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p. 58 of 74 BACK | NEXT I. Introduction II. Background III. The Economic Rationale of A Project IV. Macroeconomic and Sectoral Context V. An Integrated Approach To Economic Analysis VI. Identification and Quantification of Costs and Benefits VII. Valuation of Economic Costs and Benefits VIII. Large Projects, Linkages, and National Affordability IX. Least-Cost and Cost-Effective Analysis X. Investment Criteria: Economic Viability XI. Discount Rate XII. Uncertainty: Sensitivity and Risk Analysis XIII. Sustainability of Project Effects XIV. Distribution of Project Effects XV. Projects and Policies XVI. Appendices Appendix 1: Key Questions For The Economic Analysis of Projects Appendix 2: Project Economic Rationale: Market and Nonmarket Failures Appendix 3: The Project Framework Appendix 4: Identification and Measurement of Consumer Surplus Appendix 5: Treatment of Working Capital Appendix 6: Depletion Premium Appendix 7: The Use of Constant Prices In The Economic Analysis of Projects Appendix 8: General Methodology For Building Up Project Statements Appendix 9: Economic Evaluation of Project Output and Input Appendix 10: Economic Price of Traded Goods and Services Appendix 11: Valuation of Nontraded Outputs and Inputs Appendix 12: Shadow Wage Rate and The Shadow Water Rate Factor Appendix 13: The Economic Price of Land Appendix 14: Treatment of Resettlement Components of Projects Appendix 15: Calculating Economic Prices At The Domestic Market Price Or World Market Price Levels Appendix 16: Estimating The Shadow Exchange Rate Factor and The Standard (Or Average) Conversion Factor Appendix 17: Example of An Economic Rate of Return: An Irrigation Rehabilitation Project Appendix 18: Effect On Net Foreign Exchange and Budget Flows: An Example Appendix 19: Least-Cost Analysis and Choosing Between Alternatives Appendix 20: Estimating The Economic Opportunity Cost of Capital Appendix 21: The Treatment of Uncertainty In The Economic Analysis of Projects: Sensitivity and Risk Analysis Appendix 22: User Charges, Cost Recovery, and Demand Management: An Example For Piped Water Appendix 23: Financial Returns To Project Participants: An Illustration Appendix 24: Economic Evaluation of Environmental Impacts Appendix 25: Distribution of Project Effects Appendix 26: Impact On Poverty Reduction Appendix 27: Difference Between Economic and Financial Prices Appendix 28: Use of Economic Prices In Measuring Effective Protection Appendix 29: Exchange Rate Issues In Project Analysis XVII. Others

Guidelines for the Economic Analysis of Projects : XVI. Appendices

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Appendix 16 : Estimating the Shadow Exchange Rate Factor and the Standard (or Average) Conversion Factor

I. Introduction

1. The shadow exchange rate (SER) is the economic price of foreign currency. There is a common misconception that if the market for foreign exchange is a free float, the shadow exchange rate (SER) is equal to the market exchange rate. That would be the case only if there were no taxes and subsidies on the demand and supply of tradable goods, if all commodities and factors were priced at their economic value, and if the current account deficit was sustainable. In all cases, the SER will diverge from the market or official exchange rate (OER).

2. Exchange rates are one of the key macroprices affecting project performance. If the OER is taken as the SER, and the OER is overvalued, then projects producing nontradables with tradable inputs are favored relative to projects producing tradables with nontradable inputs. On the other hand, if the OER is undervalued, projects producing tradables with nontradable inputs are favored relative to projects producing nontradables with tradable inputs. In the event that the OER is depreciated to attain external competitiveness, or the OER is appreciated to attain internal competitiveness, project performance suffers. In general, the greater the divergence between the OER and the SER, the more likely will depreciation or appreciation occur and affect project performance.

