the nature of our objective: to analyze Lebanon’s exchange rate based stabilization. Since we can hardly call a disinflation program that has a length of more than a decade successful, it would not be very interesting or instructive to examine such an episode if policies to bring inflation under control do not influence the variables of concern. The second reason is the ample support for our approach that can be cited from the literature. This support comes both in theoretical as well as empirical forms. Finite-sample properties o f the econometric techniques used in this paper can be found in Choi (1995) and Ng (1995), who discuss the validity of our unit root tests under our conditions; Phillips and Hansen (1990), Phillips and Loretan (1991), and Hansen and Phillips (1990), who obtain finite-sample evidence on estimation of cointegrated systems; and Leyboume and McCabe (1993), Cheung and Lai (1993), 64 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Podivinsky (1990), Reimers (1992), Gregory, (1994), and MacKinnon (1991), who examine cointegration tests (especially Johansen’s) in our context Two important references here are Engle and Granger (1987), who develop their technique for cointegration testing, and Engle and Yoo (1987), who conduct simulations and provide critical values. Most of these studies use Monte Carlo simulations with 50- 100 observations to conduct their analyses. Significant empirical precedence is also available for the analytical methods employed in this paper. Some o f the relevant studies include Wu (1999), Elbadawi (1994), Elbadawi and Soto (1994), Cardenas (1997), Loayza and Lopez (1997), Hinkle and Montiel (1999), de Brouwer and Ericsson (1995), Enders (1995), Mukherjee, White, and Wuyts (1998), Eken and Helbling (1999), and MacDonald and Stein (1999). These studies lend credence to the view that it is quite standard to conduct analyses such as those in this paper with data spanning 10-12 years and consisting of 30-100 data points. We conduct our diagnostic tests using the approach advocated by Johansen (1988).1 0 We choose this method because Gonzalo (1994) shows that Johansen’s test performs better than other approaches under various specification errors. In addition, the procedure provides simultaneously the test statistics (the X ^ and Trace tests) to infer the number o f cointegrating relationships and estimates of the cointegration vectors. Also, testing for stationarity within the Johansen framework once 1 0 Another alternative procedure is the Engle and Granger (1987) methodology. This is done in two steps. Step 1 involves the fitting of the cointegrating regression which is the OLS estimation of the static model. In step 2, a unit root test is conducted on the estimated residuals. However, the long run parameter of the conintegrating vector estimated from this approach can be severely biased in finite samples. We use the Johansen procedure to avoid this shortcoming. 65 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. cointegration has been detected in any set of variables. This saves us from incorrectly interpreting stationarity of a variable as a cointegration vector (i.e., as an existence of an economic equilibrium). The choice of variables came from two considerations: first, we tried to include variables for which data was obtainable, and second, those variables were picked that had proven useful in equilibrium RER determination in previous studies such as EJbadawi (1994), Chinn (1998), Ahlers and Hinkle (1999), Baffes, Elbadawi, and O’Connell (1999), and Alper and Saglam (2000). Thus, we include RER, the terms of trade, export-import ratio, domestic-international real interest rates ratio (international interest rates are taken to be those on long-term US government securities) and domestic-international prices in our test for the number of cointegrating relations in the system Based on the tests, we conclude that the said variables have a stable equilibrium relation even though the variables are individually nonstationary. The Johansen’s-test results and eigenvectors, and the cointegrating relation associated with most significant eigenvalue are as follows: Table 3.1: Johansen’s Trace Test (5 variables) r Eigenvalues Trace Test Values Critical Values at 95% Confidence =0 0.03325 2.874 75.328 <=1 0.09507 11.37 53.347 <=a 0.1501 25.19 35.068 <=3 0.2798 53.1 20.168 <=4 0.4634 106 9.094 66 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 3.2: Eigenvectors RER TOT XM Rratio Pratio 0.6553 -0.394 1.045 -0.8583 0.72 -0.1645 -0.1027 0.1299 0.2857 0.219 -0.4217 -0.5282 0.1234 -0.1362 -0.3152 -0.6846 0.4652 1.117 -0.6743 -0.04486 0.5874 1.549 -3.708 0.8881 -1.83 R E R * = 2.637(TOT) - 6.313(XM) + \.5\2Rratio - 3.1\5Pratio, (3.5.1) where RER* is the equilibrium real exchange rate, TOT is the terms o f trade lagged by three months, X M is the ratio o f exports to imports also lagged by three months, and Rratio m d P ra tio are the three month lagged ratios o f domestic and international real interest rates and prices respectively. Since part o f our objective is to examine the contribution of inertial inflation in the stabilization process, and since the above analysis also suggests a cointegrating relationship o f the first 4 variables, we conduct the above tests in the absence o f the Pratio term. This yields the following analogous results: Table 3.3: Johansen’s Trace Test (4 variables) R Eigenvalues Trace Test Values Critical Values at 95% Confidence =0 0.02593 2.233 75.328 <=1 0.0407 5.764 53.347 <=2 0.08943 13.73 35.068 <=3 0.2993 43.96 20.168 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 3.4: Eigenvectors RER TOT XM Rratio -0.2895 0.8864 -0.09917 -0.4025 -0.03025 -0.2238 0.005196 0.2758 0.1745 -0.4297 -0.3855 -0.2179 0.6973 -0.03796 0.7911 -0.3879 RER* = -0.054{TOT) + 1.135(XM) - 0.556Rratio. Based on the analysis conducted above, we can conclude that a simple OLS regression to determine the relationship between RER* and TOT, XM , and Rratio (and Pratio) is going to give us spurious results. Thus, an OLS estimate given by RER* = 3.577 + 0.034(7197) - 0 M (X M )~ 0.143Rratio - O.OUPratio should not be considered the best.1 1 Given equilibrium RER, we can determine the deviation of actual real exchange rates from their equilibrium levels. As discussed earlier, apart from RER’s deviation from equilibrium, we would also like to take past inflation into consideration in order to assess the impact of inertial inflation as well as some 1 1 In the above OLS equation, the Pratio proves to be insignificant. An alternate OLS estimate was obtained without the Pratio in the equation yielding the following result: RER* = 3.591 + 0.032(7107) - 0.081(AM) - O.UlRratio. However, this estimate too is spurious since the cointegration analysis above suggests a relationship between the variables involved in this OLS estimate as well. 68 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. component of fiscal and monetary policy. To do this, we estimate an equation based on the one presented below: AP = a l(RER_l ~RER*-i) 12 12 12 _ (3.5.2) + £ a ,A P , + £ a H A£_„ + £ a „ A P ^ +akAD_l + alAM_ l ' i-1 m=0 m~ 0 Here, P are the domestic prices, AE represents exchange rate depreciation, P* are international prices, while AD and AM are the change in net domestic debt level and money supply respectively. Equation 3.5.2 is an unrestricted error-correction model for deviations of the real exchange rate from a cointegrating vector, depicted in equation 1, between the actual and equilibrium real exchange rates. The addition of the lags of inflation, exchange rate depreciation, and changes in debt level and money supply distinguish our unrestricted error-correction model from its more restricted variant, the fractional adjustment model in which these additions would be absent. They also play a critical role in minimizing the likelihood of simultaneity bias. This could arise because changes in inflation could feed back onto the real exchange rate. Thus, if the error correction term is autocorrelated, the lagged real exchange rate and the lagged components of the equilibrium RER would be correlated with the error term resulting in biased estimated coefficients. By providing a richer dynamic structure to explain the adjustment process of inflation, the additional variables in (3.5.2) should 69 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. reduce autocorrelations of the error-correction term and therefore reduce the likelihood of simultaneity bias. To start out on the estimation of our equation, we first check the order of integration of the data series used here. Table 3.5 below presents the results of applying Choi’s LM test for stationarity. Table 3.5: Choi’s LM Test for Stationaritv P RER TOT OPEN R E P * AD AM Level 0.0160 0.0108 0.1943 0.00721 0.01764 0.02268 0.000197 0.0058 0.044 Coef 0.1083 7.152 0.1214 2.253 1.826 7.354 4.678 4.37 5.51 Trend 0.0092 0.0064 0.0139 0.03904 0.009476 0.000818 0.004972 0.1111 0.0069 Coef 0.1515 7.194 0.6055 2.134 1.867 7.373 4.582 8.98 9.08 Given that the critical value at the 5 percent level is 0.2496 for level stationarity and 0.2498 for trend stationarity, the null for level stationarity is not rejected for any of the variables1 2 while the null for trend stationarity is rejected for none of the variables. These results suggest that the variables examined are compatibly integrated of order one and are suitable for the cointegration test Table 3.6 in the appendix presents the results from the application of the Johansen test to the log levels o f Lebanese prices, p, US prices, p*, the nominal exchange rate, e, the real exchange rate, rer, the terms of trade, tot, measure of openness, open, international real interest rates, r, net debt, d, and money supply, m. These are presented at lag lengths ranging from 0 to 4. The results suggest 8 1 2 The null o f level stationarity is rejected for D and A /but not for their first differences. 