IMPACTS OF FOREIGN SAVINGS INFLOWS ON THE PALESTINIAN ECONOMY: A CGE ANALYSIS

International Journal of Eonomis, Commere and Management United Kingdom Vol. II, Issue 12, De 2014 http://ijem.o.uk/ ISSN 2348 0386 IMPACTS OF FOREIGN SAVINGS INFLOWS ON THE PALESTINIAN ECONOMY: A CGE ANALYSIS Abdel Hakeem Ahmad Eltalla Faulty of Business and Finane, Alaqsa University, Gaza, Palestine hakeemeltalla@hotmail.om Abstrat This paper investigates the impat of inreasing foreign savings by 50% from the base line on the aggregate Palestinian eonomy variables. A simulation of inreasing foreign savings is arried out using a 2012 Palestinian Soial Aounting Matrix (SAM) and Computable General Equilibrium (CGE). We simulate the impat of a 50% inrease in foreign savings, whih ould ome about due to inreased aess to world finanial markets or in the form of foreign aid inflows. The simulation results show that real GDP inreases by 1.60 % and nominal GDP by 4.53%. The level of real private onsumption inreases by 16.53%. Import inreases by 18.89% and export dereases by 16.03 % in real term. The trade defiit inreases by 31.64 %. Real exhange rate and nominal exhange rate derease by 7.40% and 5.0 % from the base line respetively. Absorption inreases by 10.79% in real terms. This inrease ours through the domesti (non-tradable) prie index, whih dereases by 2.50%. Keywords: Trade Liberalization, foreign savings, urrent aount defiit, Computable General Equilibrium, Palestinian eonomy INTRODUCTION The Palestinian eonomy faes a more unertain prospet with fundamental hanges: GDP is driven more by government spending and foreign aid, and there are less resoures for investment, thereby further reduing the produtive base of the eonomy, whih is needed for a stable and viable independent Palestine. The ontinued isolation of the West Bank and Gaza under the Israeli losures and the blokade of Gaza have further fragmented the eonomy. Trade dependene on Israel is reinfored by the Palestinians' signifiant reliane on it for imports and exports. The trade defiit with Israel is estimated to have inreased from 38% in Liensed under Creative Common Page 1

Abdel 1999 to 56% of GDP in 2008. The inrease in the trade defiit with Israel is driven by the loss of produtive apaity and the inability of loal produers to meet demand, whih has inreased dependene on imported onsumer goods (UNCTAD, 2009). Foreign savings play a signifiant role in the infrastruture and soial setor requirements of developing ountries. The apaity to borrow apital from the rest of the world is a basi different between open and losed eonomies. Open eonomies able to finane produtive investments that ould not arry out based only on domesti savings. Open eonomies inline to borrow apital from the rest of the world, whih imply runs a urrent aount defiit. Current aount defiits lead to the build up of foreign debt that must be paid bak in the future. The urrent aount balane is the total of exports of goods and servies to the rest of the world less imports of goods and servies, in addition to net inome and unilateral transfers inluding workers remittanes, grants, gifts, et. The national aounts identities show that the urrent aount balane is the differene between domesti investment and savings. A urrent aount defiit entails an exess of investment over savings. It might aused by an investment surge due to better growth outlook or a defiient in savings due to severe publi onsumption. A foreign saving finanes the urrent aount defiit, whih are international apital inflows (Belke and Dreger, 2013). The inflow of foreign apital an indue the exhange rate to appreiate, whih boosts real wages and imports and affets exports and future eonomi growth. Asian eonomies have proteted their (ompetitive) exhange rates in order to support growth (Bresser-Pereira and Gala, 2008). Eonomi theory informs us that whether a urrent aount defiit is good or bad depends on the auses leading to inrease the defiit, however eonomi theory also onveys what to searh for in onsidering the desirability of a urrent aount defiit. If the urrent aount defiit indiates an exess of imports over exports, it may be suggestive of ompetitiveness diffiulties, however the urrent aount defiit also entails an exess of investment over savings, thus it ould similarly be indiating a highly produtive, growing eonomy. If the urrent aount defiit indiates low savings rather than high investment, whih hasty fisal poliy or a onsumption extravaganza might ause it. Without aware whih of these is aused the urrent aount defiit, it makes little sense to tell if a urrent aount defiit is good or bad. the urrent aount defiit manifest underlying eonomi inlinations, whih might be desirable or undesirable for a nation at a speifi point in time (Ghosh and Ramakrishnan, 2012). Palestine is a small, resoure-poor and import dependene eonomy. The Palestinian eonomy relies on external resoures. Palestine is highly open import dependent eonomy and imports play a ruial rule in influening domesti ativities and balane of payments situation. Current aount defiit is a persistent feature of the Palestinian eonomy. The urrent aount defiit (foreign savings) as a ratio to GDP was 8.5% 2007 and inreased to 30.3% in 2012. In Liensed under Creative Common Page 2