II. Valuing Project Outputs and Inputs

3. The purpose of economic analysis is to encourage investment in projects that promote the best use of a country's resources. That is not necessarily the same as investing in projects with the highest financial return. Financial returns are based on financial prices. Economic returns are based on economic prices.

4. The economic price for any good is based on the weighted average of its demand and supply price, with the weights depending on the market impact of the project. Most projects are small relative to market size, and output produced or input demanded is incremental by adding to that sold or bought without the project. Output and input prices are therefore unaffected by small projects. In such cases, the economic price of a project output is based on its demand price and the economic price of a project input is based on its supply price. The demand price is the price that buyers are willing to pay, that is, the market price plus consumption taxes and less consumption subsidies. The supply price is the price at which suppliers are willing to sell, that is the market price less production taxes and plus production subsidies.

5. Financial prices are different from economic prices. The financial price of a project output is its supply price and the financial price of a project input is its demand price. The relationship between the market price, the financial price, and the economic price for project output or input differs depending on the type of tax levied and other factors. The market price is the financial price when there is only a production tax on a project input and a consumption tax on a project output, whereas the market price is closer to the economic price when there is only a production tax on a project output and a consumption tax on a project input.

6. A major difference between economic and financial prices is therefore made up of indirect taxes and subsidies. For project outputs, the economic price exceeds the financial price by the amount of the indirect tax. For project inputs, the financial price exceeds the economic price by the amount of the indirect tax. This applies whether project outputs or inputs are tradables or nontradables.

III. Traded and Nontraded Goods

7. In valuing project outputs and inputs, economic benefits and costs are divided into traded and nontraded components. Whether an output or input component is traded or not depends on whether it can be profitably exported or imported. The demand price for an exported output is its FOB price and the supply price for an imported input is its CIF price. Traded output or input is valued at the border price level, that is at the level of FOB prices for exports and CIF prices for imports. FOB and CIF prices are typically expressed in local currency terms, converted from foreign currency at the official exchange rate. Nontraded output and input sold on the domestic market are also valued at economic prices, but are naturally expressed in national currency at the domestic price level.

IV. The Shadow Exchange Rate Factor

8. Market distortions tend to maintain the domestic price level for both traded and nontraded goods at higher or lower levels than if there was no intervention. The extent to which the exchange rate is overvalued or undervalued is proportional to the effect of market distortions on the domestic price level relative to the border price level. To take account of the effect of market distortions on the market price for foreign exchange, the shadow exchange rate factor is estimated.

9. The SERF is the ratio of the shadow exchange rate to the official exchange rate, with the shadow exchange rate being defined as the weighted average of the demand price of foreign exchange paid by importers and the supply price of foreign exchange received by exporters. The shadow exchange rate is often estimated as the ratio of the value of traded goods and services at the domestic price level to the value of traded goods and services at the border price level. Alternatively, it can be measured as the weighted average ratio of domestic prices to border price equivalent levels across all goods in the economy.

10. Where tariff distortions represent the only distortion to trade and there are no distortions in factor or commodity prices, the shadow exchange rate can be approximated by the demand price given by multiplying the market exchange rate by the shadow exchange rate factor, calculated as one plus the weighted average tariff rate. For example, if the weighted average tariff was 25 percent, the SERF would be 1.25 and the shadow exchange rate would be the market exchange rate multiplied by 1.25. Tradables valued at the border price level are revalued to the domestic price level by multiplying by the SERF of 1.25. Alternatively, if the unit of account for the economic analysis was denominated at the border price level, nontradables would be converted to the border price level by multiplying by the reciprocal of the shadow exchange rate factor or the standard conversion factor (SCF), in this case 0.8 (see Appendix 15).

V. Free Trade Exchange Rate

11. The SER is not the free trade exchange rate. The free trade exchange rate assumes that the markets for tradables are completely free of distortion. The SER is a second-best shadow price. It is second-best in the sense that the SER assumes that current distortions will continue during the life of the project.

