An important aspect of the diversification debate and of Africa’s experience has to do with the role that macroeconomic policy plays. This has also been investigated at the continental level in the results that are presented in table A5.1. Two important indicators of macroeconomic stability, depending on the macroeconomic policy in operation, are inflation and real effective exchange rates and these are found to be among the most critical determinants of diversification outcomes in Africa.
High levels of inflation damage diversification High levels of inflation damage diversification prospects and the tendency under such circumstances is for increased concentration with little opening-up to new export sectors. This is not surprising, given that diversification in itself requires the emergence and growth of new industries or sectors which are able to meet not just the domestic demand for their products but also the competition on the international market. A high inflation environment is not conducive to the development and maturation of new sectors, nor is it supportive of an environment that fosters other determinants of diversification so that they have significant impact. Ordinarily, it is reasonable to expect that high inflation could lead to diversification as an economy diversifies away from sector-specific income shocks. Due to incomplete markets, economies can be led to diversify for insurance purposes, and to specialize again as financial markets deepen (Saint-Paul 1992).
Effects of the exchange rate depend on existing export potential The exchange rate affects diversification prospects as there is a significant relationship between the two. The positive relationship between the exchange rate and the diversification index suggests that a depreciating currency is not always supportive of diversification efforts. These results might appear to be counter-productive in the sense that depreciation underpinned by appropriate macroeconomic fundamentals should support increases in existing exports and ease potential exportables into new markets.
Such a result supposes two elements. First, it pre-supposes that the country already has this export potential and that the depreciation has the price effect of making the exports cheaper for the foreign markets. It further assumes price-elastic export demand.
Second, it also assumes that the depreciation is supported by sound macroeconomic fundamentals with the depreciation being more than a process of building or maintaining competitiveness in the international market of the economy in question. The positive relationship between the two means that the depreciation does not lead to deepening of diversification. This could be interpreted in one of two ways.
In the first instance, it could mean that African countries have a narrow export potential base and the depreciation simply makes the narrow export base more concentrated and specialized. The second explanation could be that the depreciation is symptomatic of macroeconomic instabilities whose consequences create an environment that is not conducive for diversification. The implication of the results for inflation and the exchange rate is that macroeconomic stability is crucial for the emergence of a diversified economy.
To learn more about this author, visit United Nations Economic Commission for Africa's Website.
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