Exogenous Shocks and Macroeconomic Policies in

LDCs: A Study of Sri Lanka With an

Econometric Model

Nelson Perera, UuiversiQ of Wollor~gor~g

The main objectives of this paper are to analyze the impact of exogenous shocks on an economy with a strong primary commodity producing sector and underdevel- oped financial and capital markets. and to present some of the macroeconomrc policies that might be employed to stabilize the domestic economy in response to exopenous shocks. using an econometric model of Sri Lanka. An analysis of the impact of export price shocks on the Sri Lankan economy reveals that the sectorial adjustment mechanism and the impact on the economy are different in response to changes in the international price of each sector. However. in all cases the impact of external shocks is strongly felt in the monetary sector and the external sector. An analysis of active policies under different types of external price shocks indicates that the possibility of effective use of macroeconomic policies to offset the detrimental impact of external price shocks is constrained by the lack of independence of monetary pohcy. by the embryonic nature of the capital and tinanciai markets and by limited access to foreign finance.

1. INTRODUCTION

The main objectives of this article are to analyze the impact of exogenous shocks on an economy with a strong primary commodity producing sector and underdeveloped financial and capital markets, and present some of the macroeconomic policies that might be em- ployed to stabilize the domestic economy in response to exogenous shocks, using an econometric model of Sri Lanka. The economy of Sri Lanka has been subjected to various exogenous shocks since its independence in 1948 The shocks include changes in export prices.

Received May 1993: tinal draft accepted September 1993.

The article is based on a part of the Ph.D. thesis submitted to the La Trohr Unibersitt.

Melbourne. Australia in 1989. More details of the content of thk article are aailabk on rquc\t

from the author. I am grateful IO Profcswr\ S.P. Burley. J.R. Behrman. F.G. Jarrctt. Drs. G.

O‘Brien. .4. Hqper. and D.P. Chnudhri for many helpful comments.

51w72d of Pdic,v Moddin,~ I ht 3 ):335-3-U ( I991 1 3.35 0 Society for Policy Modeling, 199-l t; I6 I -893S/91157.IH)

336 N. Perera

increase in oil prices, a massive flow of foreign grants from various sources. flow of transfer payments in the form of migrant workers remittances from Middle Eastern countries, and crop failures due to weather conditions. The analysis of the exogenous shocks in this article is restricted to external shocks related to export prices. The organization of this article is as follows: section 2 contains a brief description of the model used in the paper: the impact of exogenous shocks on the Sri Lankan economy is evaluated in section 3; section 4 contains an evaluation of the appropriateness and effectiveness of various policies to stabilize the impact of external shocks on the economy; and finally. section 5 contains some concluding remarks.

2. THE MODEL

3n this article a macroeconometric model of the Sri Lankan econ- omy is used to analyze the impact of exogenous shocks on the Sri Lankan economy and measure the effectiveness of the policies that might be employed to stabilize the domestic economy in responre to those exogenous shocks. A comprehensive description of the model can be found in Perera ( 1989. 1991, and 1993)-t

Because of the importance of the agricultural sector in the Sri Lankan economy. the agricultural sector has been categorized into five major commodity groups: tea, rubber, coconut. paddy. and minor crops. In order to capture the long gestation periods of the tree crops. tea, rubber, and coconut. micro models for each sector have been developed by incorporating the decisionmaking process of the cultiva- tion and production of these crops.

The manufacturing sector is disaggregated into three subsectors: export processing, industrial, and construction. The value added by the export processing and industrial sectors is supply determined, while the value added by the construction sector is demand deter- mined. The services sector value added is disaggregated into four sub-sectors: trade, transport. public administration, and other services. The value added of these sectors is also determined by both demand and supply conditions.

The demand side of the model is explained under each sector of the model. The domestic consumption of tea, rubber, coconut. and minor food crops is explained in the respective subsectors. The consumption

‘A complete model together with list of variable> is available on request from the author.

A STUDY OF SRI LANKA WITH AN ECONOMETRIC MODEL 337

of industrial goods and investments in industries is explained under the industrial sector model.

In our model, the government sector is disaggregated to capture the effects of various government policies on the economy. The govem- ment revenue functions are specified in order to capture the effects of the imports. exports, and other economic activities on the economy. Government expenditure. on the other hand. is disaggregated into current and capital expenditure. These expenditure items are finally connected with the real sectors of the economy. The financing of the government budget deficit is separated into two sources: expansionary and non-expansionary. ‘i-he expansionary financing is again linked with the money supply.

The model permits the real sector to have explicit effect on the monetary sector of the economy. The money supply responds to pressure in the real sector via the 1atter”s impact on government fiscal deficit. The model establishes linkages between the external sector and the rest of the economy through a number of channels. The import sector is disaggregated into several categories in order to capture the role of different categories of imports. The export quantities and values are determined through the activities of the agricultural and industrial sectors. Finally. gross external assets are linked with the money supply.