VI. Parallel Market Exchange Rate

12. The SER is not the parallel market exchange rate. The parallel market exchange rate is determined by the informal market. Typically, it is lower than the SER but higher than the free trade exchange rate, which is, in turn, higher than the official exchange rate. The smaller the risks involved, and the greater the proportion of foreign exchange traded on the informal market, the closer the parallel market rate will be to the free trade exchange rate.

VII. Equilibrium Exchange Rate

13. Projects are undertaken within a macroeconomic and sectoral policy environment. In practically all cases, the success or failure of projects depends upon the economic and policy environment in which they are undertaken. One of the most important macroprices affecting project performance is the exchange rate. If the exchange rate is not consistent with long-run fundamentals, it will eventually change and affect project performance. In evaluating project costs and benefits, the SERF should be applied to the equilibrium exchange rate (EER) instead of the market exchange rate as presently practiced (see Figure 1).

VIII. Current Account Sustainability

14. Traditionally, the SERF, or its reciprocal the SCF, has been based on the ratio of the value of traded goods and services at domestic prices to their value at border prices. When tariffs represent the main distortion in the market for foreign exchange, the SERF has been approximated by one plus the weighted average tariff rate. These approaches assume however that the country's current account is sustainable and this is not always the case. An estimate of the SERF can be based upon judgments about the sustainability of any level of current account deficit, as incorporated in the following illustration.

IX. Shadow Exchange Rate for the Philippines: An Example

16. The Philippines has long been experiencing trade deficits sustained in the short run by capital inflows (such as, foreign investment and development aid), remittances of overseas contract workers, and drawdowns of foreign exchange reserves. The shadow exchange rate has been estimated for the Philippines under three different cases for illustration purposes, as presented in Table 1. The following paragraphs describe the adjustments and assumptions made.

17. Price-Responsive Imports. The total import value, converted from $ to P using the average official exchange rate (OER), was obtained from the Foreign Trade Statistics of the Philippines (FTSP). Adjustments in the total import value to arrive at price-responsive imports included special transactions and goods on consignment (heading 931 of Standard Trade Commodity Classification (STCC)), which are eventually reexported. To determine what other sectors are not price responsive to the foreign exchange rate, regression analysis was conducted on ten-year data on foreign exchange and imports by STCC. All sectors showed price-responsiveness to foreign exchange movements.

18. Price-Responsive Exports. The deductions from total exports (obtained from the FTSP) included special transactions and goods on consignment, reexports, and other nonresponsive exports. Reexports are defined as exports of imported goods that do not undergo physical and/or chemical transformation in the Philippines. Using regression analysis on ten-year data on official foreign exchange and exports, two sector classifications are found not to be responsive to foreign exchange. These are: crude materials, excluding fuel (sector 2 of STCC), and animal and vegetable oils and fats (sector 4 of STCC). Other nonresponsive exports included logs, lumber, plywood, and veneer, the exportation of which is regulated.

Notes:

1. Other nonresponsive exports include crude materials excluding fuel, and animal and vegetable oil and fats found insensitive to foreign exchange rate movements, as well as exports of logs, lumber, veneer, and plywood, which are regulated and slapped with a 20 percent export duty.
2. Preliminary data on import tariffs from Department of Finance and on exports of logs, lumber, veneer, and plywood from the Forestry Management Bureau of the Department of Environment and Natural Resources.
3. QRs - quantitative restrictions.

Sources: Asian Development Bank, 1995. Key Indicators, and Foreign Trade Statistics of the Philippines.

19. Import Tariffs. Special transactions and goods on consignment are considered dutyfree since the Tariff and Customs Code provides that refund or tax credit shall be allowed for the duties paid on imported articles used in the manufacture of exports, provided that exportation shall be made within one year after the importation of the materials. The import tariffs used include value added tax on imported goods.

