Project Appraisal

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Conversion factors and shadow exchange rates

Gordon Hughes

To cite this article: Gordon Hughes (1986) Conversion factors and shadow exchange rates,
Project Appraisal, 1:2, 106-120, DOI: 10.1080/02688867.1986.9726548

To link to this article: https://doi.org/10.1080/02688867.1986.9726548

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 Project Appraisal. June 1986. volume I , number 2, paces 106-1.20. & w h Tree Piihlrrhin~.10 U"ur/ord C l o s ~ .Giuldjord, .Sirrre.v GUI zEP, England
Basic principles
Conversion factors
exchange rates
Gordon Hughes
In calculating shadow prices for use in project
appraisals, the rekrtionship between the shadow
exchange rate and converslon factors (accounting
ratios) for specific items or categories of inputs is a
common source of confusion. This article sets out to
clarify links between choice of numeraire, shadow
exchange rates and conversionfactors in the UNIDO
and Little - Mirrlees methodologies. It outlines a
general method of estimating sets of shadow prices
which can easily be updated in the light of extra
information or as a result of changes in economic
policy.
Finully,the implications of an overvalued exchange
rate andor an impeding currency devaluation for
shadow pricing are &cussed. A pmedure to adjust
shadow prices in such circumstcrnces is described.
Keywords: shadow prices; social cost-benefit analysis;
exchange rates; devaluation
Gordon Hughes is a Professor of Political Economy,
Department of Economics, University of Edinburgh, George
Square, Edinburgh EH8 9JY, Scotland. He has worked on the
estimation of sets of shadow prices for project appraisal and
policy analysis in several countries, including Indonesia,
Morocco, Tanzania and Tunisia.
106 0268-8867/86/02010&15 US$03.00 8 Beech Tree Publishing1986
and shadow
OR SOME TIME the contents of various
F journals and discussion at meetings of development
economists have been punctuated by the crossfire between
proponents of different methods of project evaluation. At
the same time, some of the more important features of
these procedures - shadow wage rates, shadow exchange
rates, social rates of discount - have been adopted
increasingly widely among those concerned with the
practical assessment of development projects.
Understandably, many practitioners find themselves
confused by the seemingly contradictory arguments of the
protagonists. In particular, the divergent views expressed
by those who use shadow exchange rates and those
working in terms of conversion factors have been
troublesome.
Thus, I embarked on this paper with the purpose of
clarifying the bases for these different views, so as to
facilitate the process of making the basic assumptions and
judgements which must underpin any social cost benefit
analysis.
In the course of thinking through the literature and
writing on this subject, it became clear that much of the
conflict arises because contributors to the discussion work
with different implicit models without ever really
elucidating the consequences of adopting alternative
assumptions. There is also a basic divergence between
those who tend to think in terms of aggregate or macro-
economic variables and those who derive their
recommendations from allocative planning models which
focus on the micro-economic aspects of investment.
Thus, much of this paper is devoted to the careful
exposition of some of the assumptions which underpin
different methods of calculating shadow prices.
In advocating the use of what I have called the
Little-Mirrlees-Scott (LMS) method of estimating shadow
prices, I should declare an interest in the sense that I have
had considerable experience of the practical
implementation of the method. It was originally developed
by Scott for use in Kenya and Mauritius - particularly
for the evaluation of the Million Acres Settlement schemes
in Kenya (Scott, 1976). Subsequently, I estimated sets of
accounting ratios for various countries including
Project Appraisal June 1986

Indonesia, Morocco and Tunisia (Hughes 1979, 1980)
which have been used in the evaluation of both agricultural
and industrial projects.
Certainly, on the basis of this work I can assert that the
method is practicable in that it does not require
unreasonable amounts of data and a very extensive set of
accounting ratios can be estimated in the space of three
month’s work, depending on the amount of preliminary
work which has to be carried out. In addition, the method
can be computerised quite easily, so that it is simple to
derive alternative sets of accounting ratios corresponding
to different assumptions about a range of fundamental
parameters - such as income weights, shadow wages, the
social value/cost of private profits.
Basic issues
The LMS method is outlined later. First, we will discuss a
number of basic issues, the most important of which is the
choice of a numeraire and its effects on the appropriate
definition of shadow prices and shadow exchange rates.
Standard conversion factors are discussed next as there
seems to be considerable confusion about their definition
and use. In this paper I will use the term accounting ratio
to refer to the ratio of the shadow price to the market
price of a specific good on service. On the other hand, the
term conversion factor will refer to the multipliers used to
convert from market values to values at shadow prices for
general categories of expenditure - consumption, non-
traded goods and services, and so on.
Finally, we consider an important practical problem in
the estimation of shadow prices which has not been very
adequately discussed previously. This concerns the best
way of modifying accounting ratios and shadow prices to
allow for a prospective devaluation of the domestic
currency. Not only does this raise the issue of determining
the best method of incorporating the effects of the
prospective exchange rate change in our estimation
procedures, but also the question of the circumstances
under which the structure of relative shadow prices is
unaffected by the change.
There is one issue concerning both terminology and
assumptions which needs to be settled before we embark
on any discussion of the calculation and interpretation of
shadow prices. In the literature, a distinction has been
drawn between first best and second best shadow exchange
rates. Unfortunately these tend not to be defined very
carefully, especially as regards the numeraire, and the
definitions tend to vary from author to author.
The essential feature of any first best shadow exchange
rate is that it is calculated on the assumption of optimal
trade policies - basically free trade, but allowing for
optimal export taxes or import duties when there are
inelastic foreign demand/supply functions.
Second best shadow exchange rates assume that part or
all of the existing stucture of tariffs, quotas and other
forms of intervention should be taken as given, so that
they indicate the social value of foreign exchange under
particular assumptions about trade and other policies. In
all cases I will assume that shadow exchange rates are
expressed in terms of aggregate consumption as the
Project Appraisal June 1986
Conversion factors and shadow exchange rates
numeraire for project evaluation.
It seems fairly clear that the first best concept of the
shadow exchange rate is not likely to be very helpful in
project evaluation, though it may yield useful information
about the overall effects of the structure of trade
intervention when studying macro-economic policy in
some countries. While I hope that there would be no
disagreement about using a second best shadow exchange
rate, it is unfortunately less clear which features of a
particular structure of trade intervention should be taken
as given in deriving the shadow exchange rate.
In practice, the decision must rest on a judgement
about which elements of the structure are likely to be
operative throughout the period during which the shadow
prices will be used. Generally my inclination would be to
assume that tax and tariff rates are fixed, but that
additional quotas and other quantitive restrictions will or
should be eliminated. This is partly because such
restrictions tend to be varied much more readily in
response to balance of payments pressures than tax or
tariff rates.
Thus, provided one allows for the appropriate exchange
rate adjustment to achieve trade balance in the absence of
quantitive restrictions, it seems reasonable to assume that a
move towards more consistent and efficient government
policies would involve the dismantling of quotas, import
licensing and similar schemes.
Another reason for preferring this assumption is the
difficulty of making proper estimates of the social costs of
the income transfers and other effects caused by
quantitative restrictions on trade. The assumptions which
guarantee the equivalence between tariffs and quotas
(Bhagwati 1969) are most unlikely to be satisfied in most
Less Developed Countries (LDCs) so that the precise
effects of quantitative restrictions will depend upon the
way in which they are operated, on whether there is price
control for imported items, and so on.
These contributory factors may well change over time,
so that it is better not to attempt to incorporate them in the
estimation of a general set of shadow prices. Rather they
should be specifically examined in those cases for which
the effects of a quota or other form of non-fiscal
intervention may significantly affect the net social value of
a project.
Shadow exchange rates and the numeraire
The choice of a numeraire should not affect the relative
shadow prices derived for use in project appraisal so long
as analysts adopt similar assumptions or simplifications in
carrying out their work. However, much of the confusion
in the literature concerning the relationship between
alternative methods of project appraisal seems to flow
The choice of a numeraire should not
affect the relative shadow prices
derived for use in project appraisal so
long as analysts adopt similar
assumptions or simplifications in
carrying out their work
Conversion factors and shadow exchange rates
from differences in implicit assumptions about government
behaviour and institutional arrangements prompted by
different choices of numeraire.
In this paper I will basically use the Little-Mitrlees
(L-M) numeraire - uncommitted income in the hands of
the government measured in terms of convertible foreign
exchange. As is usual, I will assume that the actual
calculations are performed in terms of domestic currency
- rupees - with foreign (dollar) prices converted at the
official exchange rate.