70 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. cointegrating relationships. The existence of a cointegrating vector among the said variables suggests that Lebanese inflation, i.e., log change in Lebanese prices, is stationary. Table 3.6: Cointegration Analysis (trace values) for p. o*. e. c L m. rer. tot open, and r Lag Value 0 Lag Value 1 Lag Value 2 Lag Value 3 Lag Value 4 R<8 0.7691 0.8844 1.072 2.155 0.006871 R < 7 24.3443 10.31 8.236 9.35 4.02 R <6 57.859 35.32 20.91 23.06 20.63 R <5 104.0688 62.42 42.54 41.3 40.44 R<4 185.9126 117.7 71.15 69.24 73.1 R<3 272.8896 186.6 105.9 107.5 114.8 R < 2 421.5361 256 156.4 151 168.1 R < 1 602.3938 346.8 221.8 208 257 r=0 1627.85 458 304.3 303.9 1234 Table 3.7: Critical Values for Johansen’s Test at the 95 % Level for Lag Value 0 Critical Value (95%) r<8 3.84 r<7 18.14 r<6 34.52 r<5 54.22 r<4 77.57 r<3 104.85 r<2 135.66 r ^ l 170.36 r=0 208.63 The appropriate critical values for Johansen’s test at the 95% level are given in Table 3.7 for lag value zero. Based on the tests for stationarity and cointegration described above, it is reasonable to model the Lebanese inflation rate as a function of the gap between 71 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. actual and equilibrium real exchange rate (where equilibrium. RER is of the form suggested in (3.5.1)), lagged changes in Lebanese inflation, exchange rate depreciation, US inflation, and changes in debt levels and money supply. In order to estimate a single-equation model, we start out with a highly unrestricted model of Lebanese inflation that is similar to (3.5.2) above, but with variables expressed in logs rather than levels: Arer = a x (rer_x - rer*-j) J2, J2, . (3 .5 .3 ) + ZJZt&P-t + L a nAe-, + L .a n,& P -m + a kAd_x + a,Am_x + u /=1 n~ 0 m~0 Here, u is the residual term. The equation was estimated using monthly data over 1993 to 2001. The lags in the equation were progressively removed in accordance with the standard general-to-specific methodology, if they were found to be substantially insignificant by way of having t-statistics significantly less than 2. The heteroscedasticity-corrected estimation results appear in Table 3.8 below.1 3 The statistical significance of the coefficients on lagged rer, tot, open, and r, confirm the error-correction feature of Lebanese inflation. In addition, the sum of the coefficients on lags of the dependent variable is 1.351 suggesting that inflation shows some degree of persistence. Also, changes in the nominal exchange rate also affect inflation in a statistically significant manner. 1 3 The results are effectively the same for the basic OLS estimation. 72 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 3.8: Results for the Main. Inflation Model Unstandardized Coefficients Standardized Coefficients (OLS) t Sig. B Beta (Constant) -5.608 -3.142 .003 RER1 .954 .442 2.186 .033 TOT .278 .647 3.008 .004 OPEN .159 .160 2.586 .118 INTR -.342 -.198 -2.318 .192 INF2 -.294 -.356 -2.624 .011 INF4 -.336 -.462 -3.332 .001 INFS -.245 -.341 -3.020 .004 INFS -.328 -.646 -4.061 .000 INFS -.148 -.564 -2.474 .016 SNF12 5.044E-02 .725 2.776 .007 DELE 8.753 .725 3.304 .002 DELE2 -7.380 -.603 -3.039 .003 DELE9 5.221 .411 2.180 .033 DELE10 -3.086 -.405 -2.000 .050 INFUS .122 .023 .221 .826 1NFUS2 .722 .134 1.168 .247 INFUS4 .652 .122 1.221 .227 INFUS9 -.596 -.108 -1.186 .240 INUS10 1.612 .292 3.040 .003 DELDEBT 1.690E-02 .019 1.192 .848 DELM2 .121 .181 1.734 .088 Figure 3.3 below plots the estimated rer* over the entire period of study, along with the actual real exchange rate. The figure indicates that the actual real exchange rate remained highly depreciated at the beginning of the period but later appreciated rapidly and came and stayed close to its equilibrium level. This tallies with the pick-up in economic activity that followed the government’s adoption of its new stabilization program. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Figure 3.3: Equilibrium and Actual RER (1993-2001.) Equilibrium Actual 1993 1995 1997 1999 2001 To determine the relative contribution of the different factors to the appreciation of the Lebanese pound, the estimated inflation model was used to perform a number of simulation experiments. Figure 3.4 below presents the first of these simulations of the model. We can see that the model does reasonably well in sketching the movements of inflation. We then use this simulated path of prices to simulate real exchange rate. This is shown in Figure 3.5. The simulated RER movements essentially follow the path of the actual RER. 74 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Figure 3.4: Actual and Simulated Inflation “ “ Simulated 2 — Actual 1.8 1.6 1.4 1.2 1 0.8 0.6 - 0.4 - 0.2 - 0 - 1993 1995 1997 1999 2001 Figure 3.5: Actual and Simulated RER (Seasonally Adjusted) Actual Simulated 4.1 4 3.9 3.8 3.7 3.6 3.5 3.4 3.3 3.2 3.1 1993 1995 1997 1999 2001 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. We next calibrate our model in. a manner such, that it generates the actual path of inflation and the real exchange rate for our simulation period. Figure 3.6 presents the two simulation experiments performed using this calibrated model. In. the Inflation Simulation, lagged values of Lebanese inflation during 1993 were set to I percent at an annual rate, compared to actual inflation of about 30 percent for that same year. The objective of this simulation was to determine the contribution of inertial inflation to the pound’s real appreciation. If inertial inflation did indeed significantly contribute to the pound’s appreciation, then the high inflation rate prior to stabilization must also have been important to the pound’s real appreciation The simulation plot with a lower inflation rate produces a path for the real exchange rate that is more depreciated than the actual rate for about a year after which it rapidly converges to its actual level. This means that inertial factors in Lebanese inflation were weaker than the error-correcting factors and therefore could not have alone changed the path of the real exchange rate for an extended period of time. However, the initial sharp appreciation of the pound can still be attributed to this persistence of inflation. The second simulation (the Policy Simulation) was conducted with the inflation rates still kept at their low levels and, in addition, with a static fiscal and monetary policy. The purpose of this experiment was to determine the contribution of the traditional determinants of inflation. The distance between the path traced out by our Policy Simulation and the actual path represents the contribution of fiscal and 76 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. monetary policy to the appreciation of the pound. Changes in policy significantly contribute to the appreciation of the pound Figure 3.6: Actual RER with 2 Simulations - Policy Simulation —Actual 4.2 Inflation Simulation 3.8 3.6 3.4 3.2 1993 1995 1997 1999 2001 Since we controlled for the effects of changes in fiscal and monetary policy as well as for inertial effects, the only factors contributing to the path of the real exchange rate are those of the lags of Ap, Ae, and Ap* and the error-correction process moving the actual RER toward its equilibrium value. If the lagged variables are assumed to not explain the broad trends in real exchange rates, then the appreciation of the real exchange rate in the Policy Simulation can be attributed to the movement of the RER toward equilibrium. 77 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 3.6 Policy Implications There have been suggestions that the Lebanese authorities should intervene to depreciate the nominal exchange rate to ensure that the appreciation of the real exchange rate is curtailed and the pound is kept highly competitive. On the other hand, many observers view favorably the stability of the nominal exchange rate because it would keep inflation under control. This section examines the efficacy of these policy recommendations. We generate forecasts of inflation and real exchange rates over two years under two different scenarios. We keep changes in fiscal and monetary policy static. In the first scenario, we assume that the pound virtually remains fixed as it has for close to a year. Figure 3.7 below shows that the inflation will dampen out in the next two years as is illustrated by the plot toward the right end of the x-axis. In Figure 3.8, the forecast extends the appreciation that the pound has experienced in recent years further into the next two years suggesting a convergence to equilibrium rates. Also, given that these levels of real exchange rates were associated with large trade deficits, this suggests that a policy tailored to achieve