Foreign trade, resource allocation, and structural adjustment in Yugoslavia : 1976-80

DISCUSSION PAPER 1 FOREIGN TFADE, RESOURCE k.LLOCATION, I AND STRGCTURAL ADJUSTMENT I N YUGOSLAdIA: 1976-8C Sherman Robinson The Warld Bank Laura D'Andrea Tyson ' University of California, Berkeley September 1983 Development Research Department Economics and R e ~ a r c hStaff World Bank The views presented here a r c those of the author, and they should a o t be interpreted a s reflecting those of the World Bank  Abstract: This paper u t i l i z e s a multisector, computable general equilibrium (CGE) simulrtion model t o analyze Yugoslav economic performance during the 1976-80 period. The model is used f o r a variety of purposes. F i r s t , it is applied t o an evaluation of the sectera1 investment p r i o r i t i e s of the 1 9 7 6 8 0 plan. Second, it is used t o assess the incentive e f f e c t s of alternative i n s t i t u t i o s mechanisms f o r allocating foreign exchange. Finally, the model i s used t o explore the relative contribution of domestic and external factors t o the foreign exchange crisis that began t o develop i n 1979-80. The paper demonstrates the usefulness of the CGE methodology for two related purposes: estimating the incentive e f f e c t s of policy actions on the behavior of decentralized economic actors; and doing controlled, counterfactual - experiments t o s o r t out the individual e f f e c t s of a number of simultaneous, interdependent factors affecting ecor~omfcperformance.  Table of Contents - 1. Introduction 2. The CGE Model Production and Employment Foreign Trade Demand and Prices 3. The Policy Environment, Incentives and Resource Allocation: 1976-80 A. T h a . ~ o c a t i o nof Capital %*A m.,q.~.da- L. The U l o c a t t o n of Foreign Exchange The Incentives f o r Rent Seeking The Bia? i n Trade Incentives 4. The Sources of the Foreign Exchange Crisis of 1979-80 5. Conclusion Appendix: Mathematical Presentation of the CGE Model References  1. Introduction During t h e l a s t decade, t h e Yugoslav economy weathered a number of shocks. Externally, t h e r e were two rounds of i n c r e a s e s i n t h e p r i c e of o i l , two worldvide recessions, changes i n t h e r e l a t i v e p r i c e s of both exports and imports, and s h i f t s i n major export markets--including major changes i n t h e composition of t r a d e with E a s t and West Europe. I n t e r n a l l y , t h e r e were major i n s t i t u t i o n a l refcrms i n 1974-76 and continuing p o l i t i c a l s t r a i n over t h e e n t i r e period on t h e a b i l i t y of policy makers t o respond t o the various challenges facing t h e economy. Since 1979-80, problems with foreign t r a d e have domiriated a s e c o n o d c performance has become s t e a d i l y more severely cunstrained by shortages of foreign exchange. The economic problems t h a t Yugoslavia has faced, and is facing, a r e a l s o evident i n a number of o t h e r semi-industrial countries.L1 And t h e policy debate i n Yugoslavia a l s o , h a s p a r a l l e l s i n o t h e r countries. Do t h e s e problems o r i g i n a t e i n e x t e r n a l shocks o u t s i d e t h e c o n t r o l of Yugoslav policymakers, o r a r e they due t o f a i l u r e s i n domestic policy? What is t h e a p p r o p r i a t e response t o changes i n e x t e r n a l conditions? Are major changes necessary i n t h e way resources a r e a l l o c a t e d among s e c t o r s and i n t h e r o l e of market incentive mechanisms i n t h e system? Are t h e problems primarily macroeconomic o r " s t r u c t u r a l " and what should be t h e mix between "expenditure-reducing" and "expenditure-switching" g o l i c i e s ? Answering t h e s e questions r e q u i r e s I I knowledge both about t h e s t r u c t u r e of t h e economy--how t h e economy functions d i f f e r e n t shocks t h a t must be d e a l t with. . -11 For a survey, see Balassa (1982).  I n t h i s paper, we analyze some of these i s s u e s within the framework of a multisector, computable general equilibrium (CGE) model of the Yugoslav economy. Such models have been used t o analyze issues of s t r u c t u r a l adjustment i n other countries, but t h i s is the f i r s t attempt t o apply them t o a s o c i a l i s t c o u n t r y Y The framework is useful becsuse it permits a n a l y s i s t h a t can only be done with an empirical model t h a t e x p l i c i t l y incorporates s t r u c t u r a l r e l a t i o n s h i p s and market interactions. We dse the model f o r tvo related purposes. F i r s t , by simulating t h e workings of the economic system, the model w i l l provide information about variables which a r e not o b s e r v a b l e ~ i v e nexisting dapa. For example, t h e model generates information about equilibrium values f o r variables sucn a s the exchange r a t e , market prices, and msrginal revenue praducts f o r f a c t o r s of production (labor and c a p i t a l ) . Such information is extremely useful i n evaluating t h e efficiency of resource a l l o c a t i o n and the s t r a i n s imposed on t h e system by shortages of foreign exchange. Second, the model can be used a s a simulation laboratory f o r doing controlled, counterfactual experiments. One can ask "what i f " questions, and measure the impact on the economy of individual shocks. Such experiments can be used t o s o r t out the r e l a t i v e importance of the d i f f e r e n t shocks t h a t have beset Yugoslavia simultaneously over the p a s t few years. A model is necessary f o r t h i s purpose because nature . is rarely kind enough t o provide the kind of controlled experiments i n - economics t h a t other s c i e n t i s t s can do i n t h e i r laboratories. 3 t - I n the next section, we &scribe the CGE model we have b u i l t f o r w r Yugoslavia. We then use the modei t o analyze Yugoslav performance i n t h e m 1976-80 period. We f i r s t consider the policy environment, focusing on i s s u e s -21 Some work is underway i n Hungary. See Zalai (1982).  of i n c e n t i v e s and t h e e f f i c i e n t a l l o c a t i o n of f a c t o r s of production, including c a p i t a l and foreign er:ha7ge. We then explore the o r i g i n s of t h e emerging f o r e i g n exchange crisis t k a t ha6 dominated t h e scene s i n c e 1980 and use t h e model t o determine t h e r e l a t i v e importance of d i f f e r e n t c o n t r i b u t i n g f a c t o r s . F i n a l l y , we g i v e some conclusions, discussing t h e l i m i t a t i o n s of t h i s type of a n a l y s i s and providing some suggestions f o r f u r t h e r research. 2. The CGE Model The model of Yugoslavia used i n t h i s a r t i c l e is i n t h e family of m u l t i s e c t o r computable g e n e r a l equilibrium (CGE) models t h a t have been developed during t h e p a s t few years a s icstruments of planning and policy a n a l y s i s f o r developing economies.-?! The CGE model f o r Yugoslavia, l i k e t h o s e designed and estimated f o r o t h e r developing economies, t r a c e s t h e evolution of s e c t o r a l outputs and r e l a t i v e p r i c e s over t i m e i n response t o changing conditions of supply and demand oil individual markets. The model embodies t h e view t h a t economic performance is the outcome of decnntralized d e c i s i o n s made by producers end consumers i n response t o market i n d i c a t o r s . Such i n d j c a t o r s , i n t u r n , a r e influenced by government policy choices, i n t e r n a t i o n a l economic conditions, and other v a r i a b l e s t h a t a r e exogenous from t h e point of view of producers and consumers who respond t o them. It is important t o emphasize a t I I 0 t h e o u t s e t t h a t t h i s view of t h e economy does not imply t h a t markets a r e p e r f e c t o r t h a t the d e c i s i o n making of producers and consumers is n e c e s s a r i l y guided by n e o c l a s s i c a l r u l e s of p r o f i t maximization and u t i l i t y maximization.. - Instead, t h e s p e c i f i c a t i o n of t h e model e x p l i c i t l y r e c o g n i z v the e x i s t e n c e of . r i g i d i t i e s and imperfections i n t h e economy and attempts t o model them formally. -3/ See Dervis, de Melo and Robinson (1982).  The emphasis on markets and market-clearing mechanisms i n the CGE model r e f l e c t s the view t h a t the independent behavior of decentralized producers and consumers plays a s i g n i f i c a n t role i n influencing economic performance. I n t h i s way, t h e model diverges from t r a d i t i o n a l planning models, such a s input-output o r l i n e a r programmming models, i n which e i t h e r fixed technological c o e f f i c i e n t s andi,r c e n t r a l planning of economic a c t i v i t y constrain o r eliminate decentralized choices. Decentralized decision making i n response t o market i n d i c a t o r s is fundamental t o the i n s t i t u t i o n s of t h e Yugoslav economic system, and it is d i f f i c u l t t o analyze a l t e r n a t i v e development s t r a t e g i e s without a framework t h a t captures the main i n s t i t u t i r n s and behavioral r u l e s of the system. The CGE model provides such a framework. The Yugoslav model, l i k e CGE models f o r other economies, is divided )*I' i n t o a s t a t i c , annual general equilibrium model and a separate between-period model which provides the necessary intertemporal linkages. The model and its data base a r e described i n d e t a i l i n separate appendices available from the authors on request. The discussion here focuses only on the main d i s t i n c t i v e features of the model. An e q u a t i o ~summary is given i n an annex. Production and Employment . I There a r e 18 sectors of production, or product markets, i n the Yugoslav model, chosen t o r e f l e c t the p r i o r i t i e s of the 1976-80 Social Plan. The model assume': t h a t each sector produces a single good and for each good the model formal zes conditions of supply and demand. & Prices a r e assumed t o I, influence supply and demand decisions i n each sector. On the supply s i d e , it is necessary t o specify for each sector of production the technological 1 conditions and behavioral r u l e s that influence supply conditions i n response t o changing prices. Technological conditions a r e given by an estimated  production f m c t i o n fo:: each sector. I n most CGE models, t h e usual p r a c t i c ? is t o assume profit maximization a s the behavioral rule, guiding input and output choices under d i f f e r e n t market conditions, given t h e assumed technology. I n t h e Yugoslav CGE model, t h e u s u a l assumption of p r o f i t maximization is replaced by a s e t of r u l e s t h a t attempt t o capture t h e behavior of self-ranaged f i r m s during t h e 1976-80 period. The s p e c i f i c a t i o n i n c o r p o r a t e s two b a s i c f e a t u r e s of such behavior: r i g i d i t i e s i n labor employment l e v e l s t h a t l i m i t t h e supply responsiveness cC t h e firm t o changes i n product market conditions; and payment r u l e s t h a t produce a divergence between t h e marginal value product of l a b o r and t h e personal income t h a t l a b o r receives. We assume t h a t output decisions of self-managed firms a r e guided by a form of constrained p r o f i t maximization.Ll Firms a r e assumed t o t r e a t a p o r t i o n of t h e i r lab02 f o r c e a s fixed i n t h e short run, r e f l e c t i n g t h e f a c t t h a t l a y o f f s o r reductions i n employment a r e e i t h e r severely r e s t r i c t e d by law o r a r e i n c o n s i s t e n t with t h e l i k e l y behavioyal r u l e s of self-management./ Decisions about t h e amount of v a r i a b l e l a b o r t o be used a r e guided by a "planning" o r "accounting" wage. For a given s e t of product market p r i c e s and a given plapning wage, t h e demand f o r v a r i a b l e l a b o r is s e t , u h e r e t h e planning wage equals t h e marginal value product of v a r i a b l e labor. Distinguishing . . ...,:, ,.. .. .. . .... , -. ., . : C. I - .. ,.,.,: .. . . ' , . , . s t , , L:>r -. ..