20. Quantitative Restrictions on Imports. According to Circular No. 1389 of the Bangko Sentral ng Pilipinas (BSP), the importation of certain commodities is regulated or prohibited for reasons of public safety, national security, international commitments, and development of the local industry. Such importation requires clearances from appropriate government agencies including the BSP. Among the regulated commodities, the importation of petroleum products; coal and coal derivatives; rice and corn; motor vehicles, parts, and components; and used trucks and automobile tires and tubes were examined.

21. The importation of rice and corn is allowed only if there is a perceived shortage in the domestic market. The last importation of corn was made in 1990, while rice was imported in 1990 and 1993.

22. Among the wide range of motor vehicles, available data on imports pertain only to used trucks and the Bus Importation Program. Under Phase I of the Bus Importation Program, 1,600 units will be allowed to be imported. However, from 1989 to 1993, only 1,544 units were actually imported compared with 1,728 approved. Under Phase II, 3,500 units were programmed for importation. However, from 1992 to 1994, only 2,160 units were actually imported compared with 5,006 approved. This experience implies that obtaining import permits was not a deterrent to free importation. Considering also that the available data from the Bureau of Import Services does not distinguish between CIF or FOB prices and that domestic prices are difficult to obtain, the impact of quantitative restrictions on motor vehicles and used trucks was not included in the computation of the average tariff.

23. On refined petroleum products, the 1994 Tariff and Customs Code of the Philippines specifies tariff rates ranging from 10 to 20 percent. Products such as kerosene, aviation gas, gasoline, and liquified petroluem gas (LPG) carry an additional special duty of P1.00/liter. The rates of tariff equivalent of quantitative restrictions range from 9.7 percent to 110.7 percent (see Table 2). On coal and coal derivatives, the tariff equivalent does not deviate very much from the prescribed tariff rate because of a policy linking the domestic price of coal to its import price. Thus, the net tariff equivalent used in the SER computation pertains to coal and petroleum products, except fuel oil. Due to the cross-subsidization policy in petroleum product pricing, fuel oil is not subject to a specific tax. Thus, since its tariff equivalent is approximately equal to its tariff rate, the effect of quantitative restrictions on its importation is disregarded.

Note: Tariff revenue may be overstated since petroleum products used for power generation are allowed a refund or tax credit up to 50 percent.

Source: Energy Regulatory Board, Department of Energy, Philippine Chamber of Coal Mines; and 1994 Tariff and Customs Code (TCC).

24. Export Taxes and Subsidies. Although an export tax of 20 percent is levied on exports of logs, lumber, veneer and plywood, this is not included in the estimation of the average tax rate since the corresponding export value has already been deducted from total exports. Also, export subsidies were disregarded for three reasons. First, the data are not readily available. Second, export incentives are mainly in the form of duty-free importation of capital and intermediate inputs and there are no direct subsidies. Third, although the Board of Investments (BOI) grants income tax holidays to registered firms, previous studies showed that export incentives constitute very low effective output subsidy rates.

25. Quantitative Restrictions on Exports. The calculation of the SER included the effects of restrictions on the exports of petroleum products (see Table 3). Export of petroleum products requires permits from the Department of Energy to ensure that the exportation will not lead to shortages in domestic supply. In the near future, however, this will not be the case in view of moves towards the deregulation of the petroleum industry. The large export tax equivalent is accounted for by the high domestic excise tax rates on petroleum products.

Source: Department of Energy, Energy Regulatory Board

26. Weight on Demand and Supply. The regression analysis conducted for imports and exports yielded demand and supply elasticities of -2.85 and 1.89, respectively. These elasticitiy values have been incorporated in the weights applied to demand and supply of foreign exchange.

27. Assumption on Sustainability. In Case 3 below, 60 percent of the trade imbalance is assumed to be sustainable.

Results of SER Calculations

28. The SER estimates for 1994 under a partly sustainable trade imbalance and under a balanced trade regime are shown in Table 4.

It is recommended that a SERF of 1.21 be used for the Philippines, equivalent to an SCF of 0.82.

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