The model used in this article has 147 endogenous variables of which 75 are explained by behavioral equations and the remaining are defined by identities which close the model. Most of the equations of the model were estimated using data from 1960 to 1984. However. due to unavailability of data for some sectors of the economy, some equations were estimated using data from 1970 to 1984.

In the preliminary estimation of the equations of the model, the Ordinary Least Square procedure is employed. At this stage, auto- correlation is correlated by the Maximum Likelihood procedure. After deciding upon the basic form of the equations in this manner. the complete sectorial model is estimated by Two Stage Least Square combined with the instrumental variable method. and the autocorrela- tion is corrected by the Fair ( 1970) method.

3. IMPACT OF EXTERNAL SMOCKS

3A. An Unsustained Change in the London Market Price of Tea

This section focuses on the impact of an unsustained change in the London market price of tea on the Sri Lankan economy. The effects

338 N. Perera

on the tea sector and the macroeconomy of a 10 percent unsustained increase in the London market tea price can be summarized as follows:

l The higher producer price of tea resulting from the increase in the London market price of tea expands the activities of the tea sector. But the increase of production in order to gain the maxi- mum benefit from higher prices is limited by the long gestation nature of the tea crop. A limited increase in production can be achieved by delaying the uprooting activities and by higher fertil- izer application. In the long run. the increase in production will be achieved by a higher bearing area resulting from new planting and replanting activities in the previous years.

l The increase in export earnings as a result of the increase in export prices and quantities helps to narrow the deficit in the BOP current account. accumulating the external assets of the country.

l The impact of the export price increase in tea is strong in the monetary sector. The money supply increases as a result of the increase in external assets and private credits.

l The rise in the general price level also appears to be strong as a result of the increase in the money supply and the agricultural price level.

l The unsustained increase in the London market price of tea enhances the general economic activity. through higher demand for consumption and investment.

3B. An Unsustained Change in the New York Market Price of Rubber

This section focuses on the impact of an unsustained change in the New York market price of rubber on the Sri Lankan economy. The impact of a 10 percent unsustained increase in the New York market rubber price on the rubber sector and the macroeconomy can be summarized as follows:

l The higher producer price of rubber resulting from the increase in the New York market price of rubber does not change uprooting or replanting activities in the first year. The increase in production in order to gain the maximum benefit from the higher prices is limited by the long gestation nature of the sector. A limited increase in production can be achieved by higher fertilizer appli- cation. In the second and third year. uprooting and replanting activity increases, leadin g to a reduction in the tapping area.

A STUDY OF SRI LANKA WITH Ah’ ECONOMETRIC hiOGEL 239

Rubber production falls due to the reduction in the tapping area immediately after the price increase. In the long run. production increases due to greater bearing area resulting from replanting activities.

l The increase in export earnings as a result of the increase in export prices and quantities helps to narrow the deficit in the BOP current account. accumulating the external assets of the country. But from the second year. rubber exports start to decline. causing a deterioration in the BOP current account deficit.

l The impact of the export price increase for rubber is strongly felt in the ruonetary sector. The money supply increases as a result of the increase in external assets and private credits.

l The general price level rises as a result of the increase in the money supply and the agricultural price level.

0 The unsustained increase in the New York market price of rubber enhances general economic activity through higher demand for consumption and higher investment demand.

4. EXTERNAL SHOCKS AND ACTIVE POLICY RESPONSE FOR SRI LANKA

It is clear that the dynamic effects of unsustained increases in the international price of tea and rubber bring about more inflation and growth, while unsustained respective price decreases induce the oppo- site results. In the following sections, it is intended to pinpoint some active policy measures that the Sri Lankan authorities might take in order to stabilize the impact of external price shocks on government objectives. However. it should be emphasized that simultaneous achievement of all the major goals of Sri Lanka. riz., growth of the economy, stable price level and healthy BOP position. is unrealistic and impossible.

The analysis of the impact of external shocks on the macroeconomy reveals that, in the short term, fiscal and monetary policies are needed to stabilize the economy. The implementation of these policies de- pends on the type of policy instruments available to policymakers. and the choice of instruments depends on the structure of the political institutions as \,;ell as the economic situation. The instruments of fiscal policy include control over government expenditure and tax rates. In Sri Lanka, control of ad valorem and export tax rates has been commonly used as a fiscal policy instrument. The adjustments to ad valorem and export tax rates mean that changes in the Colombo

340 N. Perera

market price or export price are not passed on to producers. but are passed on to government revenue.

Monetary policy instruments comprise Central Bank of Sri Lanka (CBSL) advances to commercial banks (CBs). the reserve requirement ratios, open market operations. and direct control over c&its. Since the only component of the money supply under the direct control of the CBSL is CBS’ credits to Non Banking Private Sector (NBPS). the implementation of monetary licy involves the control of credits to NEWS. tt is often the case in at :he control of the money supply involves changes in reserve requirements together with direct credit controls.