This is, of course, based on the presumption that
border prices are the appropriate starting point in the
derivation of shadow prices so that the process of
estimating social costs and benefits is most conveniently
carried out in terms of border values. Note, however, that
it does not imply that border prices themselves are always,
or even usually, the correct shadow prices.
An alternative numeraire recommended by the UNIDO
manual is general consumption expenditure measured at
domestic prices. It would appear that we can convert from
this numeraire to the L-M one by multiplying all values
by the Consumption Conversion Factor (CCF), while the
UNIDO approach requires the use of a shadow exchange
rate (SER) to convert foreign exchange items into values
in terms of aggregate consumption.
Hence, one might infer that the relevant SER is simply
the inverse of the CCF. This broadly corresponds to one
version of the SER discussed in the UNIDO manual
(Dasgupta et a1 1972, Chapter 16 especially pages 229-
231). There is a slight difference between their procedure
and using the inverse of the CCF because the weights for
each commodity accounting ratio are based on their
average/marginal shares in trade in the UNIDO analysis
and on their average/marginal shares in consumption in
the L-M case.
In practice, the difference between the estimates may be
negligible, but it is not clear a priori that this must be SO.
It is not unusual for full sets of shadow prices to show
wide variations between individual consumption items or
groups of commodities - notably between foodstuffs,
imported manufactured goods, and non-traded goods and
services.
The role of non-traded items is ambiguous in this
version of the UNIDO approach, since intermediate
inputs into the production of consumer goods are included
but it is difficult to deduce how one is supposed to treat
the complementary factor inputs. Thus, it is quite possible
that the difference between the two values of the SER may
be significant, in which case it seems that the inverse of
the CCF will be more consistent with the remainder of the
analysis than will the value derived from the UNIDO
procedure.
The UNIDO approach
One assumption specified in the UNIDO derivation of the
SER is that there should be no ‘reverse import
substitution’ except with respect to the capital goods. In
effect this means that all extra foreign exchange is directly
spent on net additions to the supplies of non-capital goods
in the economy. This seems a rather sweeping assumption,
I08
and it illustrates a general characteristic of procedures
which use shadow exchange rates or individual accounting
ratios to perform the reverse process.
The information requirements are broadly similar -
since in the SER case we need to know the ratio of border
to domestic prices - but the process of estimating a single
SER uses this data very inefficiently. Various
assumptions are made to allow aggregation rather than
taking advantage of the opportunity to examine potentially
important micro-economic aspects of economic policy and
industrial structure which can be illuminated by the
estimaiion and study of individual accounting ratios.
Within the context of the UNIDO approach to project
appraisal, the exclusion of capital goods from the items
used in deriving the SER can be justified, but only at the
expense of adopting assumptions which run counter to
other aspects of their philosophy. Their numeraire is
aggregate consumption while the SER is to be used to
convert uncommitted foreign exchange into units of the
numeraire.
Thus, the actual allocation of extra foreign exchange
between consumption and capital goods can be neglected
by asking the question: if we have one extra unit of foreign
exchange, how many net additional units of aggregate
consumption can be provided after allowing for the
opportunity cost of any complementary resources?
In effect, the UNIDO procedure implies that the
government utilises additional foreign exchange by making
direct income transfers to households which use the money
to increase their consumption. The total amount of the
transfer is determined so that the demand for foreign
exchange generated by the increase in consumption
expenditure is equal to the original increase in the supply
of foreign exchange.
Expressed in this way, we see clearly that the SER is
simply the inverse of the CCF. However, this justification
of the UNIDO procedure does not satisfy all doubts,
because in certain respects it is not consistent with either
the details of their method or the fundamental ideas which
are stressed elsewhere in the book.
First, any increase in aggregate consumption must
involve an increase in demand for domestically produced
or non-tradable goods, such as housing, personal services,
transport and distribution. These in turn will require extra
capital inputs which may be imported. Thus, it is strictly
incorrect to exclude all capital goods in following the
UNIDO procedure, though as a matter of practicality one
might adopt the assumption that such imports would be
small relative to the imports of consumer and intermediate
goods and can thus be safely neglected.
Second, at the beginning of this discussion of the
UNIDO approach, there was a deliberate ambiguity about
whether the weights used in computing the SER should
reflect average or marginal patterns of expenditure. Partly
this is an issue of implementation because it is difficult to
obtain reliable estimates of marginal expenditure shares
whereas average shares present no such problems.
However, there is also the standard issue of whether
shadow prices should reflect the net impact of a marginal
change in the demand for or availability of a good or
resource or whether they should be valid for assessing the
Project Appraisal June 1986

impact of non-marginal changes. For most items a
marginal evaluation is appropriate, but the best choice is
less obvious in the case of the principal macro parameters
such as the SER, the shadow price of investment and the
basic shadow wage rate.
In the end, this decision must depend on the manner in
which these macro parameters will be used: whether for
the evaluation of independent, relatively small projects or
in a broader assessment of sectoral allocation and
alternative development strategies. The UNIDO
procedure relies upon weights based on the composition of
marginal expenditures of foreign exchange.
Regrettably the case studies at the end of the UNIDO
volume give no hint of how they expect the SER to be
calculated in practice. Nonetheless, in Chapter 17 they
discuss the derivation of another national parameter, the
shadow price of investment, from information related to
the macro-economic planning objectives of the
government.
This, combined with the overall emphasis on aggregate
consumption as the goal of development planning, suggests
that it might be more appropriate to use average
expenditure shares as weights in constructing the SER
rather than marginal shares as specified in Chapter 16.
Third, in various sections of the book, the UNIDO
authors stress that their approach is not based on a
presumption of optimal government policies but on the
assessment of the effects of current policies which reflect
the constraints and pressures operating on policymakers.
However, the justification for their method of estimating
the SER which was outlined above relies upon an implicit
assumption of optimality, unless we believe that the
government will actually respond to the availability of
extra foreign exchange in the manner described. Ignoring
distributional considerations, the assumption of optimal
policies implies that, at the margin, the alternative uses of
foreign exchange should be equally valuable so that
estimation of the SER by reference to the increase in
aggregate consumption allowed by the extra foreign
exchange is perfectly consistent. Once we abandon this
assumption, we are obliged to choose between two
approaches.
Maximum social value. We can define the SER as a
measure of the maximum social value of one unit of
foreign exchange subject to certain constraints on the
alternative policies. In this case, the value of the SER as
calculated in the manner described should set a lower
bound on the ‘true’ SER, provided that the income
transfers envisaged are regarded as being feasible.
Deterministic view. Alternatively, we can adopt a more
deterministic view of policy and estimate the SER by
assuming that the government can utilise additional foreign
exchange in only a small number of ways - such as by
increasing public investment, lowering taxes, increasing
public employment or the minimum wage level. In this
case, the policy option of direct income transfers which
will increase aggregate consumption must probably be
ruled out and instead we must examine the net impact of
each method of adjustment including any effects on
investment and imports of capital goods. The SER should
Project Appraisal June 1986
Conversion factors and shadow exchange rates
The UNIDO approach seeks to
distinguish between the effects of a
project on aggregate consumption and
distribution: this can only be
sustained in assessing secondary
effects of projects by ignoring
distributional considerations
then be equal to the value of foreign exchange as
measured by the increase in aggregate consumption,
resulting from the various methods of adjustment. Of
course, an extreme version of this approach would assume
that the government will restrict itself to one method of
adjustment, in which case the SER may be directly
estimated by tracing the consequences of this policy.
Fourth, until now we have ignored distributional
considerations because, as far as possible, the UNIDO
approach seeks to distinguish between the effects of a
project on aggregate consumption and on its distribution.
However, this distinction can only be sustained in
assessing the secondary or indirect effects of projects by
ignoring distributional considerations. There are two ways
in which the recognition of distributional issues may alter
the UNIDO procedure for estimating the SER:
Foreign exchange committed or uncommitted. So far, we
have implicitly assumed that aggregate consumption and
public income are equally valuable, which, within the
L-M approach, is equivalent to assuming that the
accounting rate of interest (ARI) and the consumption rate
of interest (CRI) are equal or that the critical consumption
level is equal to the average consumption level. This in
turn implies that there is no premium on savings or
investment, so that the shadow price of investment must
be I .o. Clearly, the implications of this assumption are not
compatible with other aspects of the UNIDO analysis, at
least while we treat extra foreign exchange as being
uncommitted in the sense that the government is able to
use the revenue in whichever manner will generate the
highest social return.
