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Wednesday, 23 August 2017

The Determinants of Inflation in Sudan (1)

(Kabbashi M. Suliman, Department of Economics - Faculty of Economic and Social Studies - University of Khartoum) - Introduction: Sudan experienced economic instability during the 1970s through the mid 1990s characterized by a high and volatile rate of inflation. The period between 1971 and 1990 is dominated by the occurrence of double-digit inflation averaging about 29%. A series of reforms were introduced during this period including devaluations, price and import controls and rationing. However, these efforts were largely unsuccessful, and triple-digit inflation persisted to the 1991–1996 period. Sudan is included by Fischer, Sahay and Végh (2002) among the 25 countries in the world that experienced episodes of very high inflation crossing 100% growth rate per annum. Among the main factors that could have contributed to inflation developments are the monetization of the fiscal deficit; the successive devaluations of the domestic currency, which in turn increase the costs of shocks relating to back-to-back droughts during 1983–1984 and 1993–1994.
Inflation in excess of 100% per year is disruptive and no country can practically tolerate such price growth. The pressures of the situation compelled the government to initiate economic reform in 1997, and the International Monetary Fund (IMF) started to monitor this programme in 1998. The reform emphasized the unification of the foreign exchange rate and fiscal consolidation. The inflow of foreign direct investment (FDI) attracted by the advent of the oil sector and the inflows of oil revenues helped the stabilization efforts and inflation receded to single-digits as from 2000. The real gross domestic product (GDP) growth showed strong response to these developments.
The stabilization was reached mainly through fiscal retrenchment and exchange rate anchoring. However, the challenge ahead relates to the credible commitment for marinating the internal and external balances that ensure sustained low inflation and robust output growth. Hence, it is vital to improve understanding of the determinants of inflation in Sudan that may enhance such policy endeavours.
An attempt is made in this paper to analyse the underlying sources of inflation in Sudan, a key factor in establishing macroeconomic stability. The intention is to provide answers to the following questions: what are internal and external causes of inflation
in Sudan, and how have they been propagated and evolved through time? What are the remaining bottlenecks for the success and sustainability of the current stabilization efforts in fighting inflation? Most of the previous studies on inflation in Sudan draw on the monetarist model, or aversion of it, augmented with cost-push elements. Very few of these studies, if any, explicitly incorporate the effect of foreign price measured in domestic currency in the analysis of inflation dynamics.
This paper uses data over the 1970.1–2002.4 period and hence updates most previous studies and adds to the exposition by considering temporary and more prolonged factors that affected inflation in Sudan. Some of these factors have a short-term influence, for example, episodes of aggregate demand shocks. Others have medium- to long-term effects such as the observation of the purchasing power parity (PPP) and convergence of the domestic price to the foreign price. Such a modelling strategy is more general compared with that in previous studies; more important, it examines both the short- and long-run determinants of inflation paying attention to both aggregate demand and supply sides of the economy. In particular, the use of quarterly data permits in-depth analysis of the lagged effects of key economic variables on inflation adjustments.
The empirical investigation follows two steps: first, the Johansen (1988) maximum likelihood cointegration analysis is applied to identify long-run relationships in two subsystems of variables pertaining to the monetary sector and a pass-through relation, within the PPP framework. The second stage of the investigation combines the two sub-systems within a general dynamic error correction model (ECM). Sequential reduction of the general model is then applied to establish a stable parsimonious ECM of price growth.
The main results were that inflation in Sudan is determined in the long run by the exchange rate and foreign price. Inflation is also propagated in the short run by the pass-through from the exchange rate as well as from foreign price; the contemporaneous and lagged money growth; and by the deterioration in expectations. The proxy variable included in the restricted ECM to examine the impact of the level of economic activities and liberalization of foreign exchange, suggests that an increase in the level of economic activity lowers inflation in the short run, while liberalization of foreign exchange rate
exerts an upward pressure on prices. The dummies entered to account for the effects of droughts during 1983–1984 and 1993–1994 suggest that agricultural supply is negatively affected and in turn significantly contributes to inflation. Similar results are obtained by studies on inflation experiences of other comparator countries (see for example, Chhibber, 1992; Adam, 1995; Liu and Adedji, 2000; Durevall and Ndung’u, 2001; Nachega, 2001; Sacerdoti and Xiao, 2001).
The findings suggest that the policy of defending the exchange rate reform, although it contributed to bringing inflation down, may not be sustainable in the long run due to the sluggish adjustment of the real exchange rate towards equilibrium. The authorities need to develop sound indirect monetary instruments to supplement the policy of exchange rate anchoring. Fighting inflation also depends on the ability of policy to reduce the effects of supply shocks emanating from droughts and foreign price movements as reflected in the costs of imported inputs.
The rest of the paper is organized as follows: the next section gives a brief background on the proximate sources of inflation in Sudan. Section 3 presents a brief survey of previous studies on the macroeconomic determinants of inflation in Sudan; Section
4 outlines the analytical framework and the econometric methodology; and Section 5 presents the results of the empirical analysis. The final section summarizes the major findings and discusses their policy implications.
