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Guidelines for the Economic Analysis of Projects : VII. Valuation of Economic Costs and Benefits
G. Bringing Economic Prices to a Common Base95. If the above principles are followed in estimating economic benefits and costs, then most project effects will be valued at their border price equivalent value. This will apply for traded goods and services, for the opportunity cost of surplus labor, for the opportunity cost of land, and indirectly for nontraded inputs with increasing supply. However, other items, such as the opportunity cost of scarce labor, nontraded products in fixed supply, and especially nontraded outputs, will be valued initially in domestic market price values. These two forms of valuation need to be brought to a common base so that they can be aggregated and compared. 96. The aggregation of costs and benefits requires a unit of account to be established in terms of the currency and the price level in which the analysis is to be conducted. Economic analysis can be undertaken in the currency of the borrowing country or a foreign currency, and at the domestic or the world price level. Bank economic analysis generally will be undertaken in the currency of the borrowing country. For reasons given below, there is also a preference for using the domestic price level to conduct economic analysis. However, there may be circumstances when the world price level is preferred. 97. Domestic market price values differ from border price equivalent values. Generally, domestic prices are higher than world prices. This means that purchasers in the domestic market, in general, place a higher value on imported and exported goods and services than is indicated by the border price equivalent value of those items. The difference between the domestic market price and the world market price equivalent represents the extent to which purchasers are willing to pay above the direct foreign exchange cost or value of the goods and services. The economic price of foreign currencythe shadow exchange raterather than the actual price of foreign currencythe official exchange rateshould be used in the economic valuation of goods and services. The shadow exchange rate is the weighted average of imports and exports in domestic prices to the border price equivalent value of the same goods. 98. The shadow exchange rate is greater than the official exchange rate to the extent that domestic market prices for goods and services exceed their border price equivalent value. Even where the official exchange rate is market-determined, it will differ from the shadow exchange rate. The former is affected by income and capital flows; the latter refers only to goods and services. Where foreign exchange markets themselves have been liberalized, there will remain a difference between the domestic market price and world market price values for traded products, because of trade controls and taxes, and monopolized markets. 99. The shadow exchange rate is estimated by comparing the demand for, and supply of, foreign exchange for trade purposes. Where demand and supply are elastic with respect to price, the shadow exchange rate can be estimated by directly comparing the domestic market price value of all traded products with their world market price value. The shadow exchange rate factor (SERF) is calculated as the ratio of the shadow exchange rate to the official exchange rate. This factor will generally be greater than 1. The SERF is applied to all outputs and inputs, including labor and land, that have been valued at border price equivalent values. Project effects measured at domestic market price values are left unadjusted. In this way, all project effects are brought to a common basis of measurement in the currency of the borrowing country at the domestic price level. 100. This method of adjusting border price equivalent values to the equivalent domestic price level is called using the domestic price numeraire. Project effects, as far as possible, are still measured at border price equivalent values. These values are reexpressed to correspond to the level at which the remaining project items are measured. This use of the domestic price to express all economic costs and benefits has the distinct advantage of corresponding to the price level at which the constant price financial analysis is undertaken. The distribution of net economic benefits among project participants can therefore be traced more easily in assessing financial and fiscal sustainability, as well as affordability and acceptability (see Section XII). 101. An alternative approach can be used to adjust all project items to a common basis of comparison. Domestic market price values are in general higher than border price equivalent values. Instead of adjusting border price equivalent values upward, using the SERF, the domestic market price values of project items, measured through willingness to pay or other nontraded measures, can be adjusted downward. This can be done using the standard conversion factor (SCF), which is simply the inverse of the SERF. It represents the extent to which border price equivalent values, in general, are lower than domestic market price values. It is applied to all project items valued at their domestic market price to convert them to a border price equivalent value. If this is done, they can be aggregated together and compared with all other project items valued at their border price equivalent values, in the currency of the borrowing country at the world price level. 102. Use of the standard conversion factor in this way is called using the world price numeraire. Most project effects are still measured at border price equivalent values. All project effects are brought to this level of valuation. The use of the world price numeraire may be preferred in small open economies, where it is simple to think in foreign exchange terms. It may also be preferred in transitional economies, where there remain numerous administered prices or subsidized enterprises and products. In the latter case, the unit of account may also be changed. Instead of expressing all effects in domestic currency, project effects may be expressed in foreign exchange units directly, but still using the standard conversion factor as well as the official rate of exchange to convert nontraded values to border price equivalent values. However, use of the world price numeraire in domestic or foreign currency units when assessing economic viability means that to make further comparisons with the distribution of net financial benefits in sustainability analysis, project effects would all have to be converted back to domestic market price values. 103. Estimation of the shadow exchange rate factor or the standard conversion factor can be done from time to time on a country basis. Which is applied, that is, which numeraire is chosen for the analysis affects the absolute value of economic costs and benefits, but not the economic internal rate of return (EIRR) of the project. All values using the domestic price numeraireboth costs and benefitswill be greater than the corresponding values using the world price numeraire by a fixed amount given by the SERF. Conversely, all values using the world price numeraireboth costs and benefitswill be less than their domestic price equivalent by a fixed amount given by the SCF. Of course, it is important not to confuse the two methods by using both the SERF and the standard conversion factor together. However, if the shadow exchange rate factor and standard conversion factor have been consistently estimated, that is, if one has been estimated from the other, then there will be a fixed proportion between all costs and benefits using the two methods, and, correspondingly, the EIRR will be the same. The choice of which numeraire to use will depend on how easily the analysis of economic viability fits together with the analysis of financial and fiscal sustainability. 104. The SWRF can also be expressed in both numeraires. The ratio between the economic and financial cost of labor for different categories forms the basis of the SWRF. Where the economic costs are measured in domestic market price values, the SWRF can be used directly in a domestic market price analysis. Where economic viability is being measured in world market price values, the SWRF also has to be expressed in world market price values, using a specific or the standard conversion factor. Hence, the SWRF for domestic market price analysis is multiplied by the specific or standard conversion factor to give the equivalent SWRF for world market price analysis (see Appendix 15).
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