The impact of exchange rate policy on export performance of agricultural crops in Tanzania

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UNITED NATIONS

EconomicCommission for

Africa

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NATIONS UNIES

'lá' Commission Economique pour

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AFRICAN INSTITUTE FORECONOMIC DEVELOPMENT

AND PLANNING (IDEP)

INSTITUT AFRICAIN DEVELOPPEMENT ECONOMIQUE ET

DEPLANNIFICATION (IDEP)

4^ ^

THE IMPACT OF EXCHANGE RATE

POLICY

ON EXPORT PERFORMANCE OF

AGRICULTURAL

CROPS IN

TANZANIA

\ T

l<s i#

BY

WILBERFORCE A. MARIKI

submitted inPartial Fulfillmentof the Requirements for the Degree of Master

of Arts

in Economic Development and Planning at

the African Institute for Economic

Development and Planning

(IDEP), has been read and approved by:

ChiefSupervisor: Prof. Philip K. QUARCOO

I

Thesis Committee: Member: Dr. Dominique NJINKEU

Member: Prof. Karamoko KANE

External Examiner: Prof. Siyanbola TOMORI

jit

Director of IDEP: Dr. JegganC/SE"

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DEDICATED

TO MY BELOVED WIFE

LILIAN

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TABLE OF CONTENTS

Page

Acknowledgements

i

Abstract

ii

List ofTables

iii

List ofFigures

iv

CHAPTER ONE: INTRODUCTIONAND BACKGROUND

1

1.1 Introduction

1

1.2 Background of Tanzania's

Economic Situation 3

1.2.1 An OverviewofEconomicPerformance

3

1.2.2 TheExchange Rate Policy

9

1.2.3 Pricing and Marketing

Policy 11

1.3 Nature oftheProblem andJustificationofthe Study

13

1.4 Hypothesis and Objectives

of the Study 14

1.5 Empirical Applications

16

CHAPTER TWO: LITERATURE REVIEW

17

2.1 TheInfluence ofCurrency

Devaluation

on

Export Supply 17

2.2 Determination ofthe Real ExchangeRate

(RER) 29

CHAPTER THREE: MODEL SPECIFICATIONS

35

3.1 ProducerPrice Model

35

3.2 SupplyResponse

Model 38

3.3 Export

Supply model 40

3.4 Specification

of Functions 42

1

*"1

CHAPTER FOUR: METHODOLOGY, DATA SOURCES AND

LIMITATIONS 43

4.1 Methodology

43

4.2 Data Sources and Limitations 44

\

CHAPTER FIVE: EMPIRICAL RESULTS 46

5.1 Nominal Producer Prices 46

5.2 Supply Response

50

5.3 Export Supply

54

CHAPTER SIX: POLICY IMPLICATIONS OF THE STUDY 58

CHAPTER SEVEN: CONCLUSIONS AND POLICY

RECOMMENDATIONS 65

7.1 Conclussions 65

7.2 Policy Recommendations

67

APPENDICES 71

REFERENCES 88

ACKNOWLEDGEMENTS

1 have the great pleasure to

acknowledge all who provided assistance tor the

success of this thesis.

I wish to thank first ofall my sponsor, the

Danish International Development

Agency (DANIDA), for

granting

me a

bursary

to pursue my

studies for the Master's

degree programme cycle of

which this study is the final stage.

Secondly, 1 wish to express my

sincere appreciations to

my

employer, the

Principal Secretary and Secretary to

the Planning Commission, for allowing

me

to

absent

myself from duties in order

to pursue

this study.

Thirdly, I deeply thank my chiefsupervisor,

Prof. Philip K. QUARCOO, for

his invaluable contribution to this study. Iwould also wishto express my

gratitude to

the external examiner, Prof. Siyanbola TOMORI, as

well

as

Dr. Dominique NJINKEU,

and Prof. Karamoko KANE, for their invaluable comments

which sharpened the

focus ofthis study.

In addition _many thanks are

expressed

to

the chief Librarian of IDEP, Mr.

ODO'I EYE, and his staff, as well ^as Miss. QUENUM

and Mrs. TRAORE of the

computerunit, for their very

useful service throughout the duration of this study.

Special appreciation is

expressed

to

the Director of IDEP, Dr. Jeggan

SENGHOR, for his good leadership ofthe

Institute, the Finance and Administration

staff andall otherprofessors and lecturers

who made research work

at

IDEP

a

pleasant

experience.

Finally, I heartily thank all other persons

and institutions which in

one way, or

the other,have contributed to the success

of this study.

Wiiberforce AminielMariki.