QA. An Cbn~ in the London Market Tea Price or rk Market Rubber Prim and !3brtRun _ _

This s4xtion focu~s on the evaluation of the impact of active policies on the Sri Lankan economy in Wlation to an unsustained change in market price of tea or the New York market price Of rn event of an increase in the external prices the only unfavora pact occurs on the general price level. This is mainly due to sion of the money supply due to the accumulation of external as refore, the appropriate policy would be to sterilize the full impact of the external shock via monetary policy. As argued in earlier sections, the sterilization of the impact of the external assets involves adjustments to the CBs’ credits to NBPS. Two simula- tions were performed to investigate the impact of a 10 percent increase in the London market price of tea or the New York Market price of rubber on the economy under the active monetary policy. The active netary policy measure adopted in this case is reduction of CBs c ts to NBPS. Even though the rise in the general price level seems to be controlled by the restrictive monetary policy, the growth of the economy is also afFected due to the low level of value added by the manufacturing sector.

Additional active policy scenarios were performed using two more siPnu!stions, In these scenarios, the government increases the ad k llorem tax rate or export tax rate, depriving the producers of the full benefit of the price increase; in fact, the tax rate is adjusted upward in such a way that only 50 percent of the price increase is passed on to producers. Further, monetary policy is also maintained in a restrictive way: credit to NBPS is maintained at the control solution level. A comparison of these simulations together with the passive policy

A STUDY OF SRJ LANKA WITH AN ECONOMETRIC MODEL 3-41

scenarios reveals that lower rate of grokvth of the econcm~y un&r the active policy actions. compared \vith passive policy action. Hmvevrr. the rise in the general price level seem to be controlled in ae‘tive policy simulations. It was further revealed in the case of an increase in the external prices of tea and rubber. the preferred short run policy to

amst the rise in the price level seems to be sterilization of the excess external assets accruing in the tirst yes. However. there are some negative effects within the economy from attempting to use a restric- tive monetary policy to sterilize the full impact of the external shock. Further. the magnitude of the sterilization is so great that it may not be feasible. Therefore. one may consider the use of long term policies coupled with a less restrictive short term monetary policy. As a i#Jng term policy. the accumulated excess exzemai assets could be used to rcttire pare of the external debt of the country. Even though the change in the ad valorem tax rate or export tax rate ph~s restrictive credits policy can also achieve the same results to some extent. with lower sacrifice of economic growth. the appropriateness of such a policy is questionable becau.se such a policy leads to instability of government revenue, with fluctuations in commodity prices.

The next example of an active policy response takes the case of a IO percent unsustained decnzase in the London market price of teLt or the New York market price of rubber. A simulation of a IO percent unsustained decnzase in the external prices of tea or rubber suggests that without any active policies the real GDP is below the control solution. and the deficits in the BOP current account and the govem- ment budget are worsened. The proper policy response in this situa- tion might include expansionary fiscal and monetary policies. If government needs to maintain current and capital expenditure at the previously committed levels, the increase in the government budget deficit may be financed through foreign borrowings rather than through borrowings from the CBC. The foreign borrowings can also cover the loss of external assets due to the fail in export revenue. If the government adonis a variable tax policy by reducing the tax rate in response to the fail in external price. the government budget deficit wor.._ns further. but producers are insulated from the external shock. The impact of the above policies is evaluated using a simulation. This policy scenario assumes, first. that the government lowers the tax rate. thereby partially insulating producers: second. that the government increases its foreign borrowings to cover the loss of external assets; and finally, that the monetary authority increases credits to the private sector. This active policy scenario suggests that the growth prospects of the economy can be improved by adopting ;ee policies in that

343 N. Perera

simulation. Despite the decrease in government revenue, the reduction in the export tax rate insulates producers from the adverse external price shock. The increase in credits to the private sector is mainly responsible for the growth of manufacturing and services sector output. However, there are two main drawbacks to the above policy scenario. Firstly, the variable export tax rate creates instability of government revenue. Secondly, and more importantly, the above policies offset the impact of the price shock on real GDP. but at the cost of inflationary pressure on the economy and an increase in the BOP deficit in subsequent years. In other words. the gain in real income from the offsetting policies must be measured against- the loss in terms of not reducing *he inflation and at the same time increasing the external debt.

The above analysis of active policy scenarios under the two types of external price shocks reveals that the growth of the economy can be maintained if the producers are protected from such external shocks. The most appropriate way to protect producers from external price shocks is to establish stabilization funds for tea and rubber. This involves lowering ad valotem or export tax rates, and instead impos- ing a special levy for the fund. This operation can make a prolit, when the difference between the Colombo market price and the price paid to the producer is positive. The revenue thus collected may be invested on a short term and medium term basis. and can be used when the difference between the Coiombo market price and the producer price paid is negative. In the initial stage, this may create problems due to reduction in government revenue, but in the long run a stabilization fund would assist the tea industry by insulating producers from price shocks.