Thus, we have to choose between either the L-M view
of foreign exchange as uncommitted public income which
will be used to increase investment rather than aggregate
consumption so long as the shadow price of investment
exceeds 1 . 0 , or a strict interpretation of the suggestion in
the UNIDO manual that changes in the availability of
foreign exchange will have no influence on the amount or
composition of investment.
In the latter case, extra foreign exchange cannot be
regarded as being ‘uncommitted’ in the L-M sense, so
there need be no simple relationship between the SER and
the CCF though for the special case in which foreign
exchange is committed to aggregate consumption via a
proportional income transfer, the equivalence between the
SER and the inverse of the CCF remains valid. Under the
L-M assumptions of uncommitted foreign exchange, it is
straightforward to show that:
I09
Conversion factors and shadow exchanae rates
SER = @ /CCF
where wc, wa are the income weights for the critical
consumption level and for average consumption, and ICF
is the typical conversion factor for investment.
Constraints on foreign exchange use. When the manner in
which extra foreign exchange can be used is constrained,
we must typically allow for the specific distributional
consequences of the alternative allocations considered in
estimating the SER. For example, if the adjustment to an
increase in the availability of foreign exchange proceeds
via an increase in employment and wage payments, then
the distributional weights appropriate to the beneficiaries
of this policy should be used in computing the SER.
The alternative approach would require that we attempt
to combine the direct distributional effects of a project
with the indirect distributional effects associated. with the
adjustment to the consequential change in foreign
exchange availability or with other indirect effects of the
project. This procedure is unlikely to be practicable even
when applied to only moderately complex projects. It is
precisely because of the difficulty of carrying such
decompositions that aggregate shadow prices have been
adopted as an efficient means of valuing the wider effects
of changing the supply/demand for important resources or
inputs.
Excessive foreign borrowing. The UNIDO manual’s
second method of deriving the SER is based on the
treatment of foreign exchange as a merit item in the
government’s objective function. It is suggested, for
example, that extra foreign exchange revenue reduces
dependence on foreign loans or graQts (public and private)
and thus generates a social benefit in addition to the direct
contribution of the foreign exchange to aggregate
consumption.
This implies that foreign borrowing is above the level
regarded as desirable by the government, so that it is
willing to sacrifice aggregate consumption to reduce capital
inflows. Such a view of dependence on foreign capital is
quite common in developing countries, but it is not clear
that a higher shadow exchange rate is the appropriate
method of allowing for the underlying reasons for this
dependence.
It must be associated with institutional or political
factors which limit the government’s scope for
intervention, since otherwise it could use direct taxation to
reduce aggregate consumption and to free resources which
could be used to improve the balance of payments.
However, the existence of such constraints may not be
consistent with the initial assumption that extra foreign
exchange can be used to reduce foreign borrowing. This
may, of course, be the case, but it seems probable that the
outcome will depend upon the manner in which the
foreign exchange is earnedand the recipients of the income
associated with the activity. In other words, we must
examine the ways in which the revenue and incomes are
committed to various categories of consumption and other
expenditure.
II0
This brings us back to the point stressed above, that is,
that we are concerned with uncommitted public income so
that income which is spent in ways outside the control of
the government must be analysed more specifically to
evaluate the net impact of the expenditures. Thus, it is
neither helphl nor appropriate to use a separate shadow
exchange rate adjusted to allow for the non-optimal level
of foreign borrowing. Instead, the standard shadow
exchange rate - the inverse of the CCF - should be
used in combination with separate valuations of the social
costs of the constraints which are the cause of the over-
dependence on foreign capital.
Standard conversion factors
Just as those using shadow exchange rates have too often
been somewhat careless about the proper specification of
their numeraire, so also have practitioners within the
Little-Mirrlees school tended to be rather inexplicit about
the scope of their standard conversion factors. This is
important because it is widely believed that the shadow
exchange rate should simply be the inverse of the standard
conversion factor - see, for example, Pursell’s
comparison of his shadow exchange rate for the
Ivory Coast with Linn’s SCF (Pursell 1978, pages 43-
50). In most cases, this view is incorrect, because it
involves confusions both about the numeraire and about
the role of the SCF, as the comparison of the UNIDO
and L-M analyses in the previous section has already
shown.
in the estimation of specific accounting prices. Instead of
trying to estimate accounting prices for all items involved
in decomposing the social codbenefit of some
commodity, it is suggested that an average ratio of
accounting prices to market prices could be used. L-M
suggest (1974, page 218) that in principle the average
should be derived from a calculation of the form
SCF =
CQ i. AP
CQ i. M P i (3)
where
APi = accounting price of good i,
MP; = market price of i ,
Qi = total supply of i .
This is clearly likely to be too laborious in practice, so
that, following Scott’s work on Kenya (Scott 1974, page
I 711, they suggest that the median or the modal value of
the distribution of accounting ratios could be used as the
SCF. Both L-M and Scott then comment that the inverse
of such a SCF would be equivalent to a shadow exchange
rate estimated with respect to the value of some aggregate
basket of goods at market prices as the numeraire.
Provided that the SCF, the SER, and the numeraire are
carefully and consistently defined, this may indeed be true,
but it is not very helpful because the difficulty really lies in
the achievement of the level of detailed analysis and
consistency required.
Scott’s estimates for Kenya and my own work in
various countries indicate that for non-traded goods and
Project Appraisal June 1986

services and, to a lesser extent, for imported manufactured
goods, the accounting ratios tend to cluster reasonably
closely about the median value. Unfortunately, this tends
not to be the case for exportables and agricultural
products. As a result, choosing a ‘typical’ accounting ratio
to encompass the whole range of accounting ratios may be
seriously misleading, while the calculation of an average
valueas in equation (3) involves serious conceptual
difficulties.
For example, it is not clear whether QIshould be
defined as total domestic availability - production plus
imports - or total domestic consumption - production
plus imports minus exports. Presumably, we should use
total supply rather than final demand but this implies that
the resulting SCF may depend upon the degree of
disaggregation of inter-industry trade in the data available.
Further, the set of items to be included in the average is
not immediately obvious. Should it include commodities
which are exclusively used as inputs into the manufacture
of traded items? These issues can, of course, be resolved
once the purpose of estimating a SCF is decided, but up
until now insufficient thought has been given to them.
Squire and van der Tak (S-T) introduce their SCF for
use in converting minor direct and indirect non-traded
inputs to accounting prices when estimating the accounting
price of an item by decomposition. In addition, they
suggest that the SCF may be approximated by taking “the
ratio of the value at border prices of all imports and
exports to their value at domestic prices”.
Unfortunately, this merely serves to compound the
confusion concerning the use of standard conversion
factors, since it assumes that the accounting ratios for
non-traded goods may be approximated by the accounting
ratios for traded goods.
It is possible to specify a set of assumptions which
would justify this approach, but they are quite implausible
and imply that the accounting ratios for the unskilled
labour and profit components of domestic value. added
should be little different from the typical accounting ratio
for traded goods. This greatly narrows the scope for
studying the implications of using accounting ratios for
particular domestic resources which differ substantially
from those for traded goods.
Three general conversion factors
In order to clarify the role of standard conversion factors,
it seems advisable to work in terms of at least three distinct
general conversion factors:
The Consumption Conversion Factor (CCF) defined and
used in the manner specified by both L-M and S-T.
The Standard Conversion Factor for Traded Goods
(TSCF) which would be used to convert minor items of
expenditure on importable commodities to accounting
prices. Its value may be calculated either by using the
median tariff on imported manufactured goods in the
standard procedure for estimating the accounting ratio of
an importable or by taking the median accounting ratio for
non-agricultural imported commodities.
The Standard Conversion Factor for Non-traded Goods
(NSCF) which would be applied to miscellaneous
Project Appraisal June 1986
Conversion factors and shadow exchange rates
Experience suggests that traded
agricultural and primary commodities
usually have accounting ratios which
are very different from those
estimated for traded manufactured
goods as a result of various forms of
government intervention
expenditures on non-traded goods and services. Again one
can use the median value of the distribution of accounting
ratios for non-traded goods and services. Alternatively, an
average conversion factor may be estimated by aggregating
input-output data for all sectors which predominantly
supply non-traded items and then performing the
calculation in the usual way.
It is necessary to bear a number of points in mind when
considering this suggestion or using standard conversion
factors.