>.c.c 7<- v , , 01-?.?',-rn~?+ .."-.... - *? % <.:$",. . ..%*-.Lw. . ~ v a r i a b i l i t y and supply responsiveness r e l a t i v e t o what they would be i n a - .. . model of f i r m behavior based on unconstraine? p r o f i t maximization. - 41 The model of f1.m behavior is s i m i l a r t o t h e " r e a l i s t i c " model of t h e Yugoslav self-managed firm proposed by Horvat (1967). 5/ Within each s e c t o r , t h e d i s t r i b u t i o n of t o t a l employment between v a r i a b l e and f i x e d labor is s e t exogenously, with lower s k i l l and edrlcational c a t e g o r i e s t r e a t e d a s v a r i a b l e labor and higher s k i l l and educational c a t e g o r i e s t r e a t e d a s fixed labcr.  The specified behavior amounts t o assuming that firms maximize "accounting profits" while valuing labor a t the planning wage. The model then solves endogenously f o r the average planning wage that induces firms collectively t o h i r e t h e t o t a l supply of variable l a b o r b / The t o t a l supply of variable labor is specified exogenously, but its sectoral composition varies i n response t o the hiring behavior of individual sectors. Within a period, both fixed labor and c a p i t a l are assumed t o be immobile o r sector specific. Given the production technology and assumed behavior, a model solution generates estimates of the marginal value products of fixed labor and c a p i t a l (which w i l l , i n general, d i f f e r across sectors), a s well a s of variable labor. The model thus generates a complete s e t of factor returns t h a t can be used a s "shadow prices" t o indicate the extent t o which resources a r e e f f i c i e n t l y allocated i n the economy. The modt.1 of firm behavior distinguishes between the planning wage t h a t t h e firm uses i n deciding the employment of variable labor and the actual personal incomes paid t o firm members. Incose payments a r e seen a s consisting of two parts: a planning wage component and a component that r e f l e c t s the workers' share i n the firm's net income. The s i z e of the s e c ~ n dcomponent depends on both the l e g a l and contractual obligaticns affecting the 0 d i s t r i b u t i o n of enterprise income and on the firm's decision about what p a r t q f I t 4 J!~rl~l';.,hl~~C * n ~ r ' yr)r d f ~ : t i F : : ~ " ~ ....--'.--T-. F , ~ ~ T::6jl.. . : l i q , y . 7 1 -.., LI..~,:,~ & . ~ . shares a r e given by various \ ~ i s t o r i c a l l yestimated fixed coefficients, but - & * they can be adjustea t o r e f l e c t policies designed t o influence f i r m ?cisions . - 6 / The current vei'sion of the Y ~ j o s l a vCGE model s e t s the levels of t o t a l employment and t o t a l unemployment exogenously. Combining exogenDus I information about t o t a l employment and its composition between fixed and variable labor i n each sector, the model calculates the t o t a l supply of variable labor actually supplied and empl~yedand solves f o r the planning I wage that induces firms t o h i r e t h i s amount of variable labor.  about saving and personal income payments. Alternative model runs with d i f f e r e n t assumptions about e n t e r p r i s e d i s t r i b u t i o n a l decisions a r e very u s e f u l f a r policy a n a l y s i s - Foreign Trade I n the current version of the model, s e c t o r a l exports and net foreign c a p i t a l inflows (vhich include remittances, net f a c t o r income f r o s abroad, n e t c a p i t a l flows, and changes i n reserves) a r e s - e c i f i e d exogenously. The model thus focuses on how foreign exchange is used, r a t h e r than on how it is earned. While CGE models can be, and have been, specified with endogenous exports and foreign c a p i t a l inflows, such a treatment is not r e a i l y f e a s i b l e f o r t h e 1976-80 period i n Yugoslavia. During t h a t period, exports and foreign c a p i t a l inflows were extremely v o l a t i l e and did not r e f l e c t the workings of s t a b l e relationships which could be estimc?ted. Treating them exogenously, however, permits parametric v a r i a t i o n t o explore the importance of a l t e r n a t i v e assumptions. The model assumes t h a t domestically produced tradeable goode and imports a r e imperfect s u b s t i t u t e s . For each tradeable sector, there is a "composite" good which is a CES aggregate oz domestic and imported goods and which is demanded by consumers. E l a s t i c i t i e s of s u b s t i t u t i o n vary a c r o s s s e c t o r s , w i t h the lowest e l a s c i c l c ~ e b~n rdu u h c e r i d l dtld ~ d p i c d *&"uu:, sectors. Given t h i s s p e c i f i c a t i o n , the demand f o r imports depends on the r e l a t i v e p r i c e of domestically produced and .imported goods i n the domestic market. The world price of imports is fixed (the "small country" assumption), but t h e i r p r i c e i n the domestic market depends on the o f f i c i a l exchange r a t e ,  t a r i f f s , and premia (if m y ) 2 Thus trade policy can have important e f f e c t s on import demand. This treatment of imports conveys a certain autonomy to the domestic price system and a l s o allows f o r the possibility of two-way trade (which is. commonly observed a t an eighteen-sector level of aggregation). A pure non- traded sector whose r e l a t i v e price is e n t i r e l y determined i n the domestic market is one for which there a r e no exports or 5mports. For other sectors, the r e l a t i v e price depends on commercial policy embodied i n the exchange r a t e , t a r i f f s , and subsidies. The relative importance of each of these factors i n determining domestic prices depends on the relative importance of imports and exports i n t o t a l domestic supply, a s well a s on the trade substitution e l a s t i c i t i e s . I n the model, the t o t a l deaand for foreign exchange is determined by summing desired imports across a l l sectors. This t o t a l is compared with the supply of foreign exchange a r i s i n g from exports and foreign capital inflows. In model simulations with d flexible exchange r a t e , the exchange r a t e i s * assumed t o adjust t o equate the demand and supply of foreign exchange. The model can a l s o be run with a fixed exchange rate, i n which case some other mechanism must be specified t o achieve balance i n the foreign exchange I r market. In h i s t o r i c a l runs, we have attempted t o capture i n a stylized way the major elements of the mechanism for allocating foreign exchange that oper$ed i n Yugoslavia i n the 1976-80 period. The resuit is a cowbination of - 71 When importers are forced t o pay a premiua above the o f f i c a l exchange r a t e t o obtain the foreign exchange they need, the domestic price of imports i n sector i is given by: PDi = ER(l + tmi + PR) . PWi where ER i s the o f f i c i a l exchange r a t e , t m i is the tariff rate in sector i, PR is the import premia, and PWi is the world price i n dollars. See section 3B of t h i s paper for a discussion of premium rationing of foreign exchange i n Yugoslavia during the 1976-80 period.  q u a n t i t y end premium rationing of imports which ~111 deccribed be I 3more d e t s l l below. Demand and Prices The demand s i d e of t h ~ .model works by t r a c i n g through the incones generated i n the productive s e c t o r s of the economy an! the various demands they induce. There a r e three categories of income i e c i p i e n t s whdse behavior is modelled: productive enterprises; households; and the government (or nonproductive sector). The model contains an elaborate set of accounting and behavioral r u l e s t o determine hov value added (or f a c t o r income) is d i s t r i b u t p d among income recipients., To complete the c i r c u l a r flow, the s a v i n s and expenditure behavior of each income r e c i p i e n t is specified, leading t o demands f o r s e c t o r a l output f o r consumption and investment. For a given s e t of f a c t o r prices, s e c t o r a l domestic prices and t h e exchange r a t e , the model generates both s e c t o r a l supplies and demands. Market c l e a r i n g requires t h a t prices a d j u s t u n t i l supplie? and demands a r e equal, and t h e t a s k of the model's solution algorithm is t o f i n d t h i s s e t of equilibrii~m prices (and planning wages)./ A solution represents an economywide equilibrium i n the markets f o r products, labor, and Eoreign exchange, given the various c o n s t r a i n t s specified on t h e way markets work and on t h e t o t a l supplies of labor and capital. - resources a r e a l l o c a t e d e o n g s e c t o r s according t o neoclassicsl laws of supply a:d demand. Such an assumption does not seem warranted il the case of Yugoslavia where markets f o r c a p i t a l , labor, and foreign exchange as - 81 The accounting framework used is t h a t of a s o c i a l accounting matrix (SAM). - 91 For a discussion of solution algorithms, see Dervis, de Melo and Robinson (1982), Appendix B.  t r a d i t i o n a l l y conceived t o not e x i s t . In contrast, however, product markets do e x i s t , and i t is a fundamental assumption of the CGE model t h a t supply and demand decisions on these markets respond to prices. A model s o l u t i o n thus does noi represent a neoclassical, free-market equilibrium, but instead is a n equilibrium :onstrained by behavioral and i n s t i t u t i o n a l r e s t r i c t i o n s which represent a reasonable picture of the Yugoslav eccnomy. 3. The Policy Environment, Incentives and Resource Allocntion: 1976-80 A. The Allocation of Capital A s a r e s u l t of the i n s t i t u t i o n a l reforms t h a t occurred between 1974 and 1376, administrative guidance over c a p i t a l a l l o c a t i o n increased during t h e 1976-80 plan period. Under the new i n s t i t r i t l o n a l arrangements, banks, e n t e r p r i s e s , and f e d e r a l , regional and communal government organizations were obliged t o furmulate and execute self-management agreements and s o c i a l compacts t o finance investment p r o j e c t s i n designated "priority" s e c t o r c of deve.lopment-lO/ A t l e a s t according t o the design of these new arrangements, investment projects f o r p r i ~ r i t ys e c t o r s were t o be prepared i n advance and t h e i r financing was t o be mandatory, with financing f o r investment i n non- 7 r i o r i t y sector3 t o be determined residually. According t o the 1976-80 plan, t h e p r i o r i t y s e c t o r s included the following: e l e c t r i c a l energy; coal extraction; o i l and gas extractton and refining; f e r r o u s metals; nop-ferrous metals; basic chemicals; extraction of non-metallic rdnerala; m c h i n e r y a d , - - 1.. t , . . . . 1 ! ,: ,,,..; ,.>..!,:,' .,' -.. . , ! F2rr![J? ; f- ., :,I ' ; b . * , , ? t . ' 3" . . ..,: . : : i . 7 .).::-:. I '2 / Together, these sectr-rs were t a r g e t t e d t o receive about 65% of t o t a l - - 1 I inv&tment i n fixed a s s e t s during the 1976-83 period,yup from t h e i r r e a l i z e d j share of about 53% during the 1971-75 period. 