(ii)

ABSTRACT

The economic crisis in Tanzania has been characterized by shortage of foreign exchangeastheresult ofdecliningexports,

particularly agricultural

exports,

which account

for over 65.0 percentof total export earnings. In orderto

improve

export

performance the

government conducted massive exchange rate

adjustments since 1986 to enable

improvementsin relative producerprices ofexportcrops.

Inthatregard thisstudyaimedtoanalysetheeffectiveness

of the exchange

rate

policy

on export performance of agricultural crops. The crops

covered

are

cashewnuts, coffee,

cotton, tobaccoand^tea. Thesecrops accountfor about 50.0 percent

of total

export

earnings

overtheperiodunder review (1970-91).

The specificobjectives of this studywere (i)toinvestigate

the influence of exchange

rate policy ^on determination of producerprices ofexport crops;

(ii)

to

determine price

elasticity of supply of export crops; and (iii) to determine

the impact of exchange

rate adjustments as measured by changes in the real exchange rate on

the country's degree of

competitiveness, aswell as their influence ^on export supply

of agricultural

crops.

The hypothesis tested is that the massive exchange rate adjustment

implemented

during the 1986-91 period, couldnot improvethe exportperformance

of agricultural

crops.

The findings tend to confirm the hypothesis that the massive

exchange

rate adjustments during the period under review had insignificant impact on

the

export performance of the abovementioned^crops. The study

revealed slight improvement in real

producer prices, however this improvement was not

accompanied by

a

remarkable

improvementinproduction. The real exchangerate

depreciated significantly during 1986-91,

however export supplyremained stagnant.

The main reason for the _poor performance ofexport supply during 1986-91 was found to be lack ofadequate incentives to produce for export. Effective

pass-through of

exchangeratechangestoproducer prices wasfoundto be

lacking.

This

failure

was

noted

to

be the result of the existence ofinefficient marketingsystems.

The study therefore recommends that depreciation of the real exchange rate, supplemented by incentives for agricultural production are important for

promoting

agricultural exports which arenecessary foreconomic growth.

Table 1.1: Tanzania's Exports (million

US.$) 8

Table 1.2: Production andExport ofMajor

Agricultural Cash Crops 9

Table 1.3: Devaluation of the Tanzanian Shilling: 1971-89

11

Table 5.1: Regression Results for

Nominal Producer Prices .48

Table 5.2: RegressionResults for

Supply

Response

51

Table 5.3: Regression Results forExport

Supply 55

(iv)

LIST OF FIGURES

Page

Figure A: Consequences

of Devaluation

to a

Monopolist Country Trader:

the Case of Output

19

CHAPTER ONE

INTRODUCTION AND BACKGROUND

1.Î Introduction

The economic crisis in Tanzania lias been characterized by a shortage offoreign exchange and by persistent current account

deficits of the balance of payments. It is

usually argued that chronic current account

deficits

are

largely the product of

macroeconomic mismanagement, in particular

overvalued exchange

rates.

Indeed, in

mainstream economics ^aswell ^as the policy recommendations of the

World Bank and

the IMF, the exchange rate is at the centre of balance

of

payments management.

Before 1986, the Government ofTanzania was generally opposed to an

active

exchange rate policy ^so much thatnegotiations

with the IMF stalled from 1981 to 1986

mainly because ofdisagreement on the level of

devaluation required

to remove

past

overvaluation as well ^as which exchange rate management policy

should be adopted.

In order to encourage the expansion ofexports

and increase efficiency in the

utilization ofimports, the government aimed at

establishing

an

equilibrium exchange

rate by early July 1989 and subsequently maintaining the

equilibrium. The meaning of

equilibrium exchange rate was not clarified but

it

was

interpreted

as

the removal of

quantitative restrictions ^on most of the current account

transactions in such

a way

that

the exchange rate will equate the demand for andthe

supply of foreign exchange.

In June 1986 the Government embarked on devaluation of the shilling from

Tshs.16 _per US dollar to Tshs.40 ^per US dollar. The

gradual adjustment of the

exchange rate continued ^as agreed with the IMF

with the aim

to

attain

an

equilibrium

rate by 31 January 1988. However, due to

political opposition

to

the policy the

equilibrium exchange rate could not

be attained by January 1988. The exchange rate

adjustment continued with a

devaluation of 21

percent to

Tshs. 120

^per

US dollar

on

5lh November 1988 and 4.8 percent to Tshs.145 on

23d June 1989. From this level

depreciation of the shilling continued every

month.

By

the end of 1991 the exchange

rate was at Tshs.295 _per US dollar and by end of December 1992

il had reached

Tshs.335 _per US dollar (BoT, 1993).

