Credibility, speculation and the speed of trade liberalization with an application to Kenya

Abstract

This thesis studies the causes and consequences of the credibility problem in trade liberalization, with a special reference to African economies. The two necessary conditions for credibility are found to be macroeconomic compatibility and time-consistency, while the sufficient conditions are more difficult to identify. A lack of credibility is typically probabilistic as private agents may be uncertain about the government's intentions, or the future terms of trade. The first part of the thesis develops a theory of economic behaviour in the absence of credibility. Due to private responses, incredibility creates a welfare cost which may arise from (i) non-optimal intertemporal substitution in consumption, (ii) accumulation of stocks of imports, (iii) insufficient relocation of factors, and (iv) deferral of investment. A simple consumption model and two production models are used to assess the magnitude of the welfare cost and to derive a cost curve as a function of the probability of default. A non-monotonic curve with kinks emerges. Many standard results concerning the speed of liberalization change drastically when the assumption of full credibility is relaxed. Containing consumption costs would typically call for a gradual reform to reduce the incentive to accumulate inventories, while, from the production point of view, a big bang or initial overshooting are preferable. Gradualism is preferable when (i) reserves may otherwise be depleted by speculative imports, forcing the government to abandon the reform, (ii) only incremental devaluation is possible, or (iii) the level of the implicit tariff is unknown. The second part examines how liberalization episodes can be identified empirically using a quantitative measure of trade policy. The average implicit tariff index, which is the ratio of the domestic deflator to the world price index, is derived for Kenya. As the domestic deflator appears to be biased, a hypothetical implicit tariff index is derived from a Linear Expenditure System. Further, the other empirical study quantifies the social cost of incredibility during four Kenyan reforms. Three hypotheses are tested: (i) speculative accumulation of imports, (ii) deferral of investment, and (iii) increased liquidity in response to perceived uncertainty about future trade policy. The highest welfare cost was incurred during the 1980 reform which was not coordinated with exchange rate management and was therefore incompatible.