1 '-101 i h e formal workings of the uew system of self-management agreements and I s o c i a l compacts a r e described i n Tyson (1980) and Schrenk e t a l . (1979). i  The new system of p r i o r i t y a l l o c a t i o n was motivated by concern over s t r u c t u r ~ 1disproportions i n the economy, the most basic of which was thought t o be t h e r c l a t i v e und2rdevelopment of the energy and raw material s e c t o r s compared t o s e c t o r s producing manufactured goods and services. Sharp increases i n t h e r e l a t i v e p r i c e s of energy and raw n n t e r i a l s on both domestic and world markets during the 1971-75 period hightened t h i s concern. The introduction of a p r i o r i t y a l l o c a t i o n scheme t o reduce s t r u c t u r a l disproportions r e f l e c t e d an implicit assumption of Yugoslav policy makers t h a t i n t h e absence of such a scheme, the decentralized investsent decisions of self-managed e n t e r p r i s e s and banks would not eliminate domestic capacity c o n s t r a i n t s i n energy and raw materials. Analytically, such an assumption might be defended on t h e grounds t h a t t h e expected r e t u r n on p r i o r i t y s e c t o r investment from a s o c i a l point of view exceeded the expected r e t u r n a s perceived by individual e n t e r p r i s e s and banks. Certainly, t h i s kind of argument is applicable t o c e r t a i n kinds of p r i o r i t y sector investments, e s p e c i a l l y i n e l e c t r i c a l energy, i n f r a s t r u c t u r e and high-risk a c t i v i t i e s , such a s o i l exploration. For other kinds of p r i o r i t y s e c t o r investments, however, the reasons f o r possible divergences between s o c i a l and private r e t u r n s a r e not obvious. TG t h e Yugoslav case, one reason suggested by policy nnkers and Cconomists a l i k e was the existence of domestia price d i s t o r t i o n s t h a t depressed the r e l a t i v e prices of energy and raw n n t e r i a l s , thereby reducing - the expected return on investment i n suc~lprouucts. G n i o i i u u d i d l ~ , iithuu; ii ' .e - mu. . & full-scale comparison of domestic and world prices, it is impossible t o assess, -- .. 8 e t h e extent of such p r i c e distlbrtions and t h e i r e f f e c t s on the r e t u r n s on investment i n d i f f e r e n t sectors.  Using the CGE model, nowever, it is possible t o determine whether i n t h e absence of a p r i o r i t y allocation scheme decentralized investment decisions i n respcqse t o market indicators would have pulled investment resources i n ' t h e direction of p r i o r i t y sectors. The CGE model permits the calculation of what r i g h t be called "market p r o f i t a b i l i t y " r a t e s or r a t e s of return on c a p i t a l a t the sector.11 level. These p r o f i t a b i l i t y r a t e s a r e measured by the model's estimates of the gross marginal value product of c a p i t a l i n each sector under actual market and policy conditions. Within the model, these r a t e s of return a r e interpreted a s indicators of p r o f i t a b i l i t y that guide decc:tralized investment decisions. Table 1 presents a comparison of nnrket p r o f i t a b i l i t y rates, a s defined above, f o r the 1976-80 period. Overall, the r e s u l t s seem t o Pupport t h e view t h a t i n the absence of 3 p r i o r i t y allocation mechanism, decentralized investment decisions would not have pulled investment resources i n t o several of the p r i o r i t y sectors, including e l e c t r i c a l energy, ferrous metals, nonferrous metals, chemicals and paper, and food processing. These sectors received about 60% of the tote1 p r i o r i t y investment e f f o r t during the 19'6-80 period. In the p r i o r i t y energy and raw material sectors of coal, o i l and gas, and non-metallic minerals and construction nnterials, market p r o f i t a b i l i t y r a t e s verre above the average f o r a l l i n a . ~ s t r yand were competitive with those realized i n the manufactured goods sectors of machinery, transportation - - . , . . vldw A L . e c l j l * i ~Ud .ilL O L ) I ~ , , C L~ j ~ e t h a t market and policy conditions i n Yugoslavia systematically worked t o the r e l a t i v e disadvar'tage of energy and raw material producers and t o the r e l a t i v e advantage of manufactured goods producers, a t l e a s t during the 1976-80  periodJL1 The f i g u r e s suggest t h a t even i n the absence of the p r i o r i t y a l l o c a t i o n scheme, investment resources would have been a t t r a c t e d t o these s e c t o r s during t h e 1976-80 period, r e f l e c t i n g t h e i r enhanced p r o f i t a b i l i t y i n response t o changing market conditions. Finally, it is i n t e r e s t i n g t o compare market p r o f i t a b i l i t y r a t e s between services and industry, e s p e c i a l l ) since the p z i o r i t y scheme c a l l e d f o r an increase i n industry's share of t o t a l investment resources (from about 47% between 1971 and 1975 t o about 51%between 1976 and 1980), a share t h a t was q u i t e high when compared t o performance i n other economies a t similar development levels. According t o the figures i n Table 1, the o v e r a l l p r o f i t a b i l i l t y of services--defined t o include a l l nonagricultural a c t i v i t i e s outside of the i n d u s t r i a l manufacturing sectors--was about twice the average p r o f i t a b i l i t y of industry. Within services, p r o f i t a b i l i t y was g r e a t e s t i n construction, trade and other productive services ( c r a f t s , tourism and catering, and other personal and professional services). Indeed, these three a c t i v i t i e s consistently realized t h e highest p r o f i t a b i l i t y r a t e s i n the e n t i r e economy, y e t none r f them, with the exception of tourism within the productive service sector, was designated a p r i o r i t y sector. Taken together, the r e s u l t s support the implicit assumption . t underlying the p r i o r i t y a l l o c a t i o n mechanisnr-namely that' i f investment decisions were guided by decentralized market indicators, then the desired - reallocation of '+vestment toward c e r t a i n p r i o r i t y s e c t o r s would not occur. A proponent of t h e G f f i c i e n c y of markets might conclude t h a t t h i s evidence t 0 -li/ This finding r e f l e c t s the f a c t t h a t the producer prices of intermediate gotds rose more ra?idly than o v e r a l l i n d u s t r i a l prices and the prices of manufactured invcstmeilt goods over the e n t i r e 1970-79 period. A l l of the priorCty s e c t o r s (with the exceptions of non-metallic minerals and chemicals) benefitted from l a r g e r e l a t i v e price increases over t h i s period, with p a r t i c u l a r l y large increases f o r e l e c t r i c i t y , coal and o i l .  Table 1 Relative Market and Social P r o f i t a b i l i t y Rates by Sector of Production Social Prof i t a b i l i t y Rates3 - - ... Sector of Production Market P r o f i t a b i l i t y Rates .&I 1976 1980 avg. - - 1980 1980 Industrial average E l e c t r i c a l energy Coa1 O i l and gas Ferrous minerals Nonferrous minerals Non-metallic minerals and construction materials Machinery Transportation equipment E l e c t r i c a l equipment Chemicals and paper Consumer goods and other l i g h t manufactures Food processing Services Construction Infrastructure Trade Other pro uctive services, 27 - 1/ Ratio of sectoral profitability r a t e t o average p r o f i t a b i l i t y r a t e i n industry. P r o f i t a b i l i t y i n each sector is measured a s the gross marginal value product of - capital. Market.grofitability r a t e s are b s e d on simulation, r e s u l t s of the CGE model , that attempt t 8 c a p t u r e the actual market and policy conditions i n Yugoslavia during - the 1976-80 period. Social prof i t a b i l i t y r a t e s are based on a "shadow-price" simulation described i n the text. - i i lllcludeti crai KG, tourism and caterirrg and other.groductive personal and professional - L services. - -- - 8 . r  demonstrates t h a t some of the p r i o r i t y sectors chosen by the planners were the wrong ones, implying a movement of investment resources toward r e l a t i v e l y unprofitable uses. No such conclusion is warranted, however, since the market i n d i c a t o r s of p r o f i t a b i l i t y were themselves affected by underlying d i s t o r t i o n s i n t h e Yugbslav markets f o r c a p i t a l , labor, and foreign exchange. Finally, t h e tension e x i s t i n g betveen market p r o f i t a b i l i t y i n d i c a t o r s and plan p r i o r i t i e s suggested by the r e s u l t s explains i n part why the share of the p r i o r i t y s e c t o r s i n t o t a l investment a c t u a l l y f e l l short of t a r g e t during t h e 1976-80 p e r i o d s ! To the extent t h a t enterprises and banks were a b i s t o circumvent the p r i o r i t y system t o d i r e c t t h e i r investment e f f o r t s t o p r o f i t a b l e a c t i v i t i e s , one would have expected the a c t u a l investment share of manufactured goods i n d u s t r i e s and services t o exceed its t a r g e t , a s it did i n practice. Finally, tension between market indicators and s e c t o r a l p r i o r i t i e s , coupled with autonomous pressure f o r investment i n the nonproductive s e c t o r , played a r o l e i n the excessive growth of investment demand that s p i l l e d over i n t o macroeconomic imbalance during the 1976-80 For a v a r i e t y of reasons, the mechanisms f o r d i r e c t i n g investment resources toward p r i o r i t y s e c t o r s were not a s e f f e c t i v e a s p l a n n e d . x l A s a consequence, the attempt t o r e a l i z e investment p r i o r i t i e s resulted i n the financing of a l a r g e r than - , . . -i 2 / I , c L c ) L C ; ~ L ~ ~LC)p;dri i ~ l ; L ; l i i ~ c . . ; L ~ y r ; t ; u ' i d i A r i > l i c::-r- h., - , -- 2 : \ 7 : > 3 . ;.,, .:. - . . - -1 ! A / A the p r i o r i t y s e c t o r s i n t o t a l productive investment i n fixed a s s e t s '! c--..!,,& reached about 60% d u r b g the 1976-80 period, a s compared t o the t a r g e t hare of about 65%. . - *-.. -131 In Yugoslav terminology, nonproductive investment r e f e r s to investment i n the government s e c t o r and investment i n housing. Nonproductive investment accounted f o r an average of nearly 40% of the t o t a l investment i n f i s c a l a s s e t s over the 1976-80 period. -141 For a discussion of the d i f f i c u l t i e s encountered i n controlling both the absolute l e v e l and the composition of Investment during the 1976-80 period, see Tyson (1980, 1983).  s u s t a i n a b - d +-tment e f f o r t through excessive credit creation and foreign.b- c,-i5rr~m the tension between market p r o f i t a b i l i t y indicators ,. and the :d- y allocation of investment, there remains the question of whethe=- sectors themselves were correctly chosen. Assigning priority*#aassz-e sectors entailed c e r t a i n r i s k s , since it implied endorse-,- k&iik:spectrum of projects, not a l l of which necessarily m e r i t e d , s m . ~ a a a n e e n t . Nevertheless, given the f a c t t h a t the sector was t h e u n i t e s ~ ~ t B & e Yugoslavs i n t h e i r system of priority allocation, it is re1ev-W-her the selection was desirable, i n l i g h t of Yugoslav&&@-iource endowment. 1-33id.s question, it is necessary t o begin with some standard a g a i n s t - - s - m r E a a t e the s o c i a l p r o f i t a b i l i t y of a given investment a l l o c a t i o ~ . ~ ~ n n lii tne rga t u r e , the usual approach is t o calculate - returns.+o&K m a s e d on a s e t of shadow prices t h a t attempt t o r e f l e c t product % a m +ket conditions that would prevail i n the absence of .. market d- =is approach can be incorporated i n the CGE framework by s i m u l a t i a ~ ~ t i o thats would exist in the absence of such n d i s t o r t i o ~ ; ~ s s d f lof ssuch simulations provide estimates of "social t r p r o f i t a b i ~ ~ z k i m z r a ofk return on c a p i t a l a t the sectoral level,' t m e a s u r e d a a ~ ~ m ~ ~ ~ rvaluen product of c a p i t a l i n each sector under g i a l the assummwi.-f ree" market conditions. ZWite-Auarmuedns estimates of sectoral s o c i a r p r o f i t a b i l i t y r a t e s f o r Y u g o s l a v i W l ~ ~a m CGE model simulation that at'tempts t o abstract from market di.