Given the importance of agricultural exports

in total

export

earnings which

accounts for over 65.0 percent, the effectiveness of exchange rate

adjustment in

increasing exports will definitely depend on the

effective pass-through of exchange

rate changes to producer prices ofagricultural exports as

well

as on

the responsiveness of

supply to increases in producer prices.

The next section ofthis chapter provides an overview ofTanzania's

economic

situation. This is followed by an overview of the importance of

agriculture in the

Tanzanian _economy. Also examined is the exchange rate policy

focusing

on

the effects

of the overvaluedexchange rate^on agricultural exports. The

agricult ural policy focused

on the marketing system and pricing policy is also provided. The nature

of the problem

and justification of the study is then presented, followed by the

hypothesis, and

objectives of the study, and finally empirical applications.

Chapter Two presents ^a literature review and discusses the

theoretical

background ofthe effectiveness ofcurrency devaluation ^on export

supply.

Chapter Three presents the theoretical framework and model

specifications.

2

Chapter Four provides the

methodology for conducting this study,

as

well

as

data sources and limitations.

Chapter Five presents the

empirical results from the models tested which

examines the determinants ofproducerprices,

with the exchange

rate

being

one

ot the

explanatory variables. It also examines

price elasticity of supply, and finally

determinants ofexport supply, where the real exchange rate

is

an

explanatory variable.

Chapter Six provides policy implications of the study,

while chapter Seven

provides conclussions and policy recommendations.

1.2 Background of Tanzania's Economic Situation

1.2.1 An Overview of Economic Performance

Tanzania's economic development is characterized by three

remarkable periods

which highlight the economic trend during the past three decades

after independence

in 1961.

(i) The first period was from 1960s to mid 1970s when

reasonable economic

performance of real GDP ^average annual growth rate of 5.0 percent was achieved.

(ii) The second period from mid 1970 to 1980 was characterized by^very serious and persistent economic crisis with large internal and external inbalances and increasing foreign debt during which slow growth in total output from the mid

1970s reached its depth between 1978-80.

During this period the country

experienced ^a drastic decline in average

annual growth

rate

of GDP

as

low

as

1.0 percent combined with ^a steady population

growth

rate

of 2.8 percent which

resulted in real _per capita income negative growth rates.

(iii) The final period from 1980 to early 1992 ^saw major policy

and institutional

changes covering the adoption of IMF stand-by arrangement

in 1980, the

National Economic Survival Programme (NESP) in 1981,

the

most comprehensive three-year Structural Adjustment Programme (SAP) -

1982/83-

1984/85, and finally adopt ion of thethree-year Economic Recovery Programme (ERP-1) ^- 1986/87-1988/89 followed by the ERP-11

(1989/90-1991/92).

All theseprogrammes were aimedat revivingthe declining output in

key

sectors

of the _economy, restoring internal andexternal balance and reducing

domestic inflation

to appropriate levels.

Thus, Tanzania's economic performance to date is a reflection of a

series of

national economic _programmes launched by the government at the beginning of the

1980s and mid-1980s for accelerating economic activity, reduce inflation, improve efficiency in agricultural, industrial and the transport sector ^as well ^as to improve the

balance ofpayments.

4

¥.

The StructuralAdjustment Programme

(SAP) (1982/83

^-

1984/85)

The main objectives ofSAP were:

(i) to prepare a large-scale mining policy

with the aim of attracting long term

investment on gold mines and germstones

minerals;

(ii) to rationalize production structures so as to

achieve increased capacity

utilization, improve manpower utilization; and

(iii) to improve planning and control mechanisms

through

more

effective budgeting,

monitoring, evaluation and enforcement of

agreed priorities.

The full implementation of SAPwasconstrained by insufficient

external

resource inflows from the IMF, the World Bank and other donors. Because

of this the

governmentbudgetdeficit ^was financed by

borrowing from the banking

system

which

increased _money supply and fueled inflation. The

external balance continued

to

deteriorate as both volume and value of exports decreased. Export

growth

^was

constrained by lack of incentives to producers of export

commodities, inefficient

marketing system, poortransport infrastructure and the overvalued exchange rate.

The Economic Recovery Programme (ERPI & II) 1986/87 and 1989/90

The major objectives of the ^recovery programmes were:

(i) lo increase the output offood and export crops

through

appropriate

incentives

for production, improving marketing structures, and increasing the resources

5

available to agriculture;

(ii) to rehabilitate the

physical infrastructure of the country in support of directly

productive activities;

(iii) to increase capacity

utilization in industry through the allocation of

scarce foreign exchange to priority sectors

and firms; and

(iv) to restore internal and external

balances by pursuing prudent fiscal, monetary

andtrade policies.

