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p. 71 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 29 : Exchange Rate Issues in Project Analysis

1. Several exchange rate concepts may at times be relevant in the economic analysis of projects:

• Nominal official exchange rate (NOER). The official exchange rate, in current prices.
• Real official exchange rate (ROER). The official exchange rate corrected for changes in purchasing power between domestic and foreign currency units over time.
• Shadow exchange rate 1 (SER1). The rate at which nontraded goods and services exchange for traded goods and services. Where tariff distortions represent the only distortions to trade, SER1 is sometimes approximated by a weighted average tariff (WATR) adjustment to the official exchange rate.
• Shadow exchange rate 2 (SER2). The exchange rate that would balance trade. This is a theoretical, equilibrium exchange rate.
• Shadow exchange rate 3 (SER3). The exchange rate that would balance the current account, which includes invisibles. This, too, is a theoretical, equilibrium exchange rate.
• Informal or parallel market exchange rate. The exchange rate in the informal market, which is frequently an illegal market.

I. Forecasting Exchange Rate Changes

2. Exchange rates may change over time in response to a number of different forces. Prominent among these forces are: (i) domestic compared to foreign inflation rates, (ii) commercial polices of the Government, including tariff and nontariff barriers to trade, and (iii) international movements of capital and incomes. Anticipating movements in each of the above exchange rates will require analysis of changes in these three critical sets of variables, which often will be causally related to each other.

II. Differential Inflation Rates and the Nominal and Real Official Exchange Rate

3. Analyzing differences between domestic inflation and that of major trading partners will usually be a key factor in anticipating exchange rate adjustments. If, in the face of a high domestic and low foreign inflation rate, the NOER is held constant, then the ROER will appreciate. Similarly, if the NOER adjusts according to purchasing power parity, then the ROER will remain constant. These two cases are illustrated in Tables 1 and 2, respectively.

^a At end of respective year, the real official rate adjusts through
ROER_n = ROER_n-1 x ((1+f/100) x (1+e/100)) / (1+d/100)
where e% = is the rate of change in NOER, in this case, zero,
f% = is the annual increase in international prices, and
d% = is the annual increase in domestic prices.

^a Nominal OER adjusts by (1+d/100) / (1+f/100) to maintain real OER constant.

III. Trade Policies and the Oer Relative to SER1

4. The difference between SER1 and NOER is caused by two sets of factors: (i) border distortions, including tariffs, subsidies, and nontariff barriers to trade, and (ii) domestic distortions, including both policy distortions implicit in, for example, local taxes, and structural distortions implicit in local monopoly power. Most calculations of SER1 focus primarily upon government-induced border distortions. However, methods with a broader focus on the demand and supply of foreign currency for trade purposes can also be used (see Appendix 16), as well as methods which directly compare the economic and domestic prices for a range of traded and nontraded goods.

5. Trade policy can be used to manipulate the difference between SER1 and NOER. Differential inflation will affect domestic prices in local currency relative to border prices in foreign currency. The combination of the NOER and the border distortions will then affect the domestic prices in local currency relative to border prices in local currency. These relationships are demonstrated in Table 3. The differential inflation rates will affect the exchange rate, SER1. If border distortions stay unchanged, and if the NOER is market determined as opposed to fixed, then NOER will also change in the same proportions as SER1. In spite of the differential inflation rates, the Government can isolate the exchange rate to some extent by increasing the tariff rate on imports and increasing the subsidy rate on exports, that is, by increasing the relative border distortion. Increasing the rate of border distortion has the mathematical effect of decreasing NOER relative to SER1.

6. The same sequence can be reexpressed in terms of the standard conversion factor (SCF). The SCF may be defined as NOER/SER1. It is another way of measuring the distortions between domestic and border prices implicit in the economy.

^a At end of the respective year, SER1 adjusts to maintain purchasing power parity. The nominal official exchange rate adjusts to the combined effect of purchasing power parity and changes in border distortions (measured by SERF). SERF is assumed to be adjusted independently, and is an issue of Government policy.

IV. Capital Movements and Changes in the Exchange Rate

7. Deficits or surpluses in capital accounts have had major impacts on movements in the NOER in the past 15 years. This is true for both developed and developing countries. In the case of the developing countries, aid flows and direct foreign investment represent elements on one side of the capital account, while capital income repatriation and capital flight represent factors on the other side. Aid flows and foreign investment inflows tend to cause the NOER to appreciate, while movements of capital the other way tend to cause it to depreciate.

8. Anticipating major capital movements is difficult, especially in the case of developing countries. In addition, there is a general fear that open prediction of capital movements and exchange rate changes may be destabilizing to international financial markets and may precipitate the changes that are being predicted. However, failure to plan for exchange rate changes can have significant effects on projects.

V. Project Effects of NOER Charges

9. Observation of the various exchange rate concepts outlined above can help in anticipating changes in the NOER. Border distortions will be reflected in the SER1 and SERF calculations. As border distortions increase, pressures on the NOER tend also to increase. While border distortion rates of 15 percent to 25 percent may be considered normal in developing countries, average distortion rates greater than 25 percent and rising often will be indicative of mounting problems. This is particularly true where the distortions are nontariff distortions, for example, quotas, bans, import licensing, and foreign exchange allocation systems that may not be fully reflected in some estimates of the SER1 and SERF.

10. Changes in the NOER during the life of a project may have major positive or negative effects upon profitability. Sensitivity of projects to changes in exchange rates should be tested during project appraisal and steps taken to minimize possible adverse impacts. To facilitate sensitivity analysis of the exchange rate, analysts should maintain separation of traded and nontraded items in the basic project accounts, that is, in the investment budget, the operating budget, the working capital budget, and the revenue budget.

VI. Switching Value for the Exchange Rate

11. A major advantage of maintaining such accounts is that the analyst will be able to calculate a switching value for the exchange rate. The switching value for the exchange rate can be calculated from a project account by relating the net present value of the nontraded goods, discounted at the cutoff rate, to the net present value of the traded goods. This ratio can be referred to as the domestic resource cost (DRC) of earning foreign exchange. The ratio may be used to indicate the exchange rate that would make the project rate of return change to the cutoff rate.

12. In the example in Table 4, the OER at which the project costs and benefits have been calculated is Rs10 to $1, while the DRC for the project turns out to be Rs8.39 per $1. This value gives the switching value for the exchange rate. The project would be viable unless the real exchange rate appreciates to a level of Rs8.39 per $. In most environments, such a strengthening of the exchange rate normally would be considered an unlikely development. Indeed, in most countries the expected change would take the exchange rate in the opposite direction that is, to depreciate. Thus, a project such as this, which uses both imported and local inputs to produce primarily for the export market, would benefit from devaluation of the exchange rate.

13. Where the accounts are set up in constant prices, any expected change in the exchange rate would be a change in the real OER. Since the switching value calculation is a variant of the breakeven price calculation, the price that is used in the accounts must be invariate over the range of the period covered in the accounts.

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