-sascmed by eectoral differences in: s a l e s (turnover) taxes; t a r i f f s ; ;e--es; non-tariff import r e s t r i c t i o n s ; and planning wages. - 1 m t a b i l i t y r a t e s a r e generated i n a CGE solution that  incorporates t h e following features: (1) the exchange r a t e is allowed t o a d j u s t t o equate the demand and supply of foreign exchange, thereby eliminating any rationing of foreign exchange and any non-tariff i s p o r t r e s t r i c t i o n s ; (2) a l l t a r i f f s , export subsidies and turnover taxes a r e set equal t o zero; (3) a constant value-added tax is applied t o a l l sectors t o generate t h e l e v e l of government revenues a c t u a l l y realized i n 1980; and (4) t h e marginal value product of variable labor (or the shadow wage) is equalized across a l l i n d u s t r i a l and service s e c t o r s , assuming variable labor is p e r f e c t l y mobile and undifferentiated across a l l these sectors. These f e a t u r e s eliminate t h e e f f e c t s of major product market and labor market d i s t o r t i o n s on estimates of the return t o c a p i t a l , thereby providing approximate measures of the s o c i a l p r o f i t a b i l i t y of c a p i t a l i n each sector. The r e s u l t i n g measures provide a possible guide t o the d i r e c t i o n s i n which c a p i t a l might be allocated t o maximize its s o c i a l return, with the presumption being t h a t a t the margin c a p i t a l should be allocated t o sectors of higher s o c i a l p r o f i t a b i l i t y and away from s e c t o r s of lower s o c i a l p r o f i t a b i l i t y . A comparison of the estimated r e l a t i v e s o c i a l p r o f i t a b i l i t y r a t e s by Eector with t h e a c t u a l p r i o r i t y s e c t o r s chosen allows one t o determine whether t h e s e l e c t i o n of p r i o r i t y s e c t o r s was s o c i a l l y desirable, according t o s t a t i c I I efficiency considerations.- 151 - S n r f q ln r ? f ? t ? h i I l l v f v d I ~ - a t o + c~a l l i n t o q ~ ~ ~ s t tihoen p r i o r i t v '9 a l l o c a t i o n ofinvestment resour&:es t o t h e sectors of e l e c t r i , a l - energy, nonferrous m e a l s , chemicals and paper, and food processing. - The s o c i a l -151 The s o c i a l p r o f i t a b i l i t y r a t e s provide a c r i t e r i o n f o r c a p i t a l a l l o c a t i o n t h a t r e f l e c t s only considerations of s t a t i c efficiency. It is clear that other cocsiderations, such a s those of dynamic comparative advantage, national defense, and geographic location, may a l s o legitimately be given weight by p1ai:ners i n a r r i v i n g a t a p r i o r i t y ranking of sectors.  return on c a p i t a l i n these sectors is lower than the estimated average social return on i n d u s t r i a l c a p i t a l and significantly lower than the s o c i a l return i n some n o r p r i o r i t y sectors, such a8 transportation equipment, e l e c t r i c a l . equipment, and services. I n the case of e l e c t r i 2 a l energy, the existence of substantial unmeasured e x t e r n a l i t i e s may make even s o c i a l p r o f i t a b i l i t y a poor guide t o investment choice, and it may be reasonable t o support the p r i o r i t y allocation of investment resources t o t h i s sector despite its apparently low r a t e of return. A similar argument, however, cannot be e a s i l y made t o support the p r i o r i t y allocation of investment t o nonferrous metals, chemicale and paper, and food processing. Correcting for the d i s t o r t i n g eff,?cts of the tax, trade and foreign exchange regime on market p r o f i t a b i l i t y does not change the basic conclusion - namely, t h a t the r a t e of return on c a p i t a l i n these p r i o r i t y sectors is below the average industrial r a t e of return. These r e s u l t s suggest the need t o reconsider the choice of these sectors a s p r i o r i t y recipients of investment resources, unless substantial improvements i n efficiency can be achieved. The social prof i t a b i l i t y rates, l i k e the market prof i t a b i l i t y rates, indicate t h a t the r a t e s of return on investment resources a r e higher ihan the i n d u s t r i a l average i n the p r i o r i t y energy and raw material sectors of coal, I I 0 o i l and gas, and nonmetallic minerals and construction materials. In the cases of coal and o i l and gas, the reeulte-also indicate that the social rates a r e higher relative t e'9t h e industrial average than their C market p r o f i t a b i l i t y r a t e s are. These f i 4 i n g s suggest that product and labor I market distortions acted t o depress the r e l a t i v e r a t e s of return on investment i n these p r i o r i t y sectors a s perceived by decer!r-ralized agents. A similar conclusion is suggested by a comparison of the r e l a t i v e market p r o f i t a b i l i t y and s o c i a l p r o f i t a b i l i t y performance of ferrous metals. The market  p r o f i t a b i l i t y calculations i n d i c a t e t h a t i n the presence of these d i s t o r t i o n s , the r e t u r n on investment i n ferrous metals was s l i g h t l y below the average i n d u s t r i a l r a t e of return. Correcting f o r these d i s t o r t i o n s , however, suggests t h a t t h e s o c i a l r e t u r n on investment i n t h i s p r i o r i t y s e c t o r was s l i g h t l y above the average i n d u s t r i a l r a t e of return. Finally, the calculations of s o c i a l p r o f i t a b i l i t y , l i k e the the c a l c u l a t i o n s of market p r o f i t a b i l i t y , i n d i c a t e a need f o r the Yugoslavs t o rethink the t r a d i t i o n a l emphasis on industry i n t h e i r Investment planning and t o a l l o c a t e a l a r g e r share of t h e i r investment e f f o r t t o the service sectors. B. The Allocation of Foreign Exchange The Incentives f o r Rent Seeking Both anecdotal information and observed changes i n the foreign exchange a l l o c a t i o n system i n d i c a t e t h a t administrative intervention i n the a l l o c a t i o n of fore'gn exchange increased during the 1976-80 period z t the expense of market and f i n a n c i a l indicators. Yugoslavia entered the period i n a s t o p phase of one of its recurrent stop-go cycles of growth and balance-of- payments c o n s t r a i n t s .lb/ As a r e s u l t of mounting balance-of-payments d i f f i c u l t i e s i n 1974-75, the a u t h o r i t i e s begin t o introduce a v a r i e t y of t y p i c a l stop-phase administrative r ~ s t r i c t i o n st o reduce fmports and expand . I exports i n 1976. Over the 1976- '" period, the growing use of such .!,?.-r . . ,..,- .;b-rn 1- . - , ! I.,,, !mqrts - 8 , c . , : - l - ~ Y , . .,-.., ~ &;,- T ~ ~ ~ ? " c ' ??.:I ?tq,e 7 r ? y ~ i ? ! - 1 - f 3 subject t o some kind of q u a n t i t a t i v e control, increasing interference i n the - * * a b i l i t y of e x ~ o r t e at o dispose of retained foreign exchange earnin* a s they w saw i i t , and a p e r s i s t e n t d e r l i n e i n economywide and s e c t o r a l measures of import dependence. Together, these pieces of evidence point t o the existence -161 For a more detailed description of these stop-go cycles and t h e i r genesis, s e e Tyson (1980), Horvat (1971) and Kovacevic e t a l . (1980).  of an overvalued exchange r a t e and a p e r s i s t e n t excess demand f ~ foreign r exchange throughout t h e period. This conclusion is supported by t h e s i m l a t i o n r e s u l t s of the CGE model reported i n section 4 below. I n every year between 1976 and 1980, the model r e s u l t s indicate t h a t t h e accual o f f i c i a l exchange r a t e was overvalued r e l a t i v e to its market-clearing level. I n the presence of p e r s i s t e n t excess :emand f o r foreign exchange, Yugoslav policy makers were forced t o r e s o r t t o a complicated s e t of rationing r u l e s t o a l l o c a t e foreign excha~ge. These r u l e s had important e f f e c t s on market incentives facing decentralized a c t o r s i n the economy. Using t h e CGE model, many of these e f f e c t s can be quantified and t h e i r implications f o r behavior can be analyzed. I n essence, two major forms of foreign exchange rationing were i n operation t o varying degree6 over the 1976-80 period. Simple q u a n t i t a t i v e r e s t r i c t i o n s on e i t h e r the allowable quantity of imports, o r on the allowable foreign exchange made a v a i l a b l e f o r a given type of import, o r t o a given c l a s s of importers, represent what might be called "fixprice" mechanisms f o r a l l o c a t i n g foreign exchange. Analytically, the distinguishing c h a r a c t e r i s t i c of a f i x p r i c e rationing scheme is t h a t although the a c t u a l quantity of imports allowed t o a domestic u s e r f a l l s short of the amount he would wish t o purchase, the r e s t r i c t e d quantity he is permitted t o purchase is provided t o hCm a t t h e o f f i c l a ! p r i c e , d e t e r r n l n e d hv t h e w a r l d n r i c s , the o f f i c f a l - exchange r a t e and the o f f i c i a l t a r i f f . According t o t h i s d e f i n i t i o n , a l l of the quota r e s t r i c t i o n s used by the Yugoslavs te .control d i f f e r e n t types of iq3rts are fixprice mechasisms, because the right to import under each of them is a r i g h t t o purchase foreign exchange a t the o f f i c i a l exchange r a t e . Although f i x p r i c e mechanisms remained important throughout the 1976- SO period, there is a l e o anecdotal evidence, consistent with the form and  i n t e n t of t h e 1978 changes i n t h e foreign exchange a l l o c a t i o n system, t h a t t h e r e was growing use of a "flexible price" o r "premium" rationing mechanism i n 1979 and 1980. The distinguishing feature of t h l s "flexprice" s c h e ~ ewas t h a t some users of foreign exchange were required t o pay a premium over and above t h e o f f i c i a l r a t e t o obtain t h e foreign exchange they needed. The post- 1978 i n s t i t u t i o n a l arrangements allnwed e n t e r p r i s e s with access t o foreign exchange i n excess of t h e i r needs t o negotiate self-management agreements t o c i r c u l a s e t h e i r foreign exchange t o other d e f i c i t users. This introduced t h e p o s s i b i l i t y t h a t such agreements could implicitly o r e x p l i c i t l y value the foreign exchange being transferred a t a r a t e which represented a premium over t h e o f f i c i a l exchange r a t e . I n t h e case of flexprice r a t i o ~ ~ i n gan importer forced t o pay a , premium on t h e foreign exchange he obtains would evaluate the cost of imports a t a p r i c e which reflected t h i s premium. A s i t u a t i o n where premium rationing applied uniformly t o a l l importers would be equivalent t o a higher exchange r a t e on t h e import side. It appears that both fixprice and flexprice rationing schemes coexisted i n Yugoslavia i n 1979 and thereafter. The implication is t h a t d i f f e r e z t users of the same imports paid d i i f e r e n t dinar p r i c e s , depending bn whether tney had a c c e s s - t o foreign exchange a t t h e o f f i c i a l o r the premiua-ridden price, o r some conbination of the two. The - exckange was used i n the system i n comparison s i t h what wov.ld have occurred = ' # under e i t h e r a more f l e x i b l e exchange r a t e system o r a system of market-, determined premia paid by a l l importers. The existence of s u b s t a n t i a l unsatisfied demand for foretgn excnange a t t h e o f f i c i a l exchange r a t e implies the existence of s u b s t a n t i a l s c a r c i t y r e n t a l income. Scarcity r e n t s a r e inherent i n the workings of both the  f l e x p r i c e and the f i x p r i c e rationing mechanisms. Importers who a r e b e n e f i c i a r i e s of the f j x p r i c e rationing mechanism earn i m p l i c i t r e n t s on t h e foreign exchange they a r e allowed t o purchase a t the o f f i c i a l rate. Under the f l e x p r i c e rationing mechanism, agents who have access t o foreign exchange a t t h e o f f i c i a l r a t e earn e x p l i c i t r e n t s by s e l l i n g t h a t foreign exchange a t a premium above the o f f i c i a l r a t e . The existence of s c a r c i t y r e n t s under both rationing schemes provides powerful incentives f o r "rent-seeking" behavior j.1 t h e system, a s demanders seek access through non-market means t o foreign exchange a t the o f f i c i a l rate. Such rent-seeking behavior generates r e a l c o s t s a s resources t h a t might otherwise be used i n production a r e dive,rted t o rent-seeking a c t i v i t i e s (Krueger 1974). I n t h e Yugoslav i n s t i t u t i o n a l s e t t i n g of the 1976-80 period, these a c t i v i t i e s included such things a s enterprise lobbying f o r import a l l o c a t i o n s i n communities of i n t e r e s t , negotiating complex hidden arrangements f o r the s a l e of foreign exchange a t a prem:um r a t e among e n t e r p r i s e s , and p o l i t i c a l lobbying t o r e s t r i c t the flow of foreign exchange across regional boundaries. Even when a c t u a l rent-seeking behavior does not develop t o t h e f u l l extent ccnsi,tent with the existence of r e n t s , it is of g r e a t i n t e r e s t t o obtain measures of the s c a r c i t y r e n t s generated by thp rationing of foreign exchange. Such measures r e f l e c t t h e incentives f o r rent- i n s t i t ~ t i o n a lmechanisms f o r al.ocating foreign exchange. - The j r e a t e r ther;e - incentives, the more l i k e l y t h a resources w i l l be wasted and output l o s t a s ,.