disinflation could throw the improving trade and current accounts back toward substantial external imbalances. In the second scenario, we assume that the real exchange rate is targeted in a way such that it remains at its early 2001 levels. One way to do this is to set the rate of depreciation of the pound equal to the difference between Lebanese and US 78 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Figure 3.7: Inflation Forecast When Change in Nominal Exchange Rate = 0 1.8 1.6 1.4 0.8 0.6 0.4 0.2 1993 1995 1997 1999 2001 2003 Figure 3.8: RER Forecast When Change in Nominal Exchange Rate = 0 3.7 3.65 3.6 3.55 3.5 3.45 3.4 3.35 3.3 2003 1993 1995 1997 1999 2001 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. inflation in the previous month.1 4 We can see from Figure 3.9 that this policy results in a somewhat steady increase in inflation. Figure 3.10 shows the path for the forecast period of real exchange rates. Figure 3.9: Inflation Forecast with Targeted Change in Exchange Rate 2.5 - i.5 0.5 1995 2001 2003 1993 1997 Figure 3.10: RER Forecast with Targeted Change in Exchange Rate 4.2 3.8 3.6 3.4 3.2 - 1995 1997 2003 1993 2001 1 4 We assume that the authorities observe inflation with a lag. 80 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The RER maintains a relatively constant gap between itself and the equilibrium rate. This gap would actually result in higher rates of inflation as discussed and shown in Figure 3.9. Thus, in this case, the outcome is higher inflation together with improved trade performance. 3.7 Conclusion This paper estimated an equation for Lebanese inflation demonstrating in the process the applicability of equilibrium real exchange rate determination by way of cointegration techniques, and the subsequent use of this understanding of equilibrium real exchange rates to substitute for elaborate equilibrium theories that render it difficult to analyze interesting stabilization episodes in developing countries due to a dearth of data. We concluded that the real exchange rate as well as the components of our equilibrium RER were significant determinants of the rate of inflation. In addition, although monetary policy is somewhat significant in influencing inflation, fiscal policy proxied by the government’s policy on debt did not come out to be notably significant We also found that the actual real exchange rate was considerably more depreciated than the estimated equilibrium RER at the start of the period of study (1993-2001). However, the real exchange rate converged to its equilibrium level and 81 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. stayed close to it starting in 1994. Thus the real exchange rate could no longer be seen as a factor putting upward pressure on domestic prices. The result of decomposing the real appreciation of the pound by carrying out some simulation experiments was also instructive. The effects of inertial inflation in appreciating the real exchange rate proved to be fairly temporary and lasted only a year following the implementation of the program. A quarter of the real appreciation was attributable to monetary and fiscal policy while the rest was a result of the real exchange rate appreciating to its equilibrium level. The model also highlights the tradeoff between low inflation and competitive exchange rates. If exchange rates are kept fairly stable around their current levels, inflation would remain low and under control but the real exchange rate will appreciate leading to a deterioration in trade performance. On the other hand, if the real exchange rate is made the focus of attention and is kept highly competitive, inflation would rise considerably over the next few years. In light of these results, it is best to follow a policy that strikes a balance between inflation and exchange rate interests. Under Lebanon’s floating regime, appropriate fiscal and monetary polices might help in attaining this balance of interests. Further, the problem of establishing this balance might be mitigated by implementing appropriate structural reforms to raise savings and increase productivity as this would permit higher output growth and lower inflation while making trade gains more competitive. 