First, the procedure for estimating the TSCF
specifically focuses on manufactured goods. This is
because experience suggests that traded agricultural and
primary commodities usually have accounting ratios which
are very different from those estimated for traded
manufactured goods as a result of export taxes, low tariffs
on imports, consumption subsidies, and other forms of
government intervention. Not only do these items ’have
untypical accounting ratios as a group, but also there tends
to be a high degree of variation between the accounting
ratios for the commodities making up the group.
Further, in most cases, the principal items for which
the TSCF would be used are miscellaneous semi-
manufactured or manufactured goods which are required
as inputs in the production of goods and services. If they
form a significant proportion of costs, primary commodity
inputs should be converted to accounting prices by the use
of specific accounting ratios. Minor expenditures on
primary commodities may be treated either as purchases of
non-traded agricultural output, or, if the other methods
would be inappropriate, by applying the TSCF.
Second, a common feature of tariff structures in LDCs
as well as in developed countries is the escalation of the
relevant tariff as the stage of manufacture of the imported
item increases. In other words, raw materials like raw
cotton and wool, coal, copper and other mineral ores all
bear low tariff rates, whereas higher rates are imposed on
semi-manufactured and intermediate goods - inorganic
and organic chemicals, aluminium billets, steel coil,
electric motors, vehicle components - and still higher
rates on finished manufactured goods.
The extent of such escalation depends upon the extent
to which the government is trying to encourage import
substitution via the tariff structure. If the tariff rates differ
significantly between these categories, then it may be
sensible to use the TSCF for finished manufactured goods
subject to the relatively higher tariff rates and to estimate a
separate general accounting ratio for intermediate and
semi-manufactured goods.
Third, the non-traded items for which the NSCF is
used are likely to be dominated by various types of
111
Conversion factors and shadow exchange rates
services. Assuming that distribution, transport, electricity,
construction and similar major non-traded inputs are
treated separately, it is probable that financial services -
banking, insurance - and miscellaneous administrative
overheads for projects will be important components of
the remaining non-traded expenditures.
Unfortunately, these are conceptually difficult to deal
with and the data relating to them - whether from input-
output tables or other sources - is usually scarce and of
doubtful reliability. The payments for such services will
also include substantial transfer payments or expenditures
on the replacement of insured property and goods which
are not treated as part of the output of the relevant service
industries in constructing input-output tables or national
income accounts.
In addition, much of the value-added in these industries
is contributed by skilled labour, whose accounting ratio is
probably the most difficult to estimate of all of the
accounting ratios for the major primary inputs. All of
these considerations indicate that the NSCF may have to
be estimated in a rather rough and ready manner.
For the financial and other non-traded services - after
allowing for transport payments, and so on - I would
suggest the use of a weighted average of the accounting
ratios for skilled and unskilled labour, construction and
the TSCF. The weights would depend on the analyst’s
judgement concerning the relative importances of the
various items in net output.
In previous studies, I have combined these items in a
category ‘Business Services’ (Hughes 1979, I 980) rather
than including them in the NSCF, but the estimation
procedure followed was that described above. Other non-
traded goods and services can be analysed in the usual way
and a composite accounting ratio estimated for use as the
NSCF, either by taking the median valueor some
appropriately weighted average.
The fourth point in using standard conversion factors
follows immediately from the previous discussion. None of
the standard conversion factors specified here can be used
to derive an implicit shadow exchange rate with respect to
aggregate domestic expenditure at market prices as
numeraire. In any case, for similar reasons to those
outlined in discussing the formula for the SCF in (3), I do
not think that this is a very helpful numeraire by
comparison with either the one used here or the UNIDO
one.
This brings us back again 10 the question of the
numeraire when a shadow exchange rate is used.
Normally, the shadow exchange rate is defined simply as
the social benefidcost to the economy of
earning/spending an extra unit of foreign exchange. For
Bacha and Taylor (1971) the ideal shadow exchange rate
would come from a comprehensive programming model,
from which one may infer that they have current aggregate
consumption in mind as their numeraire, since this is the
typical unit of welfare measurement in such models.
Similarly, at several points in his article on shadow
exchange rates, Balassa (1974) indirectly refers to the
value of foreign exchange in terms of consumption; for
instance “the shadow exchange rate will be employed to
convert . . . the consumption cost of factor use into world
prices”.
I12
The Little-Mirrlees-Scott method is
relatively straightforward while at the
same time taking account of many of
the criticisms which have been
levelled against the use of conversion
factors
Thus, in the remainder of this paper, I shall assume
that shadow exchange rates are used to convert foreign
exchange expenditures into their social value in terms of
aggregate consumption. In the general case when we are
moving from the L-M numeraire of uncommitted public
income measured in terms of foreign exchange to
aggregate consumption numeraire, this implies that the
standard equivalence between accounting ratios and
shadow exchange rates is:
SER = (Ratio of the income weight at the critical
consumption level to the average income
weight reflecting the distribution of
aggregate consumption) / C C F
If, however, the government is viewed as having only
limited ability to control the utilisation of extra foreign
exchange, the income weight at the critical consumption
level in the formulation above must be replaced by an
aggregate income weight reflecting the best of the
alternative methods of allocating foreign exchange.
The Little-Mirrlees-Scott method
As experience with the application of the Little-Mirrlees
method of project appraisal has built up, procedures for
implementing it have been refined and in this section I will
briefly describe the current state of the art. The fullest
application of these procedures has been in Kenya for
which some 200 accounting ratios have been estimated
(Scott, MacArthur and Newbery, 1976; Little and Scott,
1976).
Scott’s description of the way in which the basic set of
accounting ratios for Kenya was estimated is the best
practical guide available (Scott 1976). His methods are
relatively straightforward while at the same time they take
account of many of the criticisms which have been levelled
against the use of conversion factors, such as failure to
allow for demand or supply elasticities, allowances for
externalities or economies of scale. For this reason I will
refer to the current approach as the Little-Mirrlees-Scott
(LMS) method.
In estimating a set of accounting ratios, we start by
distinguishing between a category of primary inputs and all
other goods and services. Primary inputs are those items
whose accounting prices are determined either by
considerations which cannot be incorporated in the
simultaneous equation framework to be outlined - such
as the treatment of foreign exchange or certain categories
of saving as merit items - or by the application of
relatively complex formulae/models involving assumptions
that one might wish to test in sensitivity analyses - such
as various categories of labour, profits.
Project Appraisal June 1986

The accounting ratios for these primary inputs are
determined with the aid of exogenous data and are then
used to derive the accounting ratios for other items within
a quasi-input-output framework. Applying the familiar
L-M principles, the market prices of these other items are
decomposed into expenditures on primary inputs and
other goods or services. Thus, we can construct a pair of
input matrices in value terms:
A = [a i,l
shows the market values of goods and services entering as
direct inputs into the social codbenefit of
supplying/consuming one rupee's worth of each item.
Thus aij is the cost at market prices of good j as a
component in the social cost of one rupee's worth of good
i at market prices.
shows the market values of primary inputs entering as
direct inputs into the social cost of using one rupee's
worth of each item. In this case the subscript h. denotes
the primary inputs.
Now suppose that the primary input accounting ratios
are denoted by W h (h = I , . . . m) and the commodity
accounting ratios by vj 0' = I, . . . n). Then, we have the
equation :
v = Av + Bw (4)
in which v, w are the vectors of commodity and primary
input accounting ratios respectively. This yields:
v = [I -A]-' Bw
or (5)
v = Rw, where R = [i-AI-' B
with R being the matrix of total direct and indirect
requirements of the primary inputs.
It follows that if we are given or can estimate values for
the primary input accounting ratios, then the remaining
accounting ratios can be obtained very simply once the A
and B matrices have been constructed. In fact, some of
the primary input accounting ratios themselves depend on
the commodity accounting ratios, so that an iterative
procedure is followed.
We start by assigning reasonable, though arbitrary,
values to the primary input accounting ratios and use these
to obtain commodity accounting ratios. These are fed into
the estimation of the primary input accounting ratios, and
the whole procedure is repeated until successive estimates
of the primary input accounting ratios converge.
Experience suggests that two or three iterations are
sufficient to estimate these accounting ratios to a
reasonable degree of accuracy.
It is important to recognize the assumptions underlying
this approach and also the range of factors affecting social
codbenefit which may be incorporated in the analysis.
Constant costs versus economies/diseconomies of scale
The procedure assumes that the separate items making up
the social costs of a good or service vary linearly with the
amount of the goods involved for the purposes of cost-
Project Appraisal June 1986
Conversion factors and shadow exchange rates
benefit analysis. If this were not so, then the elements of
the matrices A and B would not be invariant to the scale
of demand.
