Manipulation of effective protection by the exchange rate, under some real-world constraints

Protection of domestic industry may be pursued by a variety of instruments-some with effects more systematic and easier to analyze than others—including tariffs, quantitative restrictions on imports, an overvalued exchange rate, administrative harassment of imports, and so on. While theory, under most sets of assumptions, suggests that the simplest and least discriminating device-the tariff-is the best one, both political and administrative constraints often render this dictumd of little relevance to the applied economist. Equally impractical is the proposition that any degree of exchange rate overvaluation can be offset by the correctly chosen combination of tariffs and subsidies. Tariff rates are infrequently adjusted and are not manipulable with any flexibility, in part because changes must usually be submitted to Congress for approval with resulting delays and (often) amendments and deletions, which diminish the unity of any proposed tariff structure.While much attention has been devoted in the literature to the offsetting of a disequilibrium exchange rate's effects on effective protection, little analysis has focused on the exchange rate as a manipulable instrument in setting the level of protection, given the administrative and/or political rigidity of tariffs/subsidies and the processes by which Q.R's are determined. Most of this analysis has thus side-stepped the frequent case in which an overvalued exchange rate is the cause of higher tariffs or more stringent quantitative restrictions without the balancing export subsidies. This paper focuses on that case.Interest in affecting effective protection via the exchange rate is related to the fact that in many developing countries tariff rates imply levels of effective protection above what would seem consistent with the infant industry argument say 25-50 percent for industries getting underway, and something less for those with experience. Usually tariff levels are due more to the power of certain pressure groups than to technical considerations. Exchange rate overvaluation tends also to be in part a result of political pressures, but not normally the same ones as lead to high tariffs; while it is true that an overvalued exchange rate is a more or less permanent fixture in many developing countries, the degree of overvaluation varies rather widely and can often be inffuenced to some extent by technicians, in situations where the tariff itself is not a feasible instrument. This paper attempts some clarification of the exchange rate-level of protection relationship. It argues:(a) that raising the exchange rate (devaluation) tends to lower effective protection of the representative import substituting industry, as long as exports respond positively to a higher price;(b) that devaluation tends to affect the level of effective protection differently as among (i) industries producing capital and intermediate goods (more likely to raise it than for final goods), (ii) industries producing consumer goods using few or no imported inputs (protection lowered), (iii) industries producing consumer goods using considerable amounts of imported inputs (effect more complicated but usually to lower protection). In the last category the effect depends also on how imported inputs are marketed. The paper therefore disputes the frequently argued proposition that overvaluation helps keep rates of protection within bounds, i.e., that devaluation would raise that protection by raising the price of imports. An overvalued exchange rate normally implies quantitative restrictions. That the effects of an import control policy are easily worsened by the use of quantitative restrictions is widely accepted. Our main concern here is how the overvalued exchange rate affects the general level of protection, though since it can be a cause of use of Q.R's, its overall impact can only be judged with this in mind.