-- m - the a c t i v e pursuit of r e n t s gains i n intensity. The CGE model allows one t o c a l c u l a t e estimates of the s c a r c i t y r e n t s a r i s i n g from disequilibrium i n the foreign exchange market and thus t o a s s e s t h e incentives f o r rent-seeking behavior a t both the economywide and s e c t o r a l l e v e l s , based on assumptions about the l i k e l y d i s t r i b u t i o n of s c a r c i t y r e n t s  acrcss agents i n the economy. The model assures that these rents are distributed t o users of imports according t o t h e i r import demand. The impiication is t h a t the "chaseable rents" i n a gi- en sector ( ~ p e n don both the magnitude and composition of its import demand. In general, the larger its purchases of imports and the greater its purchases of imports t h a t are subject t o high levels of quantitative r e s t r i c t i o n s , the greater the incentives f o r a particular sector t o waste resources i n the pursuit of foreign exchange. Table 2 contains estimates of r e n t a l income distributed across s e c t o r s i n accordance with t h i s assumption. Thq r e s u l t s indicate that the overall degree of disequilibrium i n the foreign exchange market, a s measured by the magnitude of rents associated with the rationing of foreign exchange, increased shitrply i n 1979 and 1980. The r e s u l t s a l s o indicate, a s anticipated, t h a t r e n t a l income a s a percentage of value added is greater for the more import-trpendent sectors (sectors that depend most on purchases of i ~ p o r o' t ~ raw materials and c a p i t a l goods). Finally, the r e s u l t s suggest that the potential for rent-seeking behavior i n the system due t o the r l s i n g value of rents was q u i t e dramatic over the period. With a l l the good w i l l and social pressrire i n the world, the power of these incentites must have encouraged rent-seeking behavior f n a variety of forms concistent with the i n s t i t u t i o n a l constraints facing economic - actors. For example, .rent seeking undoubtedly ~ s d etheqprocess of reaching .L self-management agreements about foreign excharige more Xime-consuzing and . 8 r divisfve than would otherwise have been the case. The &ale of the gains t o be realized through privileged access t o foreign excha~qewas clearly very large and provides ac explanation f o r the fierceness of interregional and inter- enterprise debates on the rules f o r allocating foreign exchange during t h i s period.  - 24 - Table 2 - Rental Income from Quantity and Premium Rationing as a Percent of Value Added Agriculture E l e c t r i c a l energy Coal O i l and gas Ferrous metals Non-ferrous meta1.s Konmetqllic minerals and construction o n t e r i a l s Machinery and f a b r i c a t e d metals Transportation equipment and shipbuilding E l e c t r i c a l equipment Chemicals and paper T e x t i l e s , l e a t h e r , rubber, wood and miscellaneous onnufacturing Food processing Construction I n f r a s t r u c t u r e Trade C r a f t s and o t h e r productive s e r v i c e s Primary ( a g r i c u l t u r e and food processing) Industry Ser v t c e s Average - 1 :;+! a '? ? i . e . ; T::; -:.:''',P~L?[;.;c~ Given Yugoslavia's poor exRort performance during the 1976-PO period, an iaportant question about the changing i n s t i t u t i o n a l arrargements f o r foreign t r a d e and foreign exchange a l l o c a t i o n is the d i r e c t i o n and s t r e n g t h of t h e i r incentive b i a s a g a i n s t exports and i n favor of import-substitution. The evidence suggests t h a t t h e n e t e f f e c t of these arrangements -)as an increase in  t h e b i a s i n i n c e n t i v e s a g a i n s t exports. This conclusion is widely held among Yugoslav economists and is c o n s i s t e n t with t h e repeated a s s e r t i o n s of Yugoslav e n t e r p r i s e s t h a t it was more p r o f i t a b l e t o s e l l a t home than to export during t h e 1976-80 period. It is also consistent with the highly cyclical and e r r a t i c p a t t e r n of e x p o r t s over t h e period, a p a t t e r n indicatir'g t h a t Yugoslav f i r m s turned t o f o r e i g n markets only when t h e domestic economy was r e l a t i v e l y depressed o r when they were under d i r e c t a d m i n i s t r a t i v e pressure t o do so, a s i n 1976 and again i n 1980. The CGE model can be used t o q u a n t i f y t h e b i a s a g a i n s t exports and i n f a v o r of import s u b s t i t u t i o n by c a l c u l a t i n g s e c t o r a l domestic resource c o s t s (DRCOs). Formally, t h e DRC f o r an export o r import-substituting a c t i v i t y is d e f i n e s a s t h e domestic c o s t of l a b o r and c a p i t a l resources Ger u n i t of f o r e i g n exchange earned o r saved by t h a t a c t i v i t y 2 / Within a s e c t o r of production, t h e DXCs f o r exporting and f o r import s u b s t i t u t i o n w i l l be t h e same only i f t h e e f f e c t i v e exchange r a t e is t h e same f o r both imports (and hence import s u b s t i t u t e s ) and exports i n t h a t s e c t o r , -171 Formally, t h e DRC f o r import s u b s t i t u t i o n i n s e c t o r i is given by: kR' -v a l u e a d d e d per u n i t of domestic outputci'n s e c t o r i' (dinars) ' L C = n e t f o r e i g n exchange saved by s u b s t i t u t i n g a u n i t of domestic output f o r an import ( d o l l a r s ) - w h i l e t h e DRC f o r exports i n s e c t o r i is given '&: -value-added per u n i t of domestic o u t w t i n s e c t o r i ( d i n a r s ) DRC = n e t f o r e i g n exchange earned by exporting a u n i t of domestic output ( d o l l a r s ) I n bath cases, value added p e r u n i t of dom%sticoutput provides t. measure of t h e t o t a l l a b o r and c a p i t a l c o s t s per u n i t of output. The DRCs have t h e dimensions of a dinar-dollar exchange r a t e , showing t h e d i n a r s of domestic resource c o s t s required per d o l l a r of f o r e i g n exchange earned o r saved. See Dervis, de Melo and Robinson (1982), pp. 274-278.  and t h i s i n t u r n w i l l be t h e case only when the nominal exchange r a t e augmented by t a r i f f s and import t a x e s on t h e import s i d e equals the noainal exchange r a t e augmented by d i r e c t and i n d i r e c t s u b s i d i e s on th? export side. Thus, divergences i n DRCs w i t h i n each s e c t o r of production provide a measure of t h e r e l a t i v e i n c e n t i v e s generated by t h e trade regime f o r production f o r t h e home market r a t h e r than f o r exports. Across s e c t o r s , d i f f e r e n c e s i n DRCs r e f l e c t both s e c t o r a l d i f f e r e n c e s i n t h e e f f e c t s of t h e t r a d e and exchange regimes and s e c t o r a l d i f f e r e n c e s i n i n d i r e c t caxes, labor and c a p i t a l costs. Sectoral d i f f e r e n c e s i n f a c t o r r e t u r n s and i n d i r e c t t a x e s cause d i s t o r t i o n s i n market i n c e n t i v e s generated i n t h e domestic market. These e f f e c t s can be taken i n t o account i n t h e DRC c a l c u l a t i o n s by measuring l a b o r and c a p i t a l c o s t s a t estimated economywide shadow p r i c e s f o r labor and c a p i t a l . To t h e extent t h a t t h e estimated shadow p r i c e s of resources r e f l e c t t h e i r s o c i a l s c a r c i t y , t h e use of such p r i c e s converts t h e DRC c a l c u l a t i o n s from p o s i t i v e i n d i c a t o r s of the incentives f a c i n g i n d i v i d u a l producers a t a c t u a l market p r i c e s t o i n d i c a t o r s of t h e .. - s o c i a l c o s t s of t h e incentive system which has emerged. I n t h e absence of a n economywide o b j e c t i v e f u n c t i o n t o -rare shadow p r i c e s of labor and c a p i t a l , the a n a l y s i s here makes approximations t o - thebe p r i c e s based on a s o l u t i o n of t h e CGE model. Using estimated s e c t o r a l . productiza functions and t h e model of firm behavior discussed e a r l i e r , the CGE - - s o l u t i o n provides e s t i m a t e s f o r t h e m~rgin.31value products of v a r i a b l e and -- f i x e d l a b o r and t h e marginal vcIue product of c a p i t a l i n each sector. These r e s t i m a t e s provide measures of i r i t e r s e c t o r a l d i f f e r e n c e s i n f a c t o r p r o d u c t i v i t y 0 and hence i n t e r s e c t o r a l d i f f e r e n c e s i g resource c o s t s under the a c t u a l rmrket conditions on which t h e CGE s o l u t i o n is based. To e l i m i n a t e t h e e f f e c t s of such d i f f e r e n c e s i n t h e shadow p r i c e DRC c a l ~ u l a t i o r ~ san , average shadow wage  and an average r e n t a l rLte a r e c a l c u l a t e d from t h e s e c t o r a l l y d i f f e r e n t i a t e d planning wages and r e n t a l r a t e s and a r e used a s approximations f o r t h e shadow p r i c e s of labor and capital- 18/ DRC c a l c u l a t i o n s f o r 1980 based on these assumptions a r e presented in Table 3. Three major conclusions are suggested by t h e r e s u l t s . F i r s t , within most s e c t o r s of production, the DRC f o r import-substitution was higher than t h e DRC f o r exports. This was e s p e c i a l l y t r u e f o r t h e i n d u s t r i a l s e c t o r s which i n 1980 ( t h e year on which t h e c a l c u l a t i o n s a r e based) accounted f o r about 65% of d o l l a r earnings from exports of goods and s e r v i c e s and about 86% of d o l l a r expenditures on imports of good and services- Overall, the r e s u l t s i n d i c a t e t h a t from a s o c i a l point of view, the domestic c o s t of earning an a d d i t i o n a l d o l l a r of foreign exchange from exports i n most s e c t o r s of production was s u b s t a n t i a l l y lower than t h e c o s t of earning an a d d i t i o n a l d o l l a r of foreign exchange from import s u b s t i t u t i o n . Second, t h e wide dispersion of DRC r a t e s a c r o s s s e c t o r s , e s p e c i a l l y on t h e import s u b s t i t u t i o n side, p o i n t s t o the s e c t o r a l biases introduced i n the system by t h e t r a d e regime. I n a n e u t r a l t r a d e regime, with uniform t a r i f f s and subsidies acd with a f l e x i b l e exchange r a t e regime, the DRCs based on shad,., p r i c e estimates of input c o s t s would be equal f o r exports and import L , I s u b s t i t u t i o n within each s e c t o r and across a l l sectors. By c o n t r a s t , the DRCs based on t h e a c t u a l d i s t o r t e d t r a d e and exchange r-?qime of the Y1rgosln1r -18/ On the assumption t h a t c a p i t a l and labor resources a r e of d i f f e r e n t kinds and a r e not mobile between a g r i c u l t u r e and nonagricultural a c t i v i t i e s , two p a i r s of average wage and r e n t a l r a t e s a r e calculated: an average wage and r e n t a l r a t e f o r a g r i c u l t u r e , set equal t n the wage and r e n t a l r a t e f o r a g r i c u l t u r e i n t h e CGE s o l u t i o n ; and an average wage and r e n t a l rate f o r nenagricultural a c t i v i t i e s s e t equal t o the average wage and r e n ~ a lr a t e s i n a l l i n d u s t r i a l and productive s e r v i c e s e c t o r s i n t h e CGE s o l u t i o n .  