Note, however, that this is not the same as assuming
constant average costs, so long as it is recognized that the
accounting ratios are not appropriate when large changes
in the supply or demand for a particular item are
envisaged. In such cases, as always in project evaluation,,
specific analyses must be carried out for those items whose
social cost might be significantly affected by large scale
changes.
Otherwise, the assumption implies constant marginal
costs, so that the economies or diseconomies of scale may
be incorporated by using input coefficients a,, bth which
differfrom the average input requirements.' This is still
restrictive since it rules out the possibility that marginal
costs may fall or rise continuously with the scale of
production.
Probably such a pattern is fairly unusual, but when it
seems important enough to worry about it may be dealt
with by distinguishing between several accounting ratios
for the commodity, each of which is estimated on the basis
of the commodity's cost composition over some range of
total output. In effect, this means that one would follow
the usual method of linear approximations used in the
programming literature.
Inelastic world supply or demand
Cases in which a country faces demand or supply curves
which are not perfectly elastic can similarly be allowed for
within this approach by adjusting the input coefficients.
Suppose that the country exports cotton yarn at an average
cost, insurance, freight (cif) price of Rs p r per unit,2 but
faces a foreign demand curve having an elasticity of price
with respect to exports of - E ( E >o). Thus, if exports are
increased, the net foreign exchange earnings per unit are
pp( I - E ) while existing exporters lose ~ p in, terms of lower
profits or lower producer incomes.
Suppose the domestic ex-factory price of cotton yarn is
p d and that the transport and other costs of exporting the
yarn are ce. So, we can write the social cost of the cotton
yarn sold in the domestic market as:
v$d = (I-€) pewf + Epewp + cpt (6)
where
v , = accounting ratio (AR) for cotton yarn
wf = AR for foreign exchange (this will be 1 . 0 unless
foreign exchange is viewed as a merit item)
w p = AR applicable to the increased profits or
incomes due to the reduction in exports
vt = AR for transport and miscellaneous costs.
Dividing (6) through by the domestic price p d gives the
input coefficients for and A and B matrices.
Two points about this procedure should be stressed.
First, we see that it allows for the imperfections of world
demand or supply facing the country and thus invalidates
the common suggestion that procedures based on
conversion factors assume infinitely elastic world supply or
demand.
Second, in adjusting for market imperfections, it
prompts us to take proper account of any distributional
Conversion factors and shadow exchange rates
changes brought about by the price changes. This is the
role of the element €pewpin (6) which may in some cases
be quite significant and which is often neglected in other
analyses.
Thus, we may observe that the LMS procedure has the
merit of focusing our attention on the indirect effects of
producing or using certain commodities which might
otherwise be neglected. Indeed, it is possible to take the
analysis of both this point and of economies of scale one
step further by allowing for the possibility that changes in
the supply of or demand for such goods may change
domestic prices and thus indirectly lead to changes in non-
project domestic consumption and/or production whose
net social value should be incorporated in the shadow
price (Scott 1976, page 194).
Inelastic domestic supply
Items subject to elastic domestic supply may be divided
into agricultural and other product, remembering, of
course, that such constraints are only relevant so long as
the item is non-traded. For non-traded agricultural
output, the usual LMS procedure is to treat this as a
general primary input, whose accounting ratio is estimated
by special analysis.
Scott (1976, pages 156-166) discusses the factors
which affect the social cost of non-traded agricultural
output and gives a rather complicated formula which takes
account of substitution between traded and non-traded
goods in agricultural production, effects on the distribution
of income, substitution in consumption patterns, and the
costs of marketing. However the accounting ratio for non-
traded agricultural output is estimated, it is bound to be
subject to a considerable margin of error because of
difficulties with data as well as the analytical complexity of
the factors involved.
Nonetheless, by distinguishing. the category as a
separate primary input we can easily examine how
sensitive the other accounting ratios are to variations in our
assumptions about the social costs of non-traded
agricultural commodities. If it turns out to be important,
then more effort can be devoted to improving the estimate
of the accounting ratio without disrupting the other work.
Non-agricultural products subject to inelastic supply
may be treated in the same way as either non-traded
agricultural output or products subject to increasing costs
of production. In my experience, the only item which
warrants specific treatment similar to non-traded
agricultural output is the social costs of urban house rents,
since an increase in the demand for urban housing can
generate large distributional effects which should be
incorporated in the analysis. Other non-traded goods or
services with inelastic supply may be dealt with by
combining the treatment of diseconomies of scale with the
analysis of price changes in the previous two sections.
Switches in trade jlows
In general, an economist estimating a set of shadow prices
must make a judgement about whether particular goods
should be treated as exportables, importables or non-
traded goods. This judgement must be based on an
analysis of the medium term prospects given the policies
taken as fixed in our discussion of the second best above.
1x4
In the case of some projects or countries there may be
real uncertainty about whether a good should be treated as
an importable or an exportable or the pattern of trade may
be expected to switch in the medium term. For specific
projects, it is not difficult to allow for this by calculating
and using two accounting ratios appropriate to the two
patterns of trade. However, for a general set of shadow
prices, the real problems arise if the commodity is the
major foodstuff in domestic consumption and there is a
large difference between the import and export parity
prices. This was the case with maize in Kenya for a
number of reasons associated with agricultural change,
government policy and investment in transport facilities.
The appropriate procedure here is to assume a market
price for the commodity between the import and export
parity prices and then to calculate two accounting ratios
for it on the alternative assumptions about the direction of
trade. These imply two different sets of accounting ratios
which define the limits of the variation in shadow prices
due to this problem. the choice of which set of accounting
ratios to use must be based on a judgement about the
likely pattern of trade over the next 5-8 years.
Alternatively, an accounting ratio for the foodstuff in
between the two extreme values may be adopted in order
to derive a single set of accounting ratios.
I have discussed the treatment of these various features
of trade and production at some length in order to
illustrate the point that the LMS method of estimating
shadow prices encourages the analyst to examine and allow
for all the various institutional and other factors which
affect the relationship between social and market values. It
is often suggested by advocates of shadow exchange rates
that procedures which focus on shadow prices for goods
fail to allow for variable returns to scale, imperfect world
markets, etc. Quite clearly, this argument is incorrect.
Indeed, it may be turned on its head, because the
procedures outlined enable us to incorporate the specific
effects of these factors for particular commodities, whereas
they can at best be allowed for via estimates of shadow
exchange rates in a crude and aggregative manner.
This leaves the possibility that there are certain general
factors at an aggregate level which are not adequately
encompassed by the micro-level analysis of the LMS
procedure. I have discussed tlis in another paper, but note
that this would imply a real problem of consistency within
a framework based on shadow exchange rates as
conventionally specified. These are, in effect, estimated as
an index of the ratio of domestic-to-border prices, using
marginal trade flows as weights - eg Balassa (1974,
equation (7a) ). If, in addition to the use of this conversion
factor for foreign exchange, specific adjustments are made
to allow for inelastic world demand/supply in the cases of
particular commodities, then clearly there is an element of
double counting in the final shadow prices of those
commodities.
On the other hand, it would be even more inaccurate to
fail to adjust for the specific market imperfections and it
would be impossibly complicated to attempt to eliminate
the double counting
The point may be put in another way. Shadow
exchange rates were originally derived as a short-cut
Project Appraisal June 1986

method of allowing for the divergence between social
values at border prices and at domestic prices. However,
they are not designed to allow for such divergences at a
micro-level, whereas the Little-Mirrlees method starts
from that level and builds upwards.
Hence, as we shall see, it is not normally necessary to
use an aggregate shadow exchange rate in a procedure
based on properly estimated accounting ratios. The
UNIDO approach, as shown above, needs a shadow
exchange rate only because of its use of a different
numeraire, so that its shadow exchange rate is simply the
inverse of the accounting ratio for its numeraire in. the
LMS approach.
Exchange rate changes
The discussion so far has been based on the assumption
that the current money exchange rate corresponds to the
long term equilibrium exchange rate given the system of
taxes, tariffs and subsidies taken into consideration when
calculating the shadow prices. The concept' of an
equilibrium exchange rate is not well defined for
developing countries.
Here I shall assume that, given world prices and market
prospects, the exchange rate is at its long term equilibrium
if, when the level of economic activity in the economy is
such as to ensure full capacity utilisation in the long term
for the modern sector, the balance of payment shows a
deficit (surplus) which corresponds to the government's
willingness to borrow abroad (to acquire foreign assets).
