The Economic Cost of Foreign Exchange for South Africa

In economic cost benefit analysis there is a need to choose a numéraire in which all costs and benefits are evaluated. In recent years the most common practice has been to express all costs and benefits in terms of domestic currency at the domestic price level. When this numéraire is chosen it is necessary to adjust all transactions that are made with international traded goods and involve foreign exchange to account for the divergence that arise between the financial cost of foreign exchange and its economic value.*(2) The purpose of this paper is to develop an analytical framework that will enable us to estimate the economic cost of foreign exchange for South Africa. Since the demand for imported goods is generally distorted by import tariffs and non-tariff barriers (as is the supply of exports by subsidies and export taxes), there will be a difference between the economic cost of foreign exchange and the market rate for foreign exchange. This difference represents the loss of tariff revenues associated with forgone imports as well as other distortions associated with the additional production of exported goods in the external sector. A further set of distortion must be considered that includes value-added taxes (VAT) and other indirect taxes such as excise taxes. When the demand for imports by other consumers and investors decline due to the impact of the financing of the project and its demand for foreign exchange, some VAT and other indirect taxes are forgone. On the supply side, the resources required to produce the additional exports needed to earn the foreign exchange must come from the non-traded goods sector. This will reduce the supply and the corresponding demand for non-traded goods and the associated VAT and other indirect tax revenues. All of these repercussions in the economy have to be accounted for as part of the externalities associated with the use of foreign exchange. When a project generates foreign exchange, the reverse will hold. A foreign exchange premium must be applied to the foreign exchange generated by the sales of the output from a project. This adjustment will ensure that in the project’s appraisal the economic opportunity cost of foreign exchange to the country is appropriately reflected. In the same way that there is a generalized externality (the foreign exchange premium) associated with the sourcing of funds the capital market to purchase foreign exchange, there will also be either a premium or discount when funds sourced from the capital markets are used to purchase non-traded goods. It is normal that a generalized externality will be created by the combined act of sourcing funds from the capital market and using these funds to purchase non-traded goods and services. This same premium or discount should also be applied to the financial revenues generated by the production of non-traded goods.