Making sense of the Exchange Rate Depreciation

Part 1

Guyana is not a country with rapidly adjusting or flexible financial prices, such as a main stock market index or bond yields. The closest we get to a market in which the price signals new political and economic information is the foreign exchange (FX) market. The FX market affects every aspect of economic life in Guyana. The expected rate of exchange in this market is also a reflection of the health of the economy and the state of politics.

Note, I use the term expected exchange rate because the central bank targets the actual G$/US$ rate. This means the Bank of Guyana does not allow the rate to fully adjust to expectations or sentiments that in turn influence demand and supply of foreign currencies. For a country like Guyana, and those of the Caribbean, this is a good policy stance because impulsive swings in the exchange rate can have devastating effects on households and businesses.

Nevertheless, the society and the market are these days adjusting their expectations of what they feel the rate should be, right or wrong. This caused Governor Gobind Ganga to concede that the actual rate is around G$215 to G$218 to one US$ (see SN April 13, 2017), thereby representing a depreciation of just over 5% since 2015.

Trying to understand exactly why the market’s confidence is on the decline is not going to be straightforward because many of the statistics that were previously reported are no longer made public, a situation which is quite recent. However, we could possibly use the process of elimination to tease out the primary cause of the depreciating currency, a situation that signals that something is wrong in economic and political life. In the next column, I would examine some of the main proposed causes by government and opposition. For example, I would look at factors like “drugs money”, remittances, FDIs, former President Jagdeo’s alleged destabilization, etc, to get a feel for what is going on. I would try to eliminate each factor until we get to the main variable (s) causing the rate to fall since one G$ can now purchase fewer US$.

Why is a depreciation or policy devaluation so problematic for a country like Guyana? It turns out that exchange rate depreciations do not have the simulative effect for Guyana-type economies as suggested by the textbooks. This is mainly because these books are looking at macroeconomics from the point of view of an advanced economy such as the United States, which has a sophisticated economic system and the most important global currency.

The textbooks say that policy devaluation or market depreciation should cause a correction in the trade deficit after some time has passed because the change will stimulate exports and contract imports. This is why last week President Trump announced that the US$ is too strong. Now, would it not be nice for Guyana to have a flat and “strong” exchange rate of around G$200 to one US$? It is possible. More on this later. Between 2009 to around 2015, historically low US interest rates weakened the US dollar that has helped Caterpillar, Boeing, John Deere and thousands of other businesses to sell more to the world. As a matter of fact, the weak U$ also encouraged many from Russia, China, Brazil and elsewhere to buy up assets (like real estate and businesses) on the cheap inside the US because of that country’s stable laws and property rights.

Now, when the G$ devalues very few individuals, if any, are rushing to Guyana to buy houses, land and businesses. The main reason being that the prices of Guyanese properties are set in US$ and not the national currency, so the devaluation does not benefit asset prices inside Guyana as it would for America when that country’s currency depreciates. The same principle works for Guyana’s exports of goods and services, which are priced in US$ to the overseas buyer.

However, since Guyana has a de facto peg against the US$, a weakening of the US$ in the international markets should help Guyana’s exports, right? Unfortunately, it does not stimulate production in Guyana because the traditional industries do not have the capacity (supply response or elasticity) to sell more in this circumstance. The stimulation would most likely occur if Guyana manufactured a few things like consumer appliances or components for some global production chain.

On the other hand, Guyana’s imports are invoiced in US$ and the goods are sold to consumers in G$, meaning that importers will pass on the higher cost of imports to consumers. There are some goods like oil, gas and machines that Guyana must import. Devaluation, therefore, stimulates inflation and contracts aggregate demand because people’s incomes and wealth would lose value. A depreciation or policy devaluation is a sure way to deplete the middle class and put the poor under even greater stress. It is a certain way to cause the hard-earned savings of each generation to melt overnight.

The commercial banks and retailers should also have no incentive to see the rate devalue. In the case of the banks, their assets are overwhelmingly in Guyana dollars. The devaluation and accompanying inflation will erode the real value of their assets and profits. The gains made by buying and selling foreign currencies will not compensate for the decreased real values of their portfolio of treasury securities and loans. The commercial banks should have an incentive to work with the central bank to get the rate back to the average G$206 rate that prevailed in 2015. As a matter of fact, their profits will be higher if the rate appreciates to G$200.

Given that there are so many retailers in Guyana, margins are already thin. The higher cost of imports that the devaluation brings implies a competitive retail industry has to bear some of the price increase, thereby further eroding profit margins. Retailers will only be able to pass 100% of the higher import cost to consumers if they can completely collude, something which is highly unlikely in the present competitive retail space. There will be someone who will gain market share if a few colluders decide to pass on the entire cost of devaluation to consumers. Therefore, retailers have nothing to gain from the devaluation and they should do whatever it takes to stabilize the rate.

The state-owned companies, which export different commodities, would gain on the export side if the currency devalues. They will however lose when they import fuels and other intermediate inputs for production. The devaluation would raise the cost of energy for everyone, even if that company exports most of its output. While they gain on the export side, they will lose money on the import of energy and other intermediate inputs.

The depreciation will have a devastating impact on social outcomes and will make workers less motivated and speed up the migration of skilled professionals. Businesses have nothing to gain from less motivated workers because they will lose profits from diminished worker productivity. The weakened social stability would also mean businesses and the well-off folks would need to spend more on physical security, and grille doors and windows.

In the coming essays, I will address the primary cause of the market stress and possible ways to the get the rate back to the psychologically appealing G$200 to one.

Comments: tkhemraj@ncf.edu  

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