82 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Chapter 4 Conclusion The preceding chapters in this thesis make the crucial role of governments amply clear in the modem economy. While the focus here has been on countries most often classified as developing nations, many of the results are instructi ve for industrialized countries as well. This is because economies around the globe have become increasingly open over time and are part of a world that is integrated closely with regard to trade and capital flows. This implies higher levels of interdependence between nations that makes an acute awareness of international economic relationships a key requirement for conducting successful economic policy. Labor migration to a country that is plagued by high levels of unemployment is a puzzle that has been explained in this study by highlighting the role of high levels of the rates of interest. In countries like Lebanon, labor market segmentation together with rising interest rates is seen as a viable explanation for a phenomenon similar in nature to the Harris-Todaro effect in the rural-urban migration context. 83 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Moreover, a political economy explanation is proposed for rising debt levels that are often observed in developing (and many times also in developed) countries. The variety of objectives that are a natural result of having a number of coalition partners in government is identified as the primary reason behind continued borrowing by the authorities. Policy implications are then derived from the theoretical models for the case of Lebanon. Lebanon is an open economy and is part of a world that is integrated closely with regard to trade and capital flows. In addition, Lebanon has access to si gnificant pools of capi tal because of its large expatriate population. Together with the availability of expatriate savings, Lebanon can therefore finance a much larger portion of aggregate spending than is possible for many countries in similar circumstances. A faster recovery of investment and consumption could be generated from higher foreign savings. In the recent past, Lebanon has been able to finance a resource balance deficit in excess of US $6 billion (equivalent to around 40 percent of GDP) using pri vate capital inflows. This option is most feasible, especially in the medium term, because it does not require a drastic restructuring of the political set up and institutions, which is a difficult and long task. However, this does not mean that changes in the political structure would no longer be needed. This approach is favorable because it does not impede the correction of current macroeconomic imbalances and buys time for a possible de-linking of borrowing and investment decisions from re-election prospects of the politicians. 84 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. In general, there is interaction between three variables related to monetary policy. These are the interest rate, the exchange rate, and real wages. At medium and long runs, high interest rates and overvalued currency tend to decrease real wages and exacerbate poverty and inequality of incomes. Thus, a restructuring of the political set-up that leads to interest rate determination becoming independent of the politicians’ maximization problem would improve welfare by having a positive impact on the level of real wages. In addition, our model suggests that lower interest rates would increase private sector investment. Lower interest rates would accelerate private investment and thus increase the rate of job creation and hence reduce unemployment. Also, asset holders would find working at the new higher real wages more appealing particularly after the returns on their assets decline as a result. Without a significant reduction in the fiscal deficit and real interest rates, macroeconomic stability will be endangered by rising public debt. The sustainability of the reconstruction effort depends on expanding the range of profitable private investment opportunities in addition to keeping domestic interest rates near international levels. The motivation behind this strategy would be the conviction that minimum wage should provide the average family with enough household income to meet the basic needs of the family. Thus, an interest-rate focused policy could contribute to the soluti on of two very acute problems. Not only would lower interest rates encourage private sector participation in Lebanon’s reconstruction, but also viably address the persistent problem of unemployment. This would happen firstly by making participation in the 85 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. labor market more attractive for the Lebanese relative to depending on their assets for income, and secondly by rapidly expanding capital availability in both the formal and informal sectors, thus creating more jobs. It would improve macroeconomic stability by relieving the government somewhat from its tremendous debt-servicing burden that has accounted for nearly a third of the budget in recent years. In short, although much needs to be