Trade liberalisation policywas introduced where

individuals with

access

to foreign exchange outside the official systemwere

allowed

to

import basic

consumer goods at uncontrolled prices.

Otherpolicy measures adoptedincluded the increase

in producer prices through

exchange rate devaluation. The

overvaluation of the Tanzanian Shilling had led to

inefficient resource allocation and encouraged rent seeking and

capital flight.

Devaluation and its effect on higher producer prices ^was

expected

to

result in

an increase of exports, and a reduction ofimports and to the

substitution of domestic

production for imports.

The Structureof Tanzania'sExports

Agriculture is the core ofTanzania's ^economy. It comprises 50.0 percent

of the

Gross Domestic Product,about 65.0 percent of total export earnings and provides 90.0

percent ofthe population with subsistence living.

6

The export performance of the

agricultural

sector

is therefore of crucial

importance to the country because

it

creates

the capacity to import the capital and

intermediate goods needed for the growth

of the

economy.

In value

tenus

Tanzania's

exports declined from US

$

612.7

million in 1981

to

US.$ 298.5 million in 1985 (see

Table 1.1).

From 1986 export earnings started picking up, increasing

from US $ 366.5

million in 1986 to US $ 407.8 million in 1990. Improvement in export earnings

during

1986-1990 was the result of the increasedmanufactured exports,

particularly textiles

products which was brought about by the

availability of

counterpart

funds (import

support) provided byIMF/World Bankto supportthe

Economic

Recovery

Programme.

Astructural analysis ofTanzania's exportsreveals that exports

comprise mainly

agricultural commodities which account on average for about

65.0

percent

of total

exports. From 1986 onwards, however, manufacturingexportsbegan to pick ^up

leading

to declining share ofagricultural exports from 76.52 percent in 1986 to 51.28 percent

in 1990.

The change in the structure ofTanzania's exports could be traced to a

number

of factors. These include increase in thetotal population which hadraised the

domestic

absorption of output, rapid advances in domestic manufacturing which

increased

demand forraw materials. Agricultural exports were also affected by drought

problems

as well as poorproducer incentives.

The performance of the main agricultural exports is ^as depicted in Table 1.2.

Since almost all of the outputs of the major export crops are sold through the official marketing system, official purchases are areasonably reliable measure of production

7

mSmœÊÊmÊm

levels. As observed from Table 1.2 mean production as

well

as mean exports

ol

almost all _crops during 1986-91 are more or

less the

same as

the amount attained

during 1981-85.

Table 1.1: Tanzania's Exports (Million US.$).

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990

co: 164.7 130.4 130.1 153.6 118.5 184.9 109.4 96.7 110.2 85.0

COTTON 77.9 55.0 61.8 49.5 29.6 30.4 ^{43.9 75.3} 66.0 74.6

CASIIEWNUTS 34.4 9.7 6.5 21.9 11.5 15.0 ^12.4 16.0 7.9 5.6

TEA 21.6 18.1 21.8 2.3.5 ^17.0 13.6 17.7 16.2 19.4 21.5

TOBACCO 18.3 18.8 11.4 10.0 13.5 15.0 12.4 15.3 12.0 10.6

OTHERCROPS 86.0 67.0 19.6 20.71 17.9 21.6 11.3 13.02 9.7 11.8

Sul)Total 402.90 298.9 ^251.3 279.2 208.0 280.5 207.1 232.5 225.9 ^209.1

NonTraditionalExports ^{209.8 147.3 132.0 120.3 90.5 86.0 146.0 147.8 170.6 198.7}

o/wManufacturing

Products 16.7 11.8 36.0 .38.9 36.1 41.3 60.8 74.9 8.3.6 97.2

TotalExports ^{612.70 446.2 383.3 399.5 298.5 366.5 353.1 380.3 396.5 407.8}

% of Agricultural Exports to Total Exports

65.76 66.99 65.56 69.89 69.68 76.53 58.65 61.14 56.97 51.28

Source: Bank ofTanzania, Economic and Operations Report (various issues).