International Journal of Eonomis, Commere and Management, United Kingdom terms of the ertain omponents of the urrent aount, imports have always surpassed exports. The trade defiit was 64.7 % and 67.4% of GDP in 2007 and 2012 respetively. The trade defiit is the prinipal ause of the urrent aount imbalane. Further, Palestine depends on imports to meet its onsumption and prodution requirements. In 2012, imports of goods represented 80.9% of domesti GDP, while exports only ounted for 13.5%. In 2012, Palestine ran a $ 2,291.4 million urrent aount defiit, it as well onfronted a $ 2,291.4 million net inflow of foreign apital, in the form of external debt, aid, foreign diret investment, portfolio investment and other forms of apital flows (PCBS, 2014a; PCBS, 2014b). The objetive of this study is to show empirially the impat of inreasing foreign savings (urrent aount shok) by 50% on maroeonomi indiators suh as on domesti prodution, imports, export, household onsumption, and other related variables. To quantify the impat of inreasing foreign savings on the Palestinian Eonomy, we onstruted a general equilibrium model that aptures the eonomi onditions and harateristis of the Palestinian eonomy, and we onstruted a 2012 soial aounting matrix for Palestine. The study fouses on the impats of a 50% inrease foreign savings as relative to the baseline. LITERATURE REVIEW The inflow of foreign apital an indue the exhange rate to appreiate, whih boosts real wages and imports and affets exports and future eonomi growth. Ngalawa (2014) used Computable General Equilibrium model for Malawi to measure the impat of an inrease in foreign savings and tariff ut. Ngalawa fond that doubling foreign savings boost onsumption and negatively influenes the prodution side of the eonomy. A 100% raise in foreign savings is overall detrimental to the eonomy. Total real exports, real exhange rate, nominal exhange rate, deline by 4.9%, 1.4%, 1.0% respetably. Real absorption inreases by 1.9%, real household onsumption inreases by 4.0%, and total imports inreases by 1.3%. Ahmed and O Donoghue (2009) used Computable General Equilibrium model for Pakistan to measure the impat of hanges in import pries and inrease in foreign savings that are usually arranged for developing ountries in order to supplement the domesti savings and diret investment towards developments and soial setors. As a result of a 50 perent inrease in foreign savings: GDP inreases by 0.1 perent. The private onsumption inreases by 2.8 perent, imports inrease by 3.7 perent and exports deline by 6.5 perent. Siddiqui and Kemal (2006) used Computable General Equilibrium model for Pakistan to measure the impat of an inrease in foreign apital on poverty both in the presene and in the absene of trade liberalisation. They found that inrease in foreign apital inlines to derease poverty in the presene as well as in the absene of trade liberalisation. Reinhart and Reinhart (2008) evaluated apital inflow in Liensed under Creative Common Page 3

Abdel 181 ountries for the period of 1960-2007. They found that for emerging markets, apital inflows are related to a higher possibility of finanial and eonomi risis. Bresser-Pereira and Gala (2008) highlight that the inflows of foreign apital appreiate the exhange rate. That onseutively inreases the real wages and imports. This has impliations for exports and future eonomi growth. Although medium inome ountries are apital poor, urrent aount defiits (foreign savings) will boost onsumption rather than enhane the rate of apital aumulation and aggregate demand. As a result, the rate of substitution of foreign savings for domesti savings will be to a ertain extent high, and the ountry will indebted to onsume, not to invest and grow. Eihengreen and Leblang (2003), studied the effet of apital liberalization on growth between 1880 and 1997 on 21 ountries, they found that apital ontrol might be negative, as they may distort resoure alloation. However, apital ontrol is positive in evading maroeonomi failure. Bresser-Pereira and Nakano (2002) studied the impat of foreign savings on growth. They estimated the impat an inrease in foreign savings rate on GDP per apita growth. They used a sample of 51 ountries from 1979 to 1998. They found a 1 perent inrease in foreign savings in relation to GDP had a long-term effet of 0.005 perent in GDP per apita growth. Choong et al (2010) examined the impat of different types of apital flows on eonomi growth in 51 developed and developing ountries for the duration of 1988-2002. They found that FDI has a positive effet on growth, whereas foreign debt and portfolio investment have a negative effet on growth. RESEARCH METHODOLOGY Computable general equilibrium models are an important tool of analysis in development eonomis. The omputable general equilibrium methodology is a powerful methodologial tool for examining the impats aross multiple markets of hanges in poliy variables or exogenous shoks and an instrument for poliy analysis. They are used for making preditions about the behavior of eonomies in response to shoks and to different poliies. Computable general equilibrium models are derived from eonomi theory. The ompetitive market equilibrium of supply and demand is determined by the demand funtions of the onsumers and the prodution funtions of the firms. Computable general equilibrium models represent the diret and indiret interations between all setors of the eonomy. The omputable general equilibrium framework provides a theoretial quantifiation that ombines the general equilibrium struture formalized by Arrow and Debreu with real eonomi data -provided by a soial aounting matrix- to solve numerially for the quantities of supply, demand and prie that preserve equilibrium aross all markets. The omputable general equilibrium model interprets all of the payments in the soial aounting matrix. Liensed under Creative Common Page 4