In practice, those concerned with the estimation of
shadow prices may feel that the current exchange rate
diverges from the equilibrium rate in this sense, even if the
balance of payments is not systematically in surplus or
deficit. For instance, the balance of trade may be
maintained at a certain level by the use of temporary taxes
and tariffs, or by quantitive controls.
Temporary measures should clearly be excluded from
the estimation of shadow prices while we have assumed
earlier that quantitive restrictions should not be taken into
account when constructing our estimates. Alternatively, it
may be clear that the country cannot continue in the long
term to borrow abroad at the current rate or that the
exchange rate can only be sustained by restricting the level
of economic activity considerably.
For whatever reason we may therefore have to take
account of the divergence between the current exchange
rate and the equilibrium rate. It will be assumed that the
current exchange rate is overvalued and that the amount of
the devaluation required to eliminate the divergence has
been separately estimated. These are important issues, of
course, but they are not specifically related to our
consideration of the methodology of project evaluation.
The usual recommendaton then is that the shadow
prices should be calculated by adopting the equilibrium
exchange rate in place of the current exchange in
converting all foreign exchange rate as illustrated by the
discussion in Bacha and Taylor (1971).This is, however,
not a satisfactory method of adjustment for two
interrelated reasons.
Project Appraisal June 1986
Conversion factors and shadow exchange rates
Social Costs
First, shadow prices should reflect the social costs or
values of items to the economy on a medium or long term
view. This implies that we should incorporate the effect of
the devaluation on the prices of domestically produced
goods and services in calculating shadow prices. Hence,
we would need to follow through the full ramifications of
the higher prices for traded goods and services, not only
with respect to the behaviour of domestic producers faced
with an increase in the nominal cost of intermediate inputs
but also in terms of the adjustment of wage rates, profit
margins and other factor incomes.
If producers set their prices according to some kind of
markup principle and factor incomes in real terms are
unaffected by the devaluation, it can be shown that the
LMS method of calculating accounting ratios may easily
be modified to yield estimates of the post-devaluation
shadow prices.
In order to demonstrate this point, it is first necessary
to distinguish between two sets of accounting ratios (ARs)
which will be referred to in the discussion.
Current price ARs, denoted by v;, wh, give the ratios of
the shadow prices of the items at some future date to their
market prices at that date;
Constant price ARs, denoted by v*;, w*h, give the ratios
of the shadow prices of the items at some future date to
their market price at date o of the analysis.
Obviously, we need to know the current price accounting
ratios if the work of estimating shadow prices is to be
useful for the purpose of evaluating proposed projects or
policies in the future, but it is also convenient to calculate
constant price accounting ratios since these provide us with
information about the magnitude of the adjustments
associated with a move to an equilibrium exchange rate.
Let us suppose that the percentage devaluation required
to move from the current to the equilibrium exchange rate
is I ooy , Then, the LMS method will yield the current and
the constant price accounting ratios if we adopt an
appropriate normalisation of the accounting ratio for
foreign exchange:
For convenience, define a trade-weighted basket of
foreign currencies as the unit for border prices in the
analysis - denoted by the abbreviation BPU; and
define e, as the number of units of domestic currency
purchased by 1.0 BPU at date t .
Suppose that the project for which er is at its maximum
is implemented at date t = s . Denoting the accounting
ratio for foreign exchange at date t by w,(t>,we choose
the normalisation:
w,(s) = 1.0
For any other projects at date t the accounting ratio for
foreign exchange should be given by:
w,(t> = er/et
This procedure ensures that all projects are converted to
border price terms on an equivalent basis. It is then
only necessary to deflate the net present value of
different projects by an index of commodity prices
measured in border price units.
115
Conversion factors and shadow exchange rates
If the devaluation leaves relative
prices and factor incomes unaltered
there may be little point in adjusting
accounting ratios because the
adjustment will have no effect on the
ranking of alternative projects
For example, suppose that we choose the US$ as our
BPU for a country and that at present e, = 5 . 0 whereas
the medium term equilibrium exchange rate is estimated to
be e, = 6.0. Then, for all projects evaluated at pre-
devaluation market prices, we should use the constant
price set of accounting ratios which should be calculated
by using an accounting ratio for foreign exchange of wj(01
= I .2. The current price set of accounting ratios is
required for the evaluation of projects whose financial
information is based on post-devaluation market prices
and for this purpose the accounting ratio for foreign
exchange will be wj(s> = 1 . 0 .
It is not sflicient to modify only the accounting ratio
for foreign exchange in calculating the constant price set of
accounting ratios, since this change will also affect the
accounting ratios for the other primary inputs as well as
the accounting ratios for goods and services.
In fact, it is straightforward to show that, if the
devaluation leaves relative prices and factor incomes
unaltered, all of the constant price accounting ratios will
simply be equal to the accounting ratios which would be
obtained if the exchange rate adjustment had been ignored
multiplied by the ratio eJe, as described above. This
implies, of course, that there may be little point in
adjusting accounting ratios for a devaluation of this kind,
because the adjustment will have no effect on the ranking
of alternative projects.
The discussion above confirms the results obtained
from current macro-models of exchange rate adjustment.
A devaluation on its own is not sufficient to eliminate the
macro-economic disequilibrium which is the source of the
original balance of payments deficit. To be effective, the
devaluation must bring about a change in the relative
prices of traded and non-traded goods and reduce
aggregate income and expenditure levels at full
employment.
Hence the second reason for the unsatisfactory nature
of the earlier method of adjustment is that, in constructing
a set of accounting ratios which take account of the need
to eliminate initial disequilibrium, we must focus on the
real changes in the pattern of incomes and expenditures
which are associated with the adjustment. There are, in
practice, two methods of adjustment:
0 Reduce investment and/or public expenditure. This
implies that the value of public income relative to
aggregate consumption must rise, so that income
weights must fall, and also the accounting rate of
interest (ARI) will increase relative to the consumption
rate of interest (CRI), since the gap between the critical
consumption level and the average consumption level
has increased.
0 Reduce real wages and other factor incomes. This may
I 16
be achieved either via a general increase in taxation or
by holding- down the nominal wage - rates paid to
some/all workers while allowing prices to respond to
the devaluation.
Whatever the mode of adjustment, it will alter the
accounting ratios for wages and other factor payments by
changing the magnitude and the composition of the
resources committed as a result of offering additional
employment. The consumption conversion factor would
be reduced by an increase in indirect taxation, which
would in turn reduce the income weights for specific
income levels. The overall switch of resources from
personal consumption to investment and public
expenditure implied by a reduction in real wages means
that in this case also the ARI will increase relative to the
CRI.
We have seen that the elimination of a long term
balance of payments deficit requires adjustments in real
income and expenditure levels that would affect the long
term values of key national parameters in a set of shadow
prices, which would in turn also change most of the
accounting ratios fdr goods and services. Hence, an
economist charged with the task of constructing a set of
shadow prices for a country which appears to be suffering
from a fundamental balance of payments disequilibrium
must start by considering the alternative modes of
adjustment which might be adopted for the purpose of
achieving long run equilibrium.
It may then be necessary to construct several alternative
sets of long run accounting ratios - current price
accounting ratios - corresponding to different
combinations of adjustment policies. In practice, the
effects of the alternative policies on the important national
parameters are likely to be rather similar, so that one or at
most two sets of accounting ratios will be sufficient to
represent the expected long term pattern of relative social
costs and benefits of the items under consideration.
Cases where adjustments are inappropriate
There are, however, circumstances in which it would not
be appropriate to incorporate long term adjustments of the
type envisaged above in the accounting ratios computed to
assist in the appraisal of projects over a period of years.
One obvious case arises when a country is operating a
conscious policy of borrowing abroad, relying upon short
or long term capital flows to offset a trade deficit.
Equally, a country which is experiencing a temporary
balance of payments deficit because of lags in the process
in adjusting the exchange rate in response to a domestic
rate of inflation in excess of the level of world inflation as
measured by the foreign exchange costs of traded goods,
should not be treated as a country with a fundamental
balance of payments disequilibrium.
In such a case, it is nonetheless necessary to make some
allowance for the prospective exchange rate change. This
should take the form of estimating shadow prices on the
basis of a ‘normal’ set of market prices, that is, a set of
prices which reflects the pattern of relative prices which
would prevail if the exchange rate was indexed to the
difference between domestic and world inflation rates.