8

Table 1.2: Production and ExportofMajor Agricultural

Cash Crops'

PRODUCTION(Quantity'000 Metric Tons)

1970- 1980 1981 ^-1985 1986- 1991

MEAN MAXIMUM MINIMUM MEAN MAXIMU

M

MINIM U M

MEAN MAXIMUM MINIMUM

COFFEE 50.69 67.50 40.30 51.84 66.60 49.60 51.75 55.80 49.30

CASI1EWNUTS 99.29 145.08 41.50 42.86 56.60 32.10 ^18.90 24.30 ^16.50

COTTON 65.44 77.00 50.20 45.56 58.60 40.00 53.68 67.40 .31.50

TOBACCO ^15.82 19.60 11.07 13.60 17.20 11:oo 11.70 16.20 5.40

TEA ^14.04 17.90 8.49 16.20 16.80 15.50 16.90 20.20 13.90

EXPORTS(Quantity '000 M ctricTons)

COFFEE 48.60 60.23 35.5.3 50.26 54.63 43.30 52.37 71.50 ^32.94

CASHEWNUTS ^{78.14 113.89} 29.00 22.10 33.50 10.50 23.95 60.90 7.40

COTTON 49.59 64.61 31.50 34.88 44.10 22.90 ^45.00 54.40 22.90

TOBACCO 9.35 16.80 6.6.3 6.00 7.90 4.70 7.60 8.50 5.90

TEA 11.05 15.00 7.05 13.22 16.60 11.10 14.10 17.30 13.90

Source: URT(1993) "Statistical Abstract"; URT (1993)"SelectedStatistics (1957 -

1991)".

S.2.2: The Exchange Rate Policy

The exchange rate regime pursued in Tanzania^was a fixed exchange rate

untill

1989. Under the fixed exchange rate regime, the shilling was pegged to a

basket of

currencies, in which the US dollarwas heavily weighted. From 1989 the adjustablepeg

or crawling peg was adopted. Under the adjustable peg regime, the exchange rate was fixed but the authorities reserved the right to adjust theexchange rate by

small margins

'The variations noted in coffee and cashewnuts exports, as compared to production levels during 1986-91 are the result of previous accumulated stocks (see also AppendixII-Table 1).

9

agricultural sector in particular. Tanzania like many other developing countries has had

overvalued currency formany years. The mainreason forthispolicywasto shift resources from agriculture tothe industrial sectorand to keep food prices in urban ^areas low.

Before 1986,Tanzania didnotpursue an active exchangeratepolicy. Devaluations

werefew and small relative totheinflationary differentialbetween Tanzaniaand her trading partners. During 1970s inflation in Tanzania ^was not significantly different from that experienced by her tradingpartners.From mid 1970s inflation in Tanzania accelerated and

asatmid 1980s inflation ^was slightly above 22.0 percent. Given thehigh rateof inflation

and absence of nominal exchange rate adjustment, the shilling became increasingly

overvalued. The overvaluation of the shilling adversely affected the profitability ofexports and finances of the export marketingboards.

As showninTable 1.3 below, there ^were only slight andinsignificant devaluations

between 1971 and 1983. Gradual devaluation was permittedto ^occurbetween 1984 and

1986. In 1984 the shillingwas devalued by26 percentin dollar terms. However, it^was

not until 1986 that the government made major changes in its exchange rate policy and

introducedregular adjustmentstothe exchangerate. InMarch 1986 theexchange rate was Tshs. 17 to US dollar andby midJune 1986 thevalue of the shillinghad fallento 40to the

US dollar. Since then the shilling has been substantially devalued reaching Tshs. 230 in

1991. Devaluation of the Tanzania shilling has been adopted to stimulate agricultural production, particularly, that of cash crops.

Because agricultureconstitutes such a large proportion oftotal exportsin Tanzania,

any taxation of _exports will fall mainly ^on the agricultural sector. One ^measure ofthe taxation ofagriculture isthe differential between producer and international prices ofexport

crops. The differential has several components: that due to exchangerate disequilibrium

10

Becauseagriculture constitutes such ^a

large proportion of total

exports

in 1 anzania,

any taxation of exports will fall

mainly

on

the agricultural

sector.

One

measure

ot the

taxation ofagriculture is the differential between

producer and international prices ot export

crops. The differential has several components: that due to

exchange

rate

disequilibrium

(overvaluation ofthe Tanzanian

shilling)2,

processing charges, marketing costs

(transport,

storage, and administration), and the premium held by the

marketing

agent

above these

costs.

Table 1.3: Devaluation of the Tanzanian Shilling: 1971-1989

Dec.22, ^{March June June} 15, ^June 19, ^{Nov. 5. June23. Dec.4.}

1971 7, 1982 23, ^{1984 1986 1988 1989 1989}

1983

% of 7.9 10.0 20.0 25.9 25.0 21.0 4.8 17.1

Devaluation

Tsh /US$ 7.1 9.407 12.24 17.174 40.0 ^120.0 145.0 190.0

Source: Bank of Tanzania.