International Journal of Eonomis, Commere and Management, United Kingdom The model aordingly follows the soial aounting matrix disaggregation of fators, ativities, ommodities, and institutions. Computable general equilibrium models are speified in a set of mathematial equations that define the behavior of the different ators. Some of the equations are nonlinear. There is no objetive funtion. The equations ontain a set of onstraints, whih have to be satisfied by the system as a whole but are not neessarily onsidered by any single ator. These onstraints over markets (fators and ommodities) and maroeonomi losures (Savings-Investment, the government, and the urrent aount). Computable general equilibrium models are used to ompute quantities and pries in different equilibria. When the eonomy is at its initial equilibrium, poliy hanges or shoks lead to hanges in pries, ativity levels and demands that produe a new equilibrium. By omparing the new and the benhmark equilibrium pries, prodution levels, onsumptions and inome levels, we an perform a quantitative analysis and evaluate the effets of these poliies or exogenous shoks (Shoven and Whalley, 1984; Lofgren et al., 2002). A omputable general equilibrium (CGE) model of the Palestinian eonomy is onstruted for this study. The Palestinian model builds on the Lofgren et al. (2002) standard model framework. Foreign Savings in the Model The urrent aount balane, whih is artiulated in foreign urreny, requires equality between the nation s spending and it s revenues of foreign exhange. import pwm. QM + transfr row,f = pwe. QE + transfr i.row + FSVA f f + fator = export + institutional + foreign spending transfers revenue transfers savings to RoW from RoW Where: FSAV = foreign savings, QM is quantity of imports, QE is quantity of exports, pwm is import prie (foreign urreny), pwe is export prie,transfr row,f is fator transfer to the world and transfr i.row is institutional transfers from the world. Non MPS. 1 TINS. YI + GSAV + EXR. FASV transfr row,f = PQ. QINV + PQ. qdst f government + government + foreign = fixed + stok savings savings savings investment hanges Liensed under Creative Common Page 5

Abdel Where: MPS is marginal propensity to save for domesti nongovernment institution, TINS is diret tax rate for institution, YI is inome of institution, GSAV is government savings, EXR is exhange rate, PQ is omposite ommodity prie, QINV is quantity of fixed investment demand for ommodity and qdst is quantity of stok hange. Total savings and total investment have to be equal. Total savings is the sum total of savings from domesti nongovernment institutions, the government, and the rest of the world (foreign savings). Total investment is fixed investment (gross fixed apital formation) plus stok hanges. Database: Soial aounting matrix of Palestine A soial aounting matrix is a omprehensive, eonomy-wide data framework, representing the eonomy of a ountry. Soial aounting matrix is a square matrix in whih eah aount is represented by a row and a olumn. The elements of the matrix represent the payment from the aount of a olumn to the aount of a row. A soial aounting matrix aounts for the eonomy-wide irular flow of inomes and payments in the eonomy. It represents the struture, internal and external links of the eonomy, and the roles of agents and setors in the eonomy (King, 1985; Roland-Holst, 2008). A soial aounting matrix ontains most of the data required to implement a omputable general equilibrium model analysis. The omputable general equilibrium model has to be based on reent relevant available data to be redible for poliy analysis. When historial data are used for poliy analysis, it should be demonstrated that the struture of the eonomy has not substantially hanged for the evaluation and analysis of poliies to be redible and valuable. A 2012 soial aounting matrix for Palestine is onstruted. The 2012 soial aounting matrix is used as the initial data for the alibration of the Palestinian omputable general equilibrium model. See table 2: Maro 2012 soial aounting matrix for Palestine million of dollars. THE SIMULATION AND EMPIRICAL RESULTS We simulate the impat of a 50% inrease in foreign savings, whih ould ome about due to inreased aess to world finanial markets or in the form of foreign aid inflows. The simulation onsiders the impat of a 50% inrease in foreign savings on prodution, and maroeonomi aggregate. The simulation results show that real GDP inreases by 1.60 % and nominal GDP by 4.53%. The level of real private onsumption inreases by 16.53%. Import inreases by 18.89% and export dereases by 16.03 % in real term. The deline in exports indiates worsening in the trade balane. The trade defiit inreases by 31.64 %; net taxes inreases by Liensed under Creative Common Page 6