Perhaps the most interesting case in which it may not
Project Appraisal June 1986
 Conversion factors and shadow exchange raies

be necessary to take account of the real changes production - will be increased by the changing
accompanying an exchange rate change arises when we composition of production. Alternatively, it may be
consider the role of exchange rate policy as an instrument feared that serious shortages of key categories of skilled
of macro-economic control. labour will develop.
The discussion above was predicated on the assumption
We will return to both these factors in due course.
that a devaluation which has no long term real effect on
Excluding their influence, extra production or investment
relative prices and factor rewards cannot resolve the
which satisfied our criterion of social profitability on the
original disequilibrium which prompted it. If we assume a
basis of long run shadow prices must improve the balance
given structure of protection and a constant level of
of payments.
capacity utilisation or unemployment, this is indeed
The argument above shows that even if long run
correct. However, neither of these assumptions may be
relative prices and incomes are not altered the devaluation
appropriate for most developing countries, and even if
may fulfil its purpose. In effect, it provides a respite from
they were, the devaluation may be regarded as a valuable
the short term pressure of balance of payments difficulties,
component of short or medium term economic
while longer term policies of investment and structural
management.
change deal with the underlying disequilibrium. Even in
Effects of dev a1u ation the absence of investment, the re-establishment of the
original set of relative prices and incomes need not mean
It is not possible here to develop a full analysis of the
that production and employment decline back to their
relationship between exchange rate policy and investment
initial levels.
analysis, but I will sketch the main lines of the argument.
If the extra production is sufficiently profitable in terms
Suppose that the devaluation is envisaged because of the
of shadow prices, this alone may be enough to greatly
need to adjust to a current or prospective balance of
reduce or eliminate the disequilibrium. This, of course,
payments deficit or as an accompaniment to the
illustrates the fundamental point that we should not
dismantling of quantitative trade restrictions. Assuming
assume that the nature of long run
that the level of investment is determined separately then
equilibrium/disequilibrium is invariant to the policies and
the devaluation can only succeed by altering the balance
other factors influencing short run dynamics.
between factor productivity and factor incomes - or,
The analysis above applies only if the underlying
more accurately, consumption out of factor incomes.
disequilibrium is relatively small. It would take too long to
In the short run, a devaluation will typically reduce real
eliminate the fundamental balance of payments
wages and thus affect this balance directly. Further, its
disequilibria experienced by some countries by the kind of
effects on relative prices will enhance the profitability of
production and investment gains discussed. Further, while
producing tradable goods while increasing the demand for
the devaluation may leave real wages and consumption
non-traded goods. Thus, we may expect an increase in
unaffected in the long run, it will still cause changes which
capacity utilisation and employment throughout the
should be reflected in the shadow prices used for the
economy, assuming that this is possible. Provided that,
estimation of project costs/benefits in the short term.
when valued at shadow prices, this extra production is
There is a general problem concerning the appropriate
socially profitable, it will contribute to the country’s net
method of constructing and using shadow prices which
resources and thus improve the balance of payments.
vary over time. Too little attention has been given to this
Similarly, as the short term extends to the medium and
problem in the past, but I will leave a proper treatment of
long term, new investment projects will come to fruition.
it to another paper and will focus on the consequences of
Provided that these satisfy the criterion of social
the temporary effects of a devaluation.
profitability using long run shadow prices, they too will
For the project analyst the most significant short term
contribute more to the country’s aggregate income than
change caused by a devaluation may be assumed to be a
will be committed to consumption and other expenditure.
reduction in the real wages and consumption of non-
Further, as long as real wages remain below their long
agricultural workers which implies that shadow wages
term level, this contribution will be increased.
must fall relative to other shadow prices. It follows,
Against this, there are two factors which might reduce
therefore, that if we use the shadow prices calculated on
the balance of payments benefits of the increase in capacity
the assumption of no change in relative prices and
or production. These are:
incomes, we will, in most cases, tend to be too
The benefits which make the production or investment conservative about accepting projects.
socially profitable may be distributional rather than With very few exceptions, projects which are socially
resource benefits. In principle, this should not matter profitable on this basis will be at least as worthwhile when
provided that the government is prepared to increase
taxes on consumption or incomes to offset the
commitment of resources to consumption. In practice,
If we use the shadow prices calculated
of course, it may be very reluctant or unable to do this. on the assumption of no change in
As employment and capacity utilisation rise, the input relative prices and incomes we will
coefficients used in calculating the shadow prices may tend to be too conservative about
be significantly altered. In particular, it may be thought accepting projects: if the devaluation
that the marginal product of labour in agriculture - or, is taken into account they will be at
more generally, the social opportunity cost of labour in

Project Appraisal June 1986

Conversion factors and shadow exchange rates
evaluated at shadow prices revised to take account of the
effects of the devaluation. The exceptions will be those
projects whose primary benefit is derived from the direct
or indirect replacement of labour in production or
consumption by capital or other inputs - such as labour-
saving mechanisation or the displacement of pottery or
wooden consumption goods by plastic or metal-substitutes.
Given that even the short run real effects of a
devaluation are often quite uncertain, it may be sensible to
adopt the aassumption that these effects can be neglected
for most purposes with some form of special adjustment
being introduced in those cases where the shadow wage
rate is clearly of critical importance to the acceptability of
the project.
Adjustment procedure
Let me now summarise the results of implementing the
adjustments discussed above within the context of the
LMS method of estimating shadow prices.' I will do this
by outlining the estimation procedure in terms of a series
of steps. Unless otherwise specified accounting ratios
should be understood as referring to constant price ARs,
so that shadow prices will be the product of the accounting
ratios and predevaluation prices:
I. Following the LMS procedure outlined earlier,
calculate the input matrices A, B and thus the total
primary input requirement matrix R = [I-AI-IB.
2. Calculate a set of current price accounting ratios w
for the primary inputs based on data relating to the
current, pre-devaluation, levels of wage rates, market
prices and so on.
3. The accounting ratios for good and services may then
be calculated from
V* = Rw*; W* = w (.I+T) (7)
where q is the predicted proportional devaluation.
4. A judgement must be made as to whether the
devaluation will in fact affect relative prices and
incomes in the medium and long term. In part, this is
an empirical question concerning the nature of
complementary economic policies and the institutional
responses to the initial effects of the exchange rate
change. In addition, it involves an assessment of
whether real income or price changes are required in
order for the devaluation to be successful.
5. If it seems probable that the devaluation will not or
need not affect relative prices and incomes, then the
initial set of accounting ratios should be used to
evaluate all projects using constant prices. For
projects assessed after the devaluation it may be
necessary to use post-devaluation prices in which case
the relevant accounting ratios will be the initial ones
multiplied by I ( I + T I .
6. If it is believed that the devaluation will or must alter
relative prices and incomes, then the accounting ratios
for post-devaluation costs and benefits will differ
from those relevant to the pre-devaluation period.
The change in the accounting ratios may be estimated
as follows:
0 Estimate the expected proportional fall in real
118
non-agriculture wages, @ .
0 On the assumption the accounting ratio for
marginal urban household expenditure is similar to
the consumption conversion factor, vo calculate
the change in the accounting ratio for urban wages
using:
Aw*,, = -$(I-") (I-uA
~ * c (8)
where 'I'is the typical rate of direct taxation -
income plus any social security taxes - and u,, is
the relative income weight for urban workers
normalised so that the relative income weight at
the critical consumption level is 1.0.
0 The new accounting ratios may be obtained by
substituting w f u l + A W * ~for~ w * , ~ in the
calculations specified in step 3 above.
0 If the difference between the initial estimate of v * ,
and the revised estimate of this parameter is
significant, then the revised accounting ratios
should be used to estimate the change in the
primary input accounting ratios, Aw*, and the
revision process repeated until the estimates
converge. Usually it will not be necessary to
perform more than one further revision.
7. For accounting ratios to be used with post-
devaluation prices, it is necessary to multiply v *, w *
by I / ( I + ~ ) as in step 4 above.
There are three particular problems which should be
borne in mind when implementing this procedure for
adjusting shadow prices to take account of a prospective
devaluation. It is not possible to lay down any general
precepts about them, so in the following discussion I will
focus on the assumptions implicit in the usual approach
and on possible responses to the violation of these
assumptions.
Labour markets. When estimating shadow wage rates we
make a variety of assumptions about the relationship
between labour markets and the behaviour of wage rates in
response to changes in demand. The usual model is based
on the view that additional employment in the formal
sector results directly or indirectly in the transfer of an
equivalent of workers out of small scale agriculture. This
is certainly a convenient assumption, and it may even
represent the true response of the system reasonably well,
though we have little evidence on which to base careful
tests of the hypothesis.