1.2.3 Pricing and Marketing Policy

MarketingSystem

An understanding ofthe operation of the marketing system that has been used in

Tanzania is_necessarybecauseof its substantial influence on prices. Even though producer prices ^are set by the government to reflect primary costs borne by the farmer, producer prices tend tobe ^moreinfluenced by marketing costs.

2 The world marketprice of cash crops in Tshs. (Domestic price) is the world market price multiplied bytheofficial exchangerate. If the Tsh is overvalued, the official exchange ^rate is lower

than its equilibrium level and consequently the domestic price may be defined as tax (see Eriksson,1993 and Cleaver, 1985).

Until 1973, the marketing ofagricultural products ^was

carried

out

by farmer's

cooperative unions and government-controlled

marketing boards. Cooperative unions

purchasedavariety ofcrops from the region and

re-sold each commodity

to

its respective

marketing board responsible forfinal sale. Under the cooperative

marketing

system,

the

government set the price paid to cooperative unions by the marketing

boards. Actual

producer prices become residuals aftercooperative unions

had deducted

some

fraction

from the price paid to them by the marketing boards to cover

marketing

costs.

Accordingly, there were geographical variations inproducerprices

following differential

marketing costs ofindividual crop unions.

In 1973,at theoutsetofamassivevillagization(Ujamaa)'campaign, the government began^{a new}marketingsystemfor farm products which came into operation in 1976 ^upon

the completion of villagization. Registered villages took over the co-operatives role ^as primary agents. The functions of the marketing boards which were reformed into ^crop

authorities ^wereexpanded. The official marketing system had severe efficiencyproblems, however, andagricultural performancewas discouraging. By late 1970s and early 1980s

the country found itselfin a deep economic crisis.

In order to reduce marketing costs and improve the general efficiency of the

distribution system, the government decided in 1982 to reinstate the co-operatives. They

were eventually reintroduced in 1985/86 (MDB, 1987). In the beginning of the 1980s parastatal marketing costs ^rose very rapidly. Rather than lowering producer prices parastatal losses were absorbed into the government budget (Bevan et al, 1991). The

increase in themarketingcosts thereby became an important determinant of changes in the budgetdeficit and hence of therate of inflation. Marketing costsreduced producer prices

not directlybutindirectly through their effect on inflation.

1

Ujamaais aSwahili word, which means "familyhood".

Agricultural Pricing Policy

Price incentives^werenot seen as apriority policy measure on agriculture

until well

into the 1970s. The government was much concerned with the effect of changes

in

agricultural prices ^on the urban cost of living rather than about supply response.

Agricultural output was seen as largely determined by the institutional infrastructure (Eriksson, 1993). In this period prices ^were set by the Economic Committee of the Marketing Development Bureau (MDB) of the Ministry of Agriculture. The MDB

recommendations were based on detailed cost calculations. They aimed at levels of producer price which equalize thereturns to labour ^across crops.

In the mid 1970sshortly afterthe villagization of 1974, the policy began to be seen

as a dramatic failure. It became clear that agricultural production ^was rapidly declining.

During the second half of the 1980s there was a change in attitude towards supply

response. Price incentives were now recognized as being of central importance to agricultural output. The ERP stipulatedthat agricultural producer prices were to be raised by 5.0 percent annually in realtermsortobe ^setat 60.0 to 70.0 percentofFoB prices. The

liberalization ofagricultural markets ^was reflected in price policy. At the macro level, policy ^measures, particularly the devaluation of Tanzania Shilling, have been taken to stimulate agricultural production, particularly that of cashcrops.

1.3 Nature of the Problem and Justification of the Study

Agriculture isthe coreofTanzania's _economy. Itcomprises^on average 50.0 percent of the Gross Domestic Product, provides on average 90.0 percentof the population with

subsistence living and on average earns 65.0 percent ofTanzania's foreign exchange.

13

Agriculture determines the rate ofgrowth of

development and ultimately the survival of

industries.

Nevertheless, ^over the 1980s and up to date, the rate of

growth of agricultural

production has declined from ^even the lower rates

of the 1970s. This stagnation in

agricultural production has ^come at a time when the country is

being faced with the

difficult task ofcarryingout structuraladjustment. The adjustmentprocess

is hampered by

adeclining agricultural sectorthat is unabletoprovide asufficient surplus.

Given the importance of the agricultural sector for growth, there is a

need

to

detennine the best suitablepolicies to stimulate agricultural production, and in particular

theextent towhich price policy can be used to encourage agricultural growth, hi order to improve production ofexport crops, massive exchangerate adjustmentwas implemented

since 1986 to enable improvements in relative producer prices ofexport crops. In this regard, there is ^a need to investigate whether the exchange rate adjustment ^was the appropriate policy ^measure towards solving theunderlying problem.