International Journal of Eonomis, Commere and Management, United Kingdom 8.27%, as a perentage of GDP the trade defiit inreases by 13.04 perentage points from 44.16 % of GDP at base line to 52.80% of GDP after foreign savings shok (tables 1). Foreign savings an onsiderably hange the real and nominal exhange rates, whih in turn affet the trade balane. Real exhange rate and nominal exhange rate derease by 7.40% and 5.0 % from the base line respetively. In addition, hanges to the prodution of domestially onsumed goods, absorption (total domesti spending on a good estimated at the domesti pries), inreases by 10.79% in real terms. This inrease ours through the domesti (non-tradable) prie index, whih dereases by 2.50%. Base line Table 1 National Aounts millions USD Foreign saving shok As % of GDP % Change Base line Foreign saving shok Absorption 9794.700 10851.663 10.791 144.162 152.802 Private onsumption 6394.380 7451.343 16.530 94.115 104.922 Gov. onsumption 2302.570 2302.570-33.890 32.422 Investment 1097.750 1097.750-16.157 15.457 Exports 1091.460 916.466-16.033 16.065 13.276 Imports 4091.930 4864.971 18.892 60.227 70.475 Net Taxes 1408.024 1525.969 8.268 17.291 21.487 GDP 6794.230 6903.158 1.603 100.000 100.000 Trade Defiit 3000.470 3948.505 31.645 44.157 57.192 Table 2 The maro 2012 soial aounting matrix of Palestine 1 2 3 4 5 6 7 8 Total 1-Ativities 10456.04 10456.04 2-Commodities 4886.99 1033.29 6394.38 2302.57 1097.75 1091.46 16806.44 3-Fators 5386.21 5386.21 4-Households 5671.96 371.43 6043.39 5-Government 1801.95 818.65 2626.60 6-Saving-Invest. -750.92-47.40 1896.07 1097.75 7-Taxes 182.84 1225.18 399.93 1801.95 8-Rest of the world 4091.93-285.75 3806.18 Total 10456.04 16806.44 5386.21 6043.39 2626.60 1097.75 1801.95 3806.18 Liensed under Creative Common Page 7

Abdel CONCLUSION Foreign savings are neessary for developing ountries to supplement domesti savings and therefore, invest in their infrastruture and soial setor requirements. This paper represents quantifying of the impats of an inflow of foreign savings (urrent aount shok) in the Palestinian eonomy by using a omputable general equilibrium model. The results show that a 50% inrease in foreign savings leads to higher household s welfare that measured in terms of real household onsumption. However, a 50% inrease in Palestine foreign savings, whih ould ome in the shape of foreign aid will harm the eonomy s prodution side by at first adversely influening the ountry s by the appreiation to the real and the nominal exhange rates. That lowers the ompetitiveness of domesti goods on the foreign market, whih influenes exports adversely. In addition, exhange rate appreiation promotes onsumption and redues private savings. The prodution side of the eonomy is adversely affeted while the onsumption side is positively impated. Investment as a perentage of GDP delines following a ut in the prodution of export goods. As a result of the exhange rate appreiation the prie of domesti non tradable goods is weaken as onsumers preferenes lean to heaper imported substitutes. The inreases in domesti pries relative to world pries lead to hange in relative pries, whih damage the tradable setor. The redution of the tradable setors relative to the non-tradable setors reveals the existene of Duth disease. Thus, a 50% inrease in foreign savings, whih ould ome in the form of foreign aid, has a Duth Disease impat on the Palestinian eonomy. Further researh is needed to investigate the impat of inreasing the household savings on the maroeonomi variables in Palestine. REFERENCES Ahmed, V., & O'Donoghue, C. (2009). External shoks in a small open eonomy: A CGE-Mirosimulation analysis. Belke, A., & Dreger, C. (2013). Current Aount Imbalanes in the Euro Area: Does Cathing up Explain the Development?. Review of International Eonomis, 21(1), 6-17. Bresser-Pereira, L. C., Araújo, E., & Gala, P. (2014). An empirial study of the substitution of foreign for domesti savings in Brazil. EonomiA. Bresser-Pereira, L. C., & Gala, P. (2008). Foreign savings, insuffiieny of demand, and low growth. Journal of Post Keynesian Eonomis, 30(3), 315-334. Bresser-Pereira, L. C., & Nakano, Y. (2002). Eonomi growth with foreign savings?. In Seventh International Post Keynesian Workshop, Kansas City, Mi (pp. 3-27). Cambazoglu, B., & Karaalp, H. S. (2014). Does foreign diret investment affet eonomi growth? The ase of Turkey. International Journal of Soial Eonomis, 41(6), 434-449. Choong, C. K., Baharumshah, A. Z., Yusop, Z., & Habibullah, M. S. (2010). Private apital flows, stok market and eonomi growth in developed and developing ountries: A omparative analysis. Japan and the World Eonomy, 22(2), 107-117. Liensed under Creative Common Page 8

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