Macroeconomic adjustments to large energy investments in a small controlled open economy: A policy analysis of hydropower development in Paraguay

This dissertation investigates the macroeconomic effects of hydropower development in Paraguay. In particular, the development of Itaipu and Yacyreta hydropower projects are examined within the framework of natural resource development in a small resource-extracting developing economy. In such a framework, natural resource development affects the economy in three distinct stages--resource discovery, resource infrastructure development, and resource export. Therefore, this research investigates (a) the changes in Paraguayan economic agents' current economic behavior induced by the expectation of higher income from future export of hydroelectricity (resource wealth or confidence effect); (b) the macroeconomic effects induced by large inflows of foreign capital associated with hydropower infrastructure development; (c) the macroeconomic effects of electricity exports; and (d) the effectiveness of government policies to mitigate the undesirable economic effects of resource development. These questions are examined through an analysis of the national accounts data, partial equilibrium models, and a macroeconometric model of the Paraguayan economy. The examination of national accounts data and partial equilibrium models indicate that (a) current private consumption increased in expectation of higher income from future export of hydroelectricity, and (b) the construction period compared to the pre-construction period experienced a higher inflation rate, a more rapid appreciation of the real exchange rate, a decline in the share of tradables output compared to nontradables output, a decline in exports, and a rapid increase of construction sector wages. These results are consistent with the predictions of the Dutch Disease model. Simulation results show that a sustained depreciation of the official nominal exchange rate and a controlled money supply policy would have resulted in a higher level of real economic output, higher employment and income, and a more favorable balance of pavements position, all at the cost of a negligible increase in the domestic price level. These results indicate that the existing economic policies were deficient and Paraguay missed the opportunity to make larger economic gains from project construction and project-related foreign capital. Model simulations indicate that electricity export will create Dutch Disease-type effects on the economy, i.e. in the absence of appropriate economic policies, domestic inflation will increase, real exchange rate will appreciate, and the resource balance will deteriorate. Appropriate government action will be necessary to mitigate the undesirable effects of electricity exports. Model simulations also suggest that the fluctuations in capital inflows had the expected negative effects on the attainment of economic goals. Policy-makers can benefit from the economic experience and information gleaned during resource discovery and resource infrastructure development stages because policy responses to economic problems during these two stages of resource development are similar to those required during resource export.