1.4 Hypothesis and Objectives of the Study

The hypothesis to be examined is that the exchange rate adjustments implemented during the periodof structural adjustment (1986-1991) could not improve

the exportperformance of Tanzania's majoragricultural exports. The main export crops in Tanzania are coffee, cotton, tobacco, tea, cashewnuts, cloves, and sisal.

Thus the objectives of this study areto;

(i) investigate the influence ofexchange rate policy on determination ofproducer prices;

14

(ii) determine price elasticity ofsupply of major export crops; and

(iii) determine the impact of exchange rate policy as measured by changes in the real exchangerate on the country's degree ofcompetitiveness, and then examine its

influence ^on export supply.

The analysis of the real exchange rate indicator is carried out to determine

whether the country's real exchange rate has been stable and competitive ^to favour agricultural export crops over the years and to what extent this may have been

attributed to the exchange rate policy.

As regards the analysis ofproducer prices, the objective is to investigate the

influence ofexchange rate policy ^on the determination ofproducer prices and examine

whether the variation in real producer prices can be linked to the exchange rate policy.

Analysis of price elasticity of supply seeks to examine whether Tanzania farmers respond to price incentives, given the objectives of exchange rate adjustment of improving producer prices. As noted earlier on, in order to encourage the expansion of

exports, the government aimed at establishing an equilibrium exchange rate through

massive exchange rate adjustment. The effectiveness ofexchange rate adjustment in increasing exports depends on the pass-through of the exchange rate to producer prices

and the responsiveness oi supply to increases in producer prices. The objective of

massive exchangerate adjustments since 1986 was to increase real producer prices at

an annual rate ol 5.0 percent orto _pay 60.0 ^- 70.0 percent of the FoB price and improve

the financial position of marketing institutions so that they might reduce their dependency on unpaid loans from the banking system.

15

The studycovers live^crops (coffee,cotton,

cashewnuts, tobacco and lea). I hese

crops account for 50 percent oftotal export

earnings

on average

and 62 percent of total

value ofagricultural exports during the period under

the study

(

1970-1991 ).

1.5 Empirical Applications

The outcome ofthis study is expected to draw attention of policy

makers

to

the

performance ofexport supply of agricultural commodities in response to

the exchange

ratepolicy adopted since early 1980s, and in particular during the period

of Economic

Recovery Programme (1986/87 - 1991/92). It is also expected to provide reference

materials with which to assess the success of the policy. The proposed

recommendations are of vital importance because export growth relies much ^on exchange rate policy, together with other macroeconomic policies.

16

CHAPTER TWO

LITERATURE REVIEW

2.1 I he Influence of Currency Devaluation on Exports Supply

S? Jt~k-e* SiSO1 ï?S-* s->InmASXM««#.•«

jtteutetiiriujLfiuungi Oitini

The primary effect ofcurrency devaluation isto increase the price in domestic

currencyofexpertsandimports, although these pricesmay remain unchanged in terms offoreign currencies. Higher domestic prices enable exporters to offer higher prices to producers and encourage importers to shift to domestic goods. Thus, these price changes are expected to shift the internalterms of trade in favour ofcurrently traded goods (exports and import substitutes) andto redirect^resources from othersectors to the traded goods sectors. Facilitated by stabilization policies in support of the devaluation, this resource allocation is expected to have ^a favourable effect on the supply ofexports andimport substitutesas well ^{as on} output in general.

The speed withwhich^acomity's exportsrespond to exchangerate changes and inflation at home and abroad has important policy implications. Some writers have pointed out that under a fixed exchange rate system exports flow may respond differentlyto price changes thatresult from changes in the national currency price of exportable goods.Bhagwatiand Onitsuka (1974) and Orcutt

(1950)1

noted that supply

response of _{exports to} the change in domestic price resulting from a devaluation is

significantlydifferent from the price stimulus ofnormal fluctuations in external prices.

Under normal conditions, external prices mayfluctuate everyyear so that an expected

As quoted byJohn F. WilsonandWendy E. Takacs(May, 1979).

increase in exportprices may be substantially discounted by producers inview ot the possible fall in prices in the ^near future. Devaluation, however, gives certainty to the

direction of change. This implies that, the absolute and relative domestic price of

exports relevant for supply response is an "expected" price which takes into account

thepossibilityof price increase, and devaluation islikelyto affect this expectedprice.

If in addition, government takes supporting measures for export expansion, these

reinforce the favourable expectations and producers ^{are even more} convinced that expansion ofoutput will be profitable. Among others, Leaner and Stein (1970, p.34) interpreted Orcutt's point to mean that adjustment to large price changes stemming

from devaluationwill be more rapid than adjustmentto small changes but the long-run adjustment would be the same.