However, an exchange rate change may substantially
affect the overall pressure of demand in various segments
of the labour market. So long as a type of constant returns
to scale assumption is thought to be appropriate this
should not matter.
If, on the other hand, the non-agricultural sector is
almost as large as or even larger than the small scale
agricultural sector in terms of employment, we might
expect such a change to be associated with an increase in
the marginal product of labour in agriculture and a
decrease in the ratio of workers moving out of agriculture
to new employment outside agriculture.
In simple terms these two factors tend to offset each
other, but they imply that we ought to incorporate a fuller
Project Appraisal June 1986

analysis of informal sector urban labour markets when
evaluating the effect of the exchange rate change on the
social cost of labour. The same consideration applies if the
devaluation is associated with a significant change in the
relative prices facing different sets of producers. For
example, the combination of lower real urban wages and
higher relative prices for agricultural export crops may
significantly lessen the rate of transfer from agriculture to
the urban sector in response to new employment
opportunities in the latter.
It is, of course, easy to construct examples in which an
exchange rate change, or other policy changes, may affect
the shadow wage rate. In practice, these are most likely to
be relevant to countries like Taiwan, Venezuela, Turkey
and Mexico where the process of labour transfer out of
agriculture has already progressed a considerable way.
Even for such countries it is likely that the exchange rate
change would have to be associated with quite radical
changes in policy, prices or labour market forces to alter
the shadow wage rate (SWR) significantly.
This is because experience suggests that the
predominant component of the SWR is the net social cost
of the additional consumption caused by extra
employment. Certainly, in considering the implications of
a prospective devaluation serious thought should be given
to its effects on the assumptions underlying the SWR
estimates.
However, it may prove more advisable to re-estimate
the SWR at relative frequent intervals - say, every 3-4
years - rather than trying to make elaborate but probably
rather dubious adjustments to estimates based on current
data.
Income weights. I have already stressed that a devaluation
may require a fall in real incomes - probably urban real
wages - if it is to be successful. This implies a fall in the
social weight assigned to consumption relative to other
uses of resources, at least as regards its embodiment in
policy. In other words we should use lower income
weights when evaluating the distributional consequences of
projects and the income benefits incorporated in estimates
of shadow wage rates, and so on.
Strictly, it could be argued that the change does not
affect the income weights themselves, but rather the social
cost and effectiveness of policies designed to reallocate
resources from consumption to investment and other uses.
I do not find this a very plausible argument, because in
almost all countries governments could implement taxes
and other domestic policies to achieve this redistribution,
particularly with respectto urban real wages, without
resorting to exchange rate changes.
Thus, I would interpret a devaluation as implying a
reduction in the relative importance of consumption
combined with an intention to stimulate the overall level of
utilisation of resources in the economy and to achieve a
reallocation of their employment in production. Probably
the most appropriate way of incorporating the inferred
decline in income weights is to assume that the critical
income level has been reduced by the proportion 4 .
Unless there are strong reasons for believing that real
incomes in the rural sector will fall along with those in the
urban sector, it will probably be sufficient to make this
Project Appraisal June 1986
Conversion factors and shadow exchange rates
adjustment to the urban critical income level alone. This
will imply an inconsistency between the urban and rural
critical income levels, which may worry some people.
However, I am inclined to believe that governments are
almost never consistent in their distributional judgements
as between urban and rural households, since typically
urban dwellers receive much greater weight than might
seem justified by their relative income level. If the critical
income level is reduced by a proportion o , then the new
income weights u^ will be given by:
u* = (I -$)EU (9)
where E is the inequality aversion coefficient from an
isoelastic social welfare function (Scott I 976, Chapter 3,
or S-T, 136).
Changes in input coefficients
It has been shown that so long as prices continue to be
set in the same way, essentially on an input cost basis, we
can use the pre-devaluation input coefficiants, a,, brh to
calculate accounting ratios and shadow prices for the post
devaluation situation. However, as we saw earlier, changes
in the exchange rate may lead to changes in the social cost
composition of items subject to monopolistic or
discriminatory pricing in domestic markets.
Such changes are likely to be especially troublesome
where the devaluation is associated with the removal of
quotas or other import barriers. This is because the policy
changes may have the effect of eliminating monopolistic
profits accruing to those controlling the import licences.
Alternatively, they may switch the appropriate basis for
assessing the social cost of an item from that of its social
value in different uses to the social cost of increasing its
domestic supply. It is not really possible to suggest any
general procedure for dealing with the latter case, except
to note that it will imply some revision of the input
coefficients.
Arguably, in preparing shadow prices estimates using
the LMS procedure one should always focus on the social
cost of increasing domestic supply, even when there are
fairly rigid quotas, because marginal social productivity is
extremely hard to measure sensibly and may be quite
variable over time. In general, this seems a reasonable
basis on which to work but, in the case of particular
projects, it may be quite misleading to cost some key input
on this basis, so that one must always be aware of the
problem.
Of course, these comments apply primarily to shadow
pricing items on the cost side of a project, since often on
the benefit side it will be appropriate to use some valuation
of the social productivity of the -project’s output(s) - such
as water, electricity, roads.
Where quotas or other import restrictions lead to
domestic prices which exceed the equivalent import parity
level, thus creating super-normal profits for importers or
others, the simplest approach is to introduce a special
primary input category: quota profits. Then, for as long as
the quotas are in force, a conversion factor appropriate to
the social cost of these profits should be used for this
primary input.
After the devaluation and the elimination of the import
Conrwsiorr Jacrors atid shadow exchange r a m
restrictions this conversion factor will become zero -
A W * ~=~ - w l q P- so that in this way the effect of the
quotas can be integrated with the normal LMS estimation
procedure for accounting ratios and the method of
adjusting for the devaluation outlined above. In cases
where this method would be inappropriate, it will be
necessary to adjust the input coefficients specifically in
order to derive accounting ratios or shadow prices.
References
Bacha, E & Taylor, L (1971). "Foreign exchange shadow prices:
a critical review of current theories", Quarterly Journal of
Economics. Vol 85, pages 197-224.
Balassa, B (1974), "Estimating the shadow price of foreign
exchange in project appraisal", Oxford Economic Papers, Vol
26, pages 147-168.
Bhagwati, J (19691, "On the equivalence of tariffs and quotas"
in J Bhagwati Trade, Tariffs and Growth, Massachusetts
Institute of Technology Press, Cambridge, Mass).
Dasgupta, P, Marglin S Et Sen, A K (19721, Guidelines for Project
Evaluation (UNIDO, Vienna).
Dasgupta, P & Stiglitz, J E (1974). "Benefit cost analysis and
trade policies", Journal of Political Economy, Vol 82, pages 1-
34.
Hughes, G A (19761, "Investment and trade for a developing
economy with economies of scale in industry", Review of
Economic Studies. Vol 43. pages 237-240.
I20
Hughes, G A (19791, Shadow Prices for Project Appraisal in
Morocco (mimeo: World Bank).
Hughes, G A (1980). Shadow Prices and Economic Policy in
Tunisia (mimeo: Cambridge).
Little, I M D 8 bhirrlees, J A (1974). Project Appraisal and
Planning for Developing Countries (Heinemann: London).
Little, I M D & Scott, M Fg (19761, Using Shadow Prices
(Heinemann: London).
Pursell, G (19781, Estimating Shadow Exchange Rates: The Ivory
Coast (mimeo: World Bank, Washington DC).
Scott, M Fg (1976). "A set of accounting prices for Kenya" in
Scott, MacArthur 8 Newbery, pages 3-232.
Scott, M Fg (1974). "How to use and estimate shadow
exchange rates", Oxford Economic Papers Vol26, pages 169-
184.
Scott, M Fg, MacArthur, J & Newbery, D (1976). Project
Appraisal in Practice (Heinemann: London).
Squire, L 8 van der Tak, H G (1975). Economic Analysis of
Projects (John Hopkins University Press, Baltimore).
Notes
1. For a general discussion of investment with economies of
scale and a demonstration of the validity of the procedure
outlined, see Hughes (1976).
2. This is the foreign price converted into rupees a t the current
exchange rate.
3. Readers interested' in a more rigorous mathematical
treatment of the problem should refer to the author for an
earlier version of this paper which gives the details of the
analysis.
Project Appraisal June r986