The next question is financing of the shortfall in export earnings in the case of a decline in world tea prices. The IMF’s Compensatory Financing Facility (CFF) provides financial assistance to member countries of the IMF in the event of a temporary shortfall in export earnings attributable largely to circumstances beyond the member countries’ control. In fact. Sri Lanka has been using drawings under the CFF since f967 to cover the loss of export revenue.

The other important finding concerns the limitations to the use of certain macroeconomic policies to offset the detrimental impact of the external shock in the tea price. For instance_ on the one hand, the sterilization of the impact of external assets on the money supply leads to a reduction in the growth of the economy; while, on the other hand. expansionary policies designed to stimulate the economy when there is an unfavorable external price shock generates inflationary

A STUDY OF SRI LANKA WITH AN ECONOMETRIC hlODEL 93

pressure in the economy. This is mainly due to two factors: the lack of independence of the monetary policy and the embryonic nature of the capital and financial markets which restrict domestic non-inffationary financing of the government deficit. The implementation of monetary policy, therefore, virtually means adjustments to private credits. Fur- ther. the limited access to foreign finance also reduces the possibility of carrying out macroeconomic policies when there is an unfavorable external price shock.

5. CONCEUDING REMARKS

In this article. in order to examine the impact of external shocks on the Sri Lankan economy. three unsustained external shocks connected with terms of trade were conducted: an unsustained change in the international prices of each of Sri Lanka’s major export crops, tea. and rubber. The responses of the producers to change in the international prices are of two types: the 9ongrun response such as replanting, new planting, and uprooting activities: and the short-run response. such as fertilizer application. In both cases the impact of external shocks was strongly felt in the monetary sector and the external sector: in fluctua- tions in the money supply and deficit in the BOP current account.

This article presents an analysis of active policies under different types of external price shocks for tea and rubber. In this regard, an analysis of active fiscal and monetary policies is presented in the event of external price shocks for tea and. rubber. it is revealed that sterilization of the impact of external assets in the event of a favorable external price shock requires a restrictive monetary policy to achieve price stability. However, the restrictiveness of monetary policy is so severe that there is doubt as to its feasibi9ity. On the other hand. in the event of a favorable price shock. a less restrictive monetary policy plus a variable tax rate policy can also achieve price stabitity to some extent; although the appropriateness of such a policy would be ques- tionable since it would lead to instability of government revenue. In the event of unfavorable external price shocks. the growth prospects of the economy can be improved by using an expansionary monetary policy and a variable tax rate policy supported by foreign financing to cover the loss of external assets, but at the cost of inflation and external debt.

The possibility of effective use of macroeconomic policies to offset the detrimental impact of external price shocks is constrained by the lack of independence of monetary policy. by the embryonic nature of the capital and financial markets and by limited access to foreign

3-w N. Perera

finance. The implementation of independent monetary policy by the CBSL is restricted mainly because of the lack of control over the government budget and the compulsory financing of the government budget by the CBSL. On the other hand, the embryonic nature of the capital and financial markets restricts mobilization of the financing of the government budget deficit. In other words. the implementation of monetary policy means adjustments to private credits.

Another important finding of the article concerns the usefulness of a stabilization fund to neutralize the impact of external price shocks on the level of domestic economy. In contrast to the existing variable tax rate policy. a stabilization fund would reduce the instabil- ity of govemmen revenue while insulating producers from external price shocks. Fu r. the activities of such funds would also assist the development of the financial markets. as their revenue could be expected to participate in the short and medium term investment activities. Yet, even though there has been much discussion and many recommendations during boom times concerning the establishment of s:rch a fucld for tea and mbber. the enthusiasm for these funds has always diminished when the boom period is over.

REFERElWES

Fair. R.C. t 19701 The Ektimiition of Simultimeou3 Equation Xodels with Lased Endogenous Variables and First Order Serially Con-elated Errors. Etr~tcorrrt~tritr~ 38507-5 16.

Pcrera. N. 4 1993) An Econometric Model of the Sri Lankan Economy. In Ecm~~mic Prrqrets

and Grmth f H. Motanren-Scobie. Ed. ). London: Chapman and Hall (forthcoming). Pcrea N. ( 1991 b An Econometric Model of the Sri Lankan Economy. Conference paper

presented at the International Symposium on Economic Modelling. London University. Peren. N. t 1989) Exogenous Shocks and Macroeconomic Policies in Sri Lzmka: A Macroecono-

metric Study. Unpublished Ph.D dissertation. La Trobe University. Melbourne. Australia.