Inflation sources
In general, the persistence of an annual inflation rate of 40% or more over two consecutive years or more, and negative real GDP growth during the same period are known symptoms of macroeconomic instability. In terms of these performance indicators, Figure 1 suggests that inflation developments in the country since 1970 can be roughly divided into three periods: first, a period of moderate to high inflation from 1970 to 1988 with an annual inflation rate hovering around 20–30% except in 1973 and 1987 where it grew by 44% and 67% respectively. Second, there is a process of very high inflation during 1989–1996. Third, inflation receded to 17% average rate over the period 1997–2002.
Overall, it appears that the moderate macroeconomic stability between 1970 and 1988 is fragile in view of the high fiscal and current account deficits.
The exacerbations of these internal and external imbalances reached the crisis stage during 1989–1996. The mean rate of inflation during this sub-period was about 107% and the real GDP growth was negative. However, on the heels of the economic reform since 1997, supported by the inflows of FDI and the increase in oil revenues, inflation receded to single digits and the real income growth recovered during 1997–2002. The rest of this section briefly reviews macroeconomic performance and the policy stance over each of these sub-periods. The parallel nominal exchange rate is defined as the local currency per unit of the US dollar, hence positive change implies depreciation.
Export and import are deflated by the foreign price index; see Appendix A for the definition. The coefficients of variation are shown between parentheses.
The first burst of inflation during the period 1970–1988 is associated with the oil price increases in early 1970s. However, the economy
was not affected by the impact of these shocks immediately because the government managed to exploit the geopolitical position of the country at the time and attracted substantial FDI, especially from the surplus of the oil-rich Arab countries in a view to promote Sudan as a breadbasket for the whole region.
The peace agreement signed between the government and the southern rebels in 1972 encouraged the inflows of these foreign investments. Nonetheless, the FDI boom failed and by late 1970s the government had neither the foreign reserves nor the domestic resources with which to meet the politico-economic demands for spending following the peace and the debt servicing obligations. Accordingly, Sudan adopted a structural adjustment programme (SAP) with the support of IMF and the World Bank during 1978–1984. In general, these types of programmes usually emphasize outward orientation in strategy; especially export expansion to enhance the balance of payments and to eliminate the debt problem, nominal devaluation, aggregate demand retrenchment, and trade and institutional reforms to create an incentive structure consistent with the reform strategy. Notwithstanding, the instruments actively used in policy operations under SAP were fixed multiple exchange rate and controls including import and price controls.
In the early 1980s a parallel exchange rate was introduced along with liberalization measures that shifted imports and to some extent exports from the official to the parallel market. These reforms aimed at attracting the remittances of Sudanese nationals working abroad (SNWA) after failing to attract more investment funds from the oil exporting Arab countries; these efforts were largely unsuccessful.
The intensification of controls to repress inflation tolerated entrenched rent seeking, black markets and smuggling. The successive depreciations of the free exchange rate in the black market led to the vicious cycle of overvaluation of the official exchange rate and inflation and to loss of external competitiveness. During the period real export growth was negative, averaging 0.5%, and showed very high volatility, as indicated by the coefficient of variation of 41.3.
The premium, defined as the ratio of the free exchange rate to the official exchange rate, grew on average by about 10% during 1978–1984. To indicate the extent of the parallel exchange market, Hussain (1986) notes that more than 80% of imports were financed from resources from the black market. Hence the increasing diversion of
import financing towards the black market with a depreciated exchange rate implies increased cost of imports in the domestic economy. The resulting increases in the prices of intermediate imported inputs and consumer tradables fed the inflationary process, with serious implications for capacity utilization and growth in the country.
The budget deficit as a percentage of GDP averaged 8.4% during1970–1988. The fiscal gap appeared to be financed by money creation thought to substitute for external credit which dried up in the late 1970s. For example, the base money grew during 1984–1988 by more than 37%, on average, and inflation started to run loose in the economy .
The macroeconomic imbalances and the policy failures of the period2 were complicated by the outbreak of the civil war in 1983, ending 10 years of peace. The pressure of the situation not only resulted in economic U-turn but also induced massive political instability, for example, the sub-period witnessed four changes of the political regime in succession.
The second period of inflation during 1989–1996 opened with a political change in 1989. The new government was faced with a deteriorating balance of payments due to loss of competitiveness and the reversal of capital flow in terms of repayments of debts and services, and a large fiscal deficit. A National Economic Salvation Plan was introduced in 1990. The plan was a home-grown form of the SAP, albeit without IMF and World Bank support. It emphasized self-reliance as a new orientation in the development strategy. This was largely a reflection of the severe decline of the foreign finance. The main elements of the plan comprised: a) strict control of foreign exchange, including import and prices, and exports retention through Central Bank surrender requirements which furnish a base for export tax; b) adherence to a strict cash budget system; and c) privatization of the non-performing public enterprises. These measures appeared to reduce the fiscal deficit as a ratio of the GDP by two percentage points compared with the previous period, but remained high due to the burden of the civil war. The official exchange rate was occasionally devalued, but not merged with the free market rate which depreciated, on average, by about 126% during this period. The premium continued to be positive and exhibited considerable volatility.