Table 3 S e c t o r a l Domestic Rcsourcc Costs i n 1980 Sector of Production 2/ Export Import Import/Expor t Agr i c u l tur e All i n d u s t r i a l s e c t o r s Coa1 O i l and gas Ferrous metals Nonferrous metals Non-ne t a l l i c minerals and cons t r u c t ion mzierii;!.~ Machicary Transport a t i o n equipment E l e c t r i c a l equipment Chcmiczls and paper Comsumer goods and l i g h t ninufactures Food processing I n f r a s t r u c t u r e services Other productive s e r v i c e s - 1/ DRC's measured i n dinars per dollar, a r e defined as the zotal (direct and iridirect) c o s t , i n terms of domestic labor ant1 c z p i t a l , of earning o r saving one d o l l a r 02 foreigh exchange through e x p o r t i ~ go r import s c 5 s t i t u t i o n . Shadow p r i c e s a r e used to value labor and c a p i t a l inputs. The choice of shadow p r i c e a f f e c t s t h e D4C l e v e l s , but the r e l a t i v e bias both within s e c t o r s and a c r o s s s c c t o r s is not s e n s i t i v e t o t h i s choice. -2/ Including only s e c t o r s i n which t h e r e a r e both imports and exports. economy show wide s e c t o r a l divcrgenccs. Sector-specific quancity r a t i o n i n g of .. .,,. - ... . . . 1.. .- ,; : i ; :.- ,:$c,iC p~ci;ii~~Lllilces LcsLLLI; i n particularly large L i L i n t e r s e c t o r a l d l f f c r c ~ c e si n the c o s t of earning a d o l l a r of fcreign exchange - * v i a inport s \ l h s t i t u t i M . Third, the p a r t lculo r l y high DRC' s Eo r import subs t i t u t i o n i n scveral of thc nunuEnct\iring s e c t o r s producing f inishctl goods--such a s machinery, t ransprtntlon cqtiipmer~t,elect ticill cquil)~aentand consuTcr goods and l i g h t nm~1uEacturcs--rci1c?ct. tllc c f f c c t s of schvcrc c(unt~tityr a t i o n i n g of f i n i s h e d  product imports. Yugoslavia, l i k e s e v e r a l o t h e r developing c o u n t r i e s , fashioned on import r e s t r i c t i o n regime which placed t i g h t e r r e s t r i c t i o n s on t h e imports of f i n i s h e d products than on t h e imports of raw materials. This regime worked t o t h e r e l a t i v e advantage of f i n i s h e d goods producers- whose domestic markets were heavily protected and whose imported inputs were l a r g e l y a v a i l a b l e a t t h e overvalue3 o f f i c i a l exchange r a t e , and t o t h e r e l a t i v e disadvantage of raw m a t e r i a l producers, whose domestic markets were subject t o a g r e a t e r degree of i n t e r n s t i o n a l competition. The incidence of p r o t e c t i o n r e s u l t i n g from t h i s r a t i o n i n g regime was i n c o n f l i c t with the o b j e c t i v e s of the investment p r i o r i t y schese f o promote raw m a t e r i a l s e c t o r s r e l a t i v e t o f i n i s h e d goods s e c t o r s , and was i n p a r t responsible f o r higher p r o f i t a b i l i t y r a t e s i n t h e l a t t e r . 4. The Sources of t h e Foreign Exchange C r i s i s of 1979-80 The l a s t s e c t i o n discussed a number of domestic i n s t i t u t i o n a l f a c t o r s and p o l i c i e s t h a t contributed t o d e t e r i o r a t i n g economic performance over t h e 1976-80 period and used t h e CGE model t o c ~ a l u a t et h e i r effects. This s e c t i o n focuses on the foreign exchange c r i s i s t h a t emerged i n 1979-80 and uses the CGE mode; a s a simulation laboratory f o r doing "counterfactual experiments" t h a t seek t o i s o l a t e t h e q u a n t i t a t i v e impact of e x t e r n a l and po,licy-induced f a c t o r s on t h e evolution of t h i s c r i s i s z / To provide a benchmark f o r o17r cwrntorfnct3:7? e-:nl-r!-,p:lt ! --;7 '3 -with a f l e x i b l e exchange r a t e base run s o l u t i o n &at estimates the - .I C m"equilibrium" or market-clearing exchange r a t e f& each year during che 1976- I 80 period. These estimates approximate t h e exchange r a t e t h a t would have 19/ The methodology described i n t h i s s e c t i o n has a l s o been applied t o an 7 a n a l y s i s of foreign exchange c r i s e s i n Turkey. See Dervis and Robinson (1982) and Lewis and Urata (1983).  emerged i f the Yugoslavs had permitted the exchange r a t e t o be determined by the supply and demand f o r foreign exchange, given existing t a r i f f and subsidy rates. The estimates assume the elimination of the combined fixprice and . flexprice rationing schemes f o r foreign exchange discussed e a r l i e r and t h e i r replacement by a f l e x i b l e exchange r a t e regime. The exchange r a t e s generated by the model under the assumption of such a regime represent a flow equilibrium on the market f o r foreign exchange i n each year and abstract from expectations and asset market effects. They do, however, depend on assumptions about exports, remittances, reserves, and foreign c a p i t a l inflows. To the extent that capital flows and reserve movements were not normal o r sustainable during t h i s period, the resulting exchange r a t e estimates a r e not r e a l i s t i c measures of an equilibrium exchange rate. Unfortunately, the 1976-80 period was hardly "normal" for Yugoslavia (or for most other developing countries, f o r t h a t matter), and it Ls :hus not obvious a t what levels c a p i t a l flows and reserve changes should be s e t . t o yield r e a l i s t i c estimates of an equilibrium exchange rate. We have made some reasonable assumptions which are described below. It is worth noting that while the solution values of the equilibrium exchange r a t e i n the base run a r e sensitive t o these assumptions, the comparisons of the various counterfactual * experiments with the base run are q u i t e robust. Reasonable variations i n the - base run do not affect the comparative tsslll+s. 2 Table 4 presents actual h i s t o r i c a l values of reserve accumulation, . net foreign capital inflows,)and remittances over the period and the .. W "reasonable" values adopted i n the flexible exchange r a t e base run. "Normal" reserves a r e defined a s sufficient t o cover two months of imports--a standard target f o r Yugoslav planners. A t the beginning of the period, actual o f f i c i a l foreign exchange reserves were $1,019 million, and a f t e r a sharp rise to  Table 4 Sources of f o r e i g n exchar~ge,1976-80 ( b i l l i o n $) - 1976-80 1976 1977 1978 1979 1980 cumulative H i s t o r i c a l T o t a l e x p o r t s 6.61 Remittances 1.41 Net f o r e i g n c a p i t a l 0.50 Reserve l o s s -0.65 Sun (= t o t a l imports) 7.87 Base run; f l e x i b l e exchange r a t e T o t a l e x p o r t s 6.61 Remittances 1.41 Net foreign c a p i t a l 0.50 Reserve l o s s -0.65 Sum (= t o t a l imports) 7.87 C '$2,298 m i l l i o n ir.: 1976, tdey remained above t h e t a r g e t two-month impor; cover through 1978, a f t e r which they f e l l dramatically. By t h e end of 1980, they covered l e s s than 1.5 montho of imports from the convertible currency a r e a and l e s s t h a n one month of t o t a l imports. I n t h e base run- a smoother p a t t e r n is C - assumed, with t h e r a t i o of reserves to t o t a l imports dropping from above- I8 t a r g e t l e v e l s i n 1976-78 t o t a r g e t l e v e l s i n 1979-80. With respect t o borrowing, it is m c h more d i f f i c u l t to d e f i n e a normal s u s t a i n a b l e l e v e l , p a r t i c u l a r l y because what is s u s t a i n a b l e depends i n p a r t on how foreign borrowing a f f e c t s t h e productivity, growth and t r a d e  performance of the economy and in part on conditions prevaiiing i n the external c a p i t a l market. The 1976-80 growth of borrowing (as measured by growth i n nominal and r e a l mediuw and long-term external debt) l i d not d i f f e r substantially from what had occurred during the 1971-75 period, and the debt/GNP and debt service r a t i o s i n Yugoslavia remained well itithin ranges f o r other newly industrializing countries for t h i s period. Coasequently, h i s t o r i c a l levels of borrowing a r e used in the flexible exchange r a t e base run. Note f i n a l l y that i n the flexible exchange rate base run, we have assumed that exports remain unchanged from t h e i r actual h i s t o r i c a l values. Thus, no export response is permitted when the exchange r a t e changes. We w i l l consider such an export response separately a s part of the counterfactual experiments. In interpreting the model results, it is thus important t o keep i n mind t h a t the exchange r a t e eatin-:tes are conditional on a number of assr-mptions about the behavior of various sources of foreign exchange. The resulting exchange r a t e s cannot be interpreted a s "shadow prices" of foreign exchange, conditional on the dollar inflow assumptions, because we do not remove price distorting t a r i f f s and subsidies. Instead, they a r e estimates of the market clearing exchange r a t e s that would have obtained without fixprice I r and flexprice import rationing, conditional on the assumptions about dollar inflows from exports, remittances, reserves, R ~ Jr ? ~ f t n ?nfTqv.j. I The 'gase run equilibrium exchange rates a r e presented i n Table 5. - They i n d i c a t e a h a t the o f f i c i a l exchange r a t e was persistently overvalued - D during ~ > 197680 period, with the extent of overvaluation particularly e severe i n 1979 and 1980, despfte the large devaluation i n the o f f i c i a l exchange r a t e which occurred i n 1980. Needless t o say, the persistent and worsening overvaluation i n the o f f i c i a l exchange r a t e was accompanied by the  Table 5 Actual and Market Clearing Exchange Rates, Equilibrium Actaal Exchange Rate Exchange Rate -2/ 1976 18.19 22.05 1977 18.30 19.85 1978 18.64 21-99 1979 19 00 26.15 1980 24.91 31.04 -1/ Period average e s t i m a t e s of o f f i c i a l r a t e prepared by The World Bank. -21 Estimates based on CGE model f o r Yugoslavia. growing use of the f i x p r i c e and f l e x p r i c e r a t i o n i n g mechanisms discussed e a r l i e r . ,The foreign exchange c r i s i s i s c e r t a i n l y evident by 1980. Using t h e f l e x i b l e exchange r a t e base run a s a benchmark, t h e CGE --,,;.,I - .- -.,:;: c c - ~ ~ t i ~ i ; d ~ ; d $ & ~ d l ;.i ... , - . . d:::cL.e.: I d ~ i i u a p c i i l t l s LO estimate the c o n t r i b u t i o n of various factozti t o t h e developing f o r e i g n exchange c r i s i s . * i Table 6 summarizes t h e r e s u l t s of f o u r counterfactual simulations designed tc L * measure the contribution of the following four f a c t o r s : (1) a s h o r t f a l l i n t h e growth of exports during t h e 1976-80 period; (2) the, inadequate devaluation t o c o r r e c t f o r t h e i n f l a t i o n d i f f e r e n t i a l between Yugoslavia and its trad?ng partners; (3) the o i l price increases of 1979 and 1980; and (4)  - 34 - Table 6 -FlexibleExchange Rate and Counterfactual Simulations: Summarv Descri~tionand-- ----- .