Theoretical presentation of benefits of devaluation to producers of agricultural export crops has been provided by Jean (1992) in figure A. It is based ^on the assumptionsthat farmgate prices ofexportcommodities do not increase automatically

after devaluation and, in any case, do not increase at the ^same rate as the rate of devaluation. In the long chain of processes from farmgates to borders, many intermediate decision-makers (including governments) may maintain the difference

between increased selling prices and former buying prices.

As depited in figure A, before devaluation, the monopolist, maximizing his oi¬

lier profit, operates quantity Qb, which equates world price (in local currency, at

current exchange rate) withthemarginalbenefit (receipt, minus price givento farmer),

í his is a curve with the same intercept and twice the slope ofthe peasants supply

curve. Therefore, he or she purchases quantity Qh at price to fanners. After devaluation, the same reasoning leads to quantity Qa, related to fanner price Ff. It is important to note that, because of the slope of the peasant's supply curve, the

Figure A: Consequences of Devaluation for a Monopolist Country Trader: the Case of Output2

Qk Gu

A=MonopolistMarginal receipt

15 Peasant Supply Curve

P„.a Border price alter devaluation

P„b=Borderprice before

devaluation

Pfa=Farmgateprice after

devaluation

Pn, = fanngate price before devaluation Qb = Quantity before devaluation

Q„= Quantity alter devaluation

JhediagramisadaptedfiomBoussard Jean. M (1992). "The Impact of Structural Adjustment

on SmallHolders", in FAQEconomic and SocialDevelopment PaperNo 103. p,55. Rome.

difference Pfa ^- Ptb (the price increase to farmer) is less than Pwa ^-Pwb (the difference in

borderprices between "before" and "after" devaluation). Thus, peasants benefit from

a price advantage, which is significant, although that is smaller than the devaluation

itself. They also benefit from an increase in the quantity they sell, as depicted by the

difference between Qaand Qb. The more elastic the peasant's supply curve ^, the bigger

the difference between Q., and Qb.

The common argument against devaluation is that it increases the cost of imported inputs that ^are necessary for the modernization of the agricultural sector.

Agricultural export producers use fertilizers and chemicals, the costs of which will

increase with the devaluation. If there is an effective pass-through of the effects of

devaluation on producer prices, then producers of exports will realize net gains,

because importedinputs areonly ^a fraction of theirtotalinputs. Forinstance, the land

is not directly affected by devaluation. Thus, the return to those resources used in

producing exports will increase. Moreover, the substitution ofdomestically available

resources forimported inputs shouldnotbe completely ruledout. One of theobjectives

of exchange rate adjustment is to improve the efficiency ofresource allocation and

reduce the use ofmore expensive imported inputs.

ExchangeRateAdjustmentanditsinfluence^on ExportSupply

Empirical evidence strongly suggests that, accompanied by appropriate

macroeconomic policies, nominal devaluations ^can produce a real depreciation and

improveacountry's external position. In hisclassic study Cooper ( 1971

)3 analysed 24

episodes and found that most nominal devaluations ^were indeed associated

with real

devaluations. Connolly and Taylor (1976 and

1970)4

found that nominal

devaluations

were translated into real devaluations in the short to medium _run, thus nominal

devaluations have ^an important positive effect on relative prices. Edwards

(1986)

analyzed 29 devaluations between 1962 and 1979. He found that in ^some countries,

nominal devaluation had succeeded in producing asizable real devaluation. Countries

that had a large (or complete) erosion ofthe effect of the nominal devaluation were those that accompanied the exchange rate adjustment with expansive credit policies, large deficits, or wage indexation. Regression results in Edwards indicate that, on average, and all otherthings given, anominal devaluation of10 percentwillresult, in

the first_year, in areal devaluation ofapproximately7 percent.

Bhagwat and Onitsuka (1974) compared the average growthrates ofexports before and after devaluation. The three-year average annual growth rates before

devaluation was compared with the three-year average after the devaluation for the

non-industrial countries in the 1960s. Exports were measured in terms of quantity

instead of value simply because, export receipts of the devaluing country can be

influencednot only by supply factors but also by such factors as world demand for its major exports. For example ifworld demand for exports ^were to increase, export

receipts of the devaluing countrycouldincrease ^evenwithout the devaluation.

The market sharewas alsoanalyzedto determine whetherthe exportingcountry experienced an increasing or decreasing trend for its _exports after devaluation. The

market share was estimated throughthree-year averagemarket share. The advantage

3In Edwards (1989).

4 Also in Edwards(1989).