done to put Lebanon back on the path of rapid development that it followed prior to the civil war, the authorities need to address the more pressing short-term problems before shifting their attention to the requirements of sustainable growth. This is because long-term growth can effectively be targeted only if short-term prospects are first made viable. In order to do this, Lebanon needs to move swiftly to check its macroeconomic imbalances. Rising public debt and unemployment levels threaten not only the country’s macroeconomic stability but also its political future. This study suggests focusing on interest rates as a policy tool to ameliorate the situation by reducing interest rates. This would not only encourage private sector participation—which would reduce unemployment through the creation of more jobs and relieve the government of some of the burden of the country’s reconstruction—but also provide breathing space to the government by decreasing the currently immense load of debt servicing. Another issue that this thesis has dealt with is the problem of a lack of data availability that is a persistent feature of developing economies and that often hampers the examination of several economic phenomena pertaining to developing countries. This is done in the context of the stabilization program that was 86 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. implemented in the aftermath of the civil war in Lebanon. The program employed the technique of using the nominal exchange rate as an anchor to bring down triple digit inflation that prevailed in Lebanon at the turn of the decade in the early 1990s. A simple error-correction model is estimated to model the dynamics of inflation in Lebanon with particular emphasis on real exchange rate misalignment as suggested by the theory. However, a new cointegrating relationship is proposed to estimate real exchange rates that is based on fundamentals but that circumvents the problem of limited data availability. We concluded that the real exchange rate as well as the components of our equilibrium RER were significant determinants of the rate of inflation. In addition, although monetary policy is somewhat significant in influencing inflation, fiscal policy proxied by the government’s policy on debt did not come out to be notably significant. Simulation experiments to study the impact of potential policies were also conducted. The effects of inertial inflation in appreciating the real exchange rate proved to be fairly temporary and lasted only a year following the implementation of the program. A quarter of the real appreciation was attributable to monetary and fiscal policy while the rest was a result of the real exchange rate appreciating to its equilibrium level. The model also highlights the tradeoff between low inflation and competitive exchange rates. If the exchange rate is kept fairly stable around its current level, inflation would remain low and under control but the real exchange rate will 87 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. appreciate leading to a deterioration, in trade performance. On the other hand, if the real exchange rate is made the focus of attention and is kept highly competitive, inflation would rise considerably over the next few years. In light of these results, it is best to follow a policy that strikes a balance between inflation and exchange rate interests. Under Lebanon’s floating regime, appropriate fiscal and monetary polices might help in attaining this balance of interests. 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Creator Shahnawaz, Sheikh (author)

Core Title Dual labor markets, public debt management, and exchange rate movements

School Graduate School

Degree Doctor of Philosophy

Degree Program Economics

Publisher University of Southern California (original), University of Southern California. Libraries (digital)

Tag economics, general,OAI-PMH Harvest

Language English

Contributor Digitized by ProQuest (provenance)

Advisor Nugent, Jeffrey B. (committee chair), Dawid, Herbert (committee member), Imrohoroglu, Selahattin (committee member)

Permanent Link (DOI) https://doi.org/10.25549/usctheses-c16-261087

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Legacy Identifier 3093917.pdf

Dmrecord 261087

Document Type Dissertation

Rights Shahnawaz, Sheikh

Type texts

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Access Conditions The author retains rights to his/her dissertation, thesis or other graduate work according to U.S. copyright law. Electronic access is being provided by the USC Libraries in agreement with the au...

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