Annex 2D


Annex 2D: Measures of Protection

One important objective of economic adjustment is the elimination of economic inefficiencies
resulting from price distortions, which give inappropriate price signals to producers and
consumers. Sources of price distortions are price, market, trade, fiscal and exchange rate
interventions. The common expression for such distortions are 'rates of protection'. The rate
of protection measures the average percentage deviation of actual prices from those that
prevail without interventions.

If a price distortion is the direct result of sector- or product-specific interventions (e.g. price or
market regulations, import/export taxes/subsidies), it is called 'direct protection'; 'indirect
protection' arises if the price distortions are the result of macro-economic policies (e.g.
exchange rate over-valuation) or of interventions in other sectors (e.g. repercussions of
industrial protection on agriculture). Both effects add to 'total protection'. In the case of an
overvalued exchange rate, the indirect protection rate has a negative value (signifying
negative protection/taxation) which may be compounded or compensated by the effects of
direct protection (taxes imply negative, subsidies positive protection rates).

Different concepts are applied to measure protection.

The simplest measurements of protection are "price gaps" measures. Amongst those, the most
popular measure is the so-called "nominal protection coefficient" (NPC), defined as the
percentage ratio between the domestic distorted price and the counterfactual undistortedd)
price. For a "small country" the undistorted price is generally taken to be the border price
adjusted for transportation and marketing costs. Both domestic and border prices are measured
in a common currency by using an appropriate exchange rate. Instead of NPC the practitioners
often use the equivalent definition of "nominal protection rates" (NPR) defined as NPC 1.

The (direct) NPR is calculated using the following formula:

 NPR r PIc P
 Pfc

where NPR = nominal rate of protection for the good examined
 Plc = border price in units of local currency
 Pfc = border price in units of foreign currency
 r = rate of exchange in units of foreign currency per unit of local currency

In addition to NPC/NPRs, shadow exchange rates have to be computed. These exchange rates
take into account (i) the distortions in all sectors of the economy that produce tradables and
(ii) the distortions in the non-tradable sectors. This is necessary because the ultimate effect of
protection is always two-fold: (i) it changes the combination of tradables produced moving it
away from the optimal one and, (ii) it changes the combination of tradables and non-tradables.

Notwithstanding a number of complexities and conceptual ambiguities involved in computing
the NPR it is the most frequently used measure of protection because of its relatively limited
data requirements and its ability to capture most of the market distortion effect. As an 'ex-post'


- 305 -