Estimating the Shadow Price of Foreign Exchange in Project Appraisal

The estimation of the shadow price of foreign exchange under the assumptions of optimal policies and continuing protection for project evaluation in developing countries is discussed. For any given policy alternative, the information requirements of alternative methods of project appraisal are identical. If the appropriate shadow exchange rate is used, alternative methods of project appraisal will give the same conclusion for accepting or rejecting a project. Under the assumption of optimal policies, there will be a need for using a shadow exchange rate to convert domestic values into world market prices. The use of this rate offers advantages over expressing the social opportunity cost of primary factors directly in world market prices. The shadow exchange rate has the advantage that it focuses on the balance of payments constraint of developing countries, and external factors such as world demand conditions, foreign aid, private investment, and debt servicing can easily be taken into account. Policy assumptions have implications for the prices of primary factors, the valuation of products that are not fully traded, and the origin of traded inputs.