-- - 1980 Equilibrium Exchange Rates Exchange Rate: 1980 Simulation Description 24.91 Hibtorical simulation Fixed exchange rate; historical values of parameters and exogenous variables. Base run flexible Reserves set at two-month exchange rate simulation cover for imports in 1979 and 1980; other para- meters and exogenous variables a2 historical values. Export growth at trend rate. B-1 plus domestic inflation set at trade- weighted inflation rates of trading partners. B-2 plus no oil price shock in 1979-80 (oil prices growing with average import prices). B-3 plus net remittances constant in real terms. the decline in net rev1 remittances that occurred during the period. &ch counterfactual simulation is designed to answer a question of the following form: What would the market-clearing exchange state have been in 1980 if one or more of these factors had behaved significantly differently over the 1976- 80 period? The answer is provided by comparing the :980 market-clearing  exchange r a t e generated t y the f l e x i b l e exchange r a t e base run with estimates of the 1980 market-clearing exchange r a t e generate: .ty each counterfactual * simulation. The f i r s t counterfactual simulation, simulation B-1 i n Table 6, attempts t o capture the e f f e c t s on exports from the improved incentives t h a t would have resulted had the Yugoslavs pursued a f l e x i b l e exchange r a t e policy. I n t h i s simulation, the growth r a t e of i n d u s t r i a l merchandise exports was raised from an estimated actual value of 2.9% between 1976 and 1980 t o the 1965-75 trend value of 6.2%, and the growth r a t e of t o t a l nonfactor service exports was raised fram an actual value of 7.4% t o its 1965-75 trend value of 12.0%. The actual growth r a t e of agricultural exports, 6.4% during the 1976- 80 period, did not d i f f e r much from its 1965-75 trend rate, so the r a t e was l e f t unchanged i n slmulation B-1. I n a l l sectors, exports were assumed t o grow smoothly a t t h e i r trend rates, thereby damping the e r r a t i c fluctuations that actually occurred during the period. Simulation B-2 s t a r t s from simulation B-1, but further s e t s the domestic i n f l a t i o n r a t e a t the trade weighted average i n f l a t i o n r a t e experienced by Yugos1avia':j trading partners. This experiment is designed t o estimate the e f f e c t s of the "pure" i n f l a t i o n d i f f e r e n t i a l on the c%ange i n the equilibrium exchange rate. Accordlng t o the 1976-80 data used i n the model, ; , ~ g d ~ j d ~?, si dannual i n i l a t i o n rate w a s I9 .OX, while the "world i n f l a t i o n rate," reflected i n the prices of its imports and-expcrtts, was only 13.4X, 8 leading t o an i n f l a t i o n d i f f e r e n t i a l of 5.6%. In'the absence of any other i n t e r n a l and external policy shocks, the existence of such a d i f f e r e n t i a l would have required depreciation of the dinar t o keep a constant price deflated exchange rate.  Simulation B-3 examines t h e e f f e c t s of t h e 1979-80 o i l p r i c e i n c r e a s e on the equilibrium exchange r a t e by asnuming t h a t the price of imported o i l increased a t t h e r a t e of a l l import p r i c e s (15.0% i n 1979 and 18.0% i n 1980), r a t h e r than a t t h e a c t u a l r a t e s of 45.3% and 7 8 . S i n 1479 and 1980, respectively. Finally, simulation B-4 explores t h e e f f e c t s of t h e slowdown i n n e t remittances t h a t occurred over t h e 1 9 7 6 8 0 period, which was at l e a s t p a r t l y i n response t o e x t e r n a l conditions t h a t l e d t o a steady reduction i n t h e number of Yugoslav workers employed abroad. The experimenl assumes t h a t n e t remittances i n nominal terms grew with world i n f l a t i o n (measured a s a weighted avesage of Yugoslavia's import and export prices), leaving the annual flow of r e a l n e t remittances constant. The assumption makes a d i f f e r e n c e of 1.94 b i l l i o n d o l l a r s i n cumulative c a p i t a l inflow over t h e 1976-80 period. Taken together, t h e r e s u l t s of the four counterfactual simulations and t h e r e s u l t s of t h e h i s t o r i c a l f l e x i b l e exchange r a t e base run can be used t o a s s e s s t h e contributions of t h e export elowdown, the i n f l a t i o n d i f f e r e n t i a l , t h e 1979-80 o i l p r i c e h c r e a s e and t h e slowdown i n r e a l net remittances t o t h e 19?9-00 foreign exchange c r i s i s . The assessment is c a r r i e d out by c m p a r i n g t h e 1980 equilibrium exchange r a t e s ger?erated by t h e d i f f e r e n t simulation ,experiments. For example,. comparing t h e '1980 equilibrium exchange r a t e of 31.04 from t h e h i s t o r i c a l simulation with t h e 1980 eqr*ll?$r!:;-, ssl:':.\:. q-, :':;. ,.f ? - . 1: fT?:T!2:(;2-.1L i .?L c.-_ I ~ . . 3 - ;t;ug.gests ~ h a cthe ? - a h o r t f a l l i n export growth r e l a t i v e t o trend over t h e 1976-80 period warranred * w . a d e ~ r b i a t i o nof 31.04/27.24 * o r 14. OX. Similarly, comparing the 1980 equilibrium exchange r a t e from experiment B-1 with t h e 1980 equilibri-am exchange r a t e i r o n experiment B-2 suggests t h a t the d i f f e r e n t i a l between Yugoslavia's i n f l a t i o r . r a t e and t h a t of its t r a d i n g p a r t n e r s n e c e s s i t a t e d a . h . depreciation of 27.24/22.36 o r 21.8%. Continuing with experiments 8-3 and B-   i n c e n t i v e s a g a i n s t e;.ports t h a t emerged during t h e period. This b i a s i n ..a* i n c e n t i v e s r e f l e c t e d i n c o n s i s t e n c i e s o' t h e dcmestic macroeconomic, t r a d e and exchange p o l i c i e s pursued by :he Yugoslavs. Since t h e f i r s t tvo e f f e c t s t o g e t h e r account f o r 73.2 percent of t h e change i n t h e equilibrium exchange rats, one can conclude that domestic polity choices rather than external shocks o r circumstances p e c u l i a r t o t h e 1976-80 period were t h e major cause of t h e developing f o r e i ~ nexchange crisis. A second conclusion is t h a t even a n e u t r a l crawling peg policy designed ,to o f f s e t t h e i n f l a t i o n d i f f e r e n t i a l wou'd have been i n s u f f i c i e n t to c l e a r t h e foreign exchange market, given the o t h e r f a c t o r s a t work during tMs period. I n f a c t , t h e Yugoslavs d i d roughly achieve such a r e s u l t , but it d i d n o t s u f f i c e t o remove t h e e x i s t i n g incentive b i a s a g a i n s t exports and vas far from s u f f i c i e n t given t h e o t h e r f a c t o r s a t work. This conclusion suggests t h a t simple purchasing power p a r i t y c a l c u l a t i o n s may be q u i t e misleading a s a guide t o policy, and t h e f a c t t h a t t h e i n i t i a l year was a l s o f a r from equilibrium f u r t h e r strengthens t h e point. F i n a l l y , t h e r e s u l t s suggest t h a t t h e o i l p r i c e i n c r e a s e s of 1979 and 1980 c l e a r l y had a n adverse impact on t h e Yugoslav economy, explaining about 1 0 percent of t h e underlying change i n t h e equilibrium exchange r a t e . This conclusion is not s u r p r i s i n g given t h e magnitude of Yugoslavia's o i l imports and supports t h e view t h a t e x t e r n a l shocks played a s i g n i f i c a n t r o l e i n t h e ~-L>:;JTLILL~,. of L ; ~ C i eL J ~ L I A I CAL~L ~ 9 7 3aria i 9 b U . B g n e t h ~ i e s s ,when I analyzed a g a i n s t t h e backdrop of t h e other findings r e e r t e d here. i t a p p e a r s e t h a t tfie o i l p r i c e shock and remittance slowdown were cdnsiderably less l a p o r t a n t than domestic policy choices i n the evolution of the foreign exchange c r i s i e .  5. Conclusion The r e s u l t s presented i n t h i s paper suggest a few general policy conclusions. While external shocks were important, the policy response w i t h i n Yugoslavia was inadequate f o r d e a l i n g with the e m e r ~ i n gproblems i n t h e 1976- 80 period. Resorting t o q u a n t i t a t i a v e r e s t r i c t i o n s on imports l e d t o s e r i o u s d i s t o r t i o n s i n t h e domestic market, which were exacerbated by t h e i n a b i l i t y of policy makers t o implement a n e f f i c i e n t mechanism f o r a l l o c a t i n g f o r e i g n exchange. The Yugoslavs would have been well advised i n t h i s period t o have followed a "crawling peg" exchange r a t e policy, i n order t o prevent t h e i n c e n t i v e b i a s a g a i n s t exports from worsening over time. Indeed, i f p u r s ~ e d azgressively, sucb a policy could have gradually c o r r e c t e d f o r t h e i n i t i a l overvalued exchanrz r a t e and prevented t h e emergence of s c a r c i t y r e n t s f o r f o r e i g n exchange, with concomitant i n e f f i c i e n c y and "rent-seeking" behavior. I n s t e a d , t h e i n t e n s i f i c a t i o n of t h e b i a s over t h e period generated severe d i s t o r t i o n s i n market s i g n a l s and lower exports, with consequent l o s s e s i n o u t p u t and growing pressure f o r t h e emergence of an i l l e g a l f o r e i g n exchange market. Methodologically, t h e kinds of questions considered i n t h i s paper a r z very d i f f i c u l t t o analyze wichout r e s o r t i n g t o an e x p l i c i t empirical model. The CGE'model provides a framework t h a t permits a n a l y s i s of v a r i a b l e s which a r e otherwise unobservable i n t h e Yugoslav system; i t a l o o permits counterfactual a n a l y s i s t o s o r t out t h e r e l a t i v e impact of t h e many shocks t h a t worked simultaneously during th& period. A general equilibrium model is I needed t o provide a c o n s i s t e n t framework f o r considering important i n t e r a c t i o n s among key variables. As t h e a n a l y s i s of t h e equilibrium exchange r a t e i n d i c a t e s , p a r t i a l equilibrium analysis--such a s looking only a t d i f f e r e n t i a l i n f l a t i o n rates--would have been i n s u f f i c i e n t and misleading.  *.'- References I Balassa, Bela, " S t r u c t u r a l Adjustment P o l i c i e s i n Developing Economies, " (1982) World Development, Vol. 10, No. 1. Dervis, Kemal and Robinson, Sherman, "A General Equilibrium Analysis of t h e Causes of a Foreign Exchange Crisis: The Case of Turkey," Weltwirtschaftliches Archiv, 1982, Band 118, Heft 2, pp. 259-280. Dervis, Kemal, de Melo, Jaime, and Rcbinson, Sherman, General Equilibrium Models f o r Development Policy. Cambridge University Press, 1982. Horvat, Branko, Business Cycles i n Yugoslavia, White Plains: I n t e r n a t i o n a l Arts and Sciences Press, 1971. Horvat, Branko, "Prilogzasmivanju t e o r i j e jvgoslovenskog poduzeca," Ekonomska Analiza, Vol. I, No. 1, pp. 7-28. r - Kovacevic, Mlajden; Madzar, Ljubomir; Marovic, Zvonimir; Popov, Sof ija; Popov, Zoran; Savor, Davin; and Zubic, Nikola, Basic Determinants of and Conditions f o r Dynamic Development and Balanced Economlc Trznds i n t h e 1981-85 Period, Belgrade: I n s t i t u t e of Economic Sciences, 1980. Krueger, Ann, "The P o l i t i c a l Eccnomy of the Rent-Seeking Society," American Economic Review . -' 1974, Vol. 64, No. 3, pp. 293-303. I Lewis, Jeffrey D. and Urata, Shujiro, "Turkey: Recent Economic Performance and - Medium-Term prospect^, 1978-1990," World Rank Staff WnrLf~c,P2ycr Yn. '! 602, Washington, D.C.: The World Bank, 1983. - ~ c k e n k ,Martin, Ardalan, Cyrus, and El Tatavy, Naval, Yugoslavia: Self. . 0 bnagement Socialism and t h e Challenges of Development. Baltimore and London: Johns Hopkins University Press, 1979. Tyson, 7,aura D0Andrea, The Yugoslav Economic System and Its Performance i n t h e -- 1970s. Berkeley: I n s t i t u t e of I n t e r n a t i o n a l Studies, Research S e r i e s No. 44, 1980.  Tyson, Laura D'Andrea, "Investment Allocation: A Comparison of the Reform Experiences of Hungary and Yugoslavia." Forthcoming in Journal of Comparative Economics, September, 1983. Zalai, E. (1982), "Computable General Equlibrium Models: An Operational Planning Perspective," Mathematical Modelling, vol. 3, no. 5.  WJ"I'EHATICAL PRESENTATION OF THE CGE MODEL A. Introduction In this appendix, we present a more formal mathematical description of the static, within-period, CGE model of Yugoslavia. In the next section, we present the equations of the flexible exchange rate version of the model, and then discuss the adjustmerlts that must be made to the equations to accomodate fixprice and flexprice import rationing schemes under a fixed exchange rate regime. B. Eauations of the Flexible Exchange Rate Model Endogenous variiagles are denoted by capital letters vithout a bar. Lower case letters, Greek letters, and letters vith a bar are exogenous variables or parameters. The subscripts i and j refer to sectors, the subscript k refers to labor categories, and the subscript g refers to consumer groups. There are n sectors, m labor categories, and g consumer groups. Non- linear functions are not written out explicitly. Instead, the symbe? for a function f(-) is used and the form of the particular function is explained with each such equation. The income and f low-of-funds equations are not explicitly written out. In terms of the mathematics of the model, they serve to distribute total value added :o the various institutions (enterprises, households and government), determine the split between savings and consumption, and ensure that each economic actor--and the system as a whole-satisfies a budget constraint. These relationships are discussed in the previous Appendix and repeating the presentation here vould only complicate the notation of the model, without adding any substance. Prices Endogenous variables: ER : exchange rate, PMi : domestic price of imports,  PEi : domestic price of exports, Pi : composite good price, Psi : average price of domestic and export sales, pNi : net price or value added, PDi : domestic price of domestic sales, : input-output coefficients, A ~ i e S : export share in sectoral sales. Sxogenous variables and functions: - PWi : world price of imports , - PUEi : world price of exports, tmi : tariff rate, tei : export subsidy rate, tdi : indirect tax cate, : aggregate price index weights, -Oi P : exogenous level of price index, f - ) : equation (3), cost function dual of the CES trade aggregation function. In the model, imports and domestic goods are assumed to be imperfect substitutes. Purchasers demand a composite good which is a CES aggregation of imports and domestic goods, with a different tradt aggregation function for each s'ector. This specification implies that the price of imports need not equal the price of domestic goods (PMi # PDi) and that the domestic price system acquires a large degree of autonomy not present in standard trade T O ~ i? ~Y S' ~ J L C ~y ~ n r ? r !3tf:p5 d ~ t p ~ " 1 ~r?7-,e-n-,k!~7 y i : - 1 . .- ,m!-,< ~ ' 7 purchasers desire to minimize the cost of acquiring a given amount of the composite good, the resulting first-order conditions can be solved to yield a cost function for the composite g60d, equation (3). Given that t1.e trade aggregation function is linearly vomoge:leous, this cost function depends only on prices. Production and Employment  Endogenous variables: S Xi : sectoral production, Li : aggregate variable labor input, VDi : aggregate intermediate input by sector of destination, hi : variable labor of category k in sector i :intermediate input demand by sector i from sector j, v-li WLk : average wage of labor category k, < WKi : market profitability rate, : demand for labor of category k. Exogenous variables and functions: - : exogenous sectoral capital stock, Ki tif : exogenous sectorally fixed labor, : fixed share of sector j in aggregate intermediate input to a ~ i sector i a j i = 11, - tvi : value-added tax, 8 : proportionality ratio of sectoral wage rate to a;erage wage r a t e Yki for labor categorg k, : exogenous variable labor supply of cptegory k, f (-1 : equation (71, two-level Cobb-Douglas o r CES production function, f(-): equation (8). Cobb-Douglas or CES labor aggregation function.  The production function i n most sectors is simply a Cobb-Douglas o r CES function of labor and capital. Intermediate input requirements a r e given by fixed input-output coefficients, so equations ( 9 ) , (12) and (13) a r e not needed. However, the model a l s o permits a three-level specification i n which, a t the f i r s t level, aggregate variable labor is a CES aggregation of variable labor of different categories, and aggregate c a p i t a l and intermediate inputs a r e fixed coefficients aggregates. A t the second level, aggregate value added i s a Cobb-Douglas or a CES aggregation of aggregate capital, fixed labor and variable labor. Finally, output is a Cobb-Douglas function of aggregate value - 8 added and aggreqate intermediate inputs. The various specifications allow a great deal of f l e x i b i l i t y within the general framework of smooth, neoclassical production functions. Equations ( l o ) , (11) and (12) represent the conditions that factor returns equal marginal value products for a l l inputs. Given fixed c a p i t a l stocks by sectors, the market rentals WK a r e assumed t o d i f f e r by sectors. For variable labor, the accounting wage fs assmed t o adjust so t h a t the denand for variable labor equals the supply, and the excess demand equation (15) is satisfied for each category of labor. A s discussed i n Appendix I, some labor i n each sector is assumed t o be immobile or f i :ed. Such labor is treated a s a fixed factor, analogous t o s e c t o r a l l y fixed capital. The demand f o r intermediate inputs is also solved endogenously so that the c c s t of the intermediate-input aggregate for each sector equals its marginal revenue product-equation (12). Fox the sectors i n which input-output coefficients a r e fixed, t h i s equation is not needed. Foreign Trade Endogenous variables: I e Mi : imports, : domestic Remand for production. Df Exogenous varlables'tand functions : - 4 - .. * Ei : exports* - F : exogenous net inflow of foreign exchange, f(-): equation (17), derived from first-order conditions associated with the trade aggregation functions. The CGE model pennits a variety of specifications of export behavior. In the Yugoslav model, sectoral exports a r e s e t exogenously which implies that i n equation (16) the export share parameters se a r e s e t to achieve the rarget exports. In other versions of the model: the share  parameters can be determined behaviorally. They reflect export supply behavior and can be specified as functions of the relative price of exports to domestic sales, PE/PD. The Yugoslav model uses an extreme version of this formulation in which export supplies are assumed fixed. In the model, the export and domestic markets are segmented. Thus, there is no requirement that PE = PD in any sector. If they deviate, it implies that there is a wedge in incentives between the two markets. Such a wedge is inconsistent with the usual neoclassical assumption that producers must reach a point where they are indifferent between selling on the export or domestic markets. Given institutional rigidities and difficulties in "breaking into" export markets, the assumption of segmented markets is probably reasonable. However, if forward runs of the model yield diverging values of PD and PE for various sectors over time, then one must question the validity of the underlying specification of export behavior. In the runs of the model reported in the text, the time paths of PD and PE were examined as a check on the viability of the exogenous export targets. Income and Flow of FunCs Endogenous variables calculated (19) GY : total government revenue, (20) Yg : income of consuming groups, (21) TZ : total investment, (22) GC : total government consumption, (23) Cg : total consumption by consuming groups. Producl; Markets  Endogenous variables: investment by sector of d e s t i n a t i o n , ZDi :investment by sector of origin, Zi GCi :government demand by sector, C private demand by groups and s e c t o r s , i g ' : intermediate demand by sector of origin, Pi : domestic demand ratio, i : total demand for domestic production. X: Exogenous variables and functione: - SZi : s e c t o r a l investment a l l o c a t i o n shares (Xi Ei = I ) , - bji : c a p i t a l composition c o e f f i c i e n t s (Ejbji l), - - SGi : government expenditure shares (XXi 11, - S : private expenditure shares ( 11, 1g i ig f(-): equation (30), derived from first-order conditions associated w i t h t h e trade aggregation function. The Operation of Markets There a r e t h r e e types of markets i n t h e model; those f o r labor, output, and foreign exchange. 'L'tie model assumes t h a t these three s e t s of markets a l l "clear" which means t h a t t h e excess-demand equations f o r labor (15j, output (32), and foreign exchange (18) must a l l equal zero a t ,equilibrium. Indeed, the solution problemris t o find a s e t of accounting wages (Wk), product prices ( P D ~ )and an exchange r a t e (ER) suc t h a t t h e t h r e e s e t s of excess-demand equations a r e simultaneously s a t i s f i e d -1'1 -- C u ~ r , ~ : n g , cnzre are i 9 . n r 2.m + - 2 . g + 2.n.n. + m.n + g.n + 4 -9 endogenous variables. Note that tihe number of equations is one g r e a t e r tifan the number of endogenous variablec. The system is a Walrasian general = .equilibrium system i n w h i c b t h e excess-demand equations must s a t i s f y W a l r q ' Law and, hence, a r e not inkpendent. The system can only determine r e l a t i v e p r i c e s , and the price normalization equation (6) is required t o s e t t h e absolute price level. --I / For a discussion of solution methods, aee K. Dervis, J. de Melo, and S. Robinson, r x n e r a l Equilibrium Models for Development Policy (Cambridge: Cambridge University Press, 1982).  C. Fixed Exchangz Rates and Import Rationing If one assumes tkat the exchange rate is fixed, then some other mechanism must be specified to satisfy che balance of payments equation ( 1 8 ) - One simple approach used in many planning models is simply to make the net inflow of foreign exchange endogenous. Such an assumption is not reasonable for a country such as Yugoslavia, and alternative adjustment mechanisms must lx specified. Under a premiun or flexprice rationing scheme, a new endogenoe t variable is introduced; the premium rate. Equation (1) is replaced by: .) - I (la) PHI = PWi (1 + mi+ PR) t 'I The premium rate PR is determined endogenously so as to satisfy the balance of payments equation (18). The resulting premium income (CPW Mi.PR.ER) must also be taken into account in the income and flow-of-funds equations (as discussed in the previous appendix). Under quantitative or fixprice rationing, the situation is more complicated. In this version, the desired ratio of imports to domestic demamd given by equation (17) is assumed not to hold. Instead, demanders are assumed to be limited to some fraction of their desired ratio, and this fraction is determined endogenously in order to satisfy the balance of payments equation (18). Demanders of imports ar assumed to be off their demand curves and equation (17) is replaced by--17 where RM is the endogenous quantity rationing rate. Note that in this situation, the cost function dual to the trade aggregation function, equation (3), no longer holds. The composite price equation can be redefined using the identity that the total value of composite - goods must equal the value of imports and domestic goods: Pi Qi = miM + PDi Di, where Qi f(?i ,Di) is the CES trade aggregation function. In tiis case, the composite prfce equation becomes: where f(M /D , I ) Is the trade aggregation function evaluated at (Mi/Di,l). 4. Equation f3af is valid whether or not users of imports are on their demand - curves. I ;Ihen both fixprice and f1exp.-ice import radoning are assumed to be operating simultaneously, then the quantitative rationing fraction is set exogenously and the premium rate PR is solved endogenously. The quantity rationing is thus applied on top of the premium rationing, since the desired ratio of imports to domestic goods MID is a functioc of the premium-ridden price, PM. In this case, both equations (la) and (3a) must be used. -11 Equation (30) must also be adjusted. See Dervis, de Relo and Robinsor, (1982), ibid, for further discussion.