Devaluation lesson

Ever since the economic upheaval experienced in the early 1990s, which saw Barbadians staring down a legitimate threat of devaluation, the mere utterance of the word has taken on an inflated aura of fear, panic and anxiety.

Indeed when any of the economic indicators remotely resemble trends or levels of the 1990 to 1993 period, the nerves of many a layman are rattled. Fear is driven into the hearts of consumers, local business people and some foreign investors.

For these reasons it is important for policy makers and politicians to stand clear of making loose statements about the necessity of doing x or y to stave off devaluation and defend the parity of the Barbados dollar. Care should also be taken when making impulsive predictions about x or y action or inaction leading to devaluation as if it is an inevitable proposition.

In my view the Government, the governor of the central bank and the Opposition have all, at different times and in different ways, been guilty of fanning the flames of devaluation hysteria.

For example, when the Government makes grandiose statements about their (post-2009) success in protecting the country’s exchange rate by avoiding devaluation, it suggests that there was a real and live threat. The subtext is that the threat of devaluation was on the horizon and the Government’s economic policies successfully staved it off.

The governor’s recent comments about the urgent need to cut $400 million in expenditure from the national 2013/14 budget generated a bit of economic insecurity among many Barbadians. This is likely a result of the governor’s assertion that his prescription was necessary in order to put the brakes on the decline of the foreign reserves so as to avoid a devaluation of the dollar.

It is fair to suggest that the substance and tone of the statement evoked both a sense of urgency and the notion that there is an imminent threat.

Effective macroeconomic policy is as much about signalling (candid but inspiring communication) as it is about sound policy. This is why it isn’t surprising that confidence in the Barbados economy is sparse.

So what exactly is devaluation? What are its implications, particularly for a country like Barbados? And the big question on many people’s minds is whether or not Barbados is heading towards devaluation.

Here is a brief rundown of the nuts and bolts of devaluation. Devaluation is when the value of a fixed exchange rate currency, expressed in the currency to which it is pegged is officially reduced. For example, if the rate of exchange of a Barbados dollar was $1 BDS for $1 USD and that peg was officially changed from a 1:1 conversion rate to a conversion rate of $2 BDS for $1 USD that would constitute a devaluation.

The opposite is called a revaluation.

A fixed exchange rate is usually pegged to an internationally accepted trading currency. When a country adopts a fixed exchange rate currency it tends to peg its currency to the currency of its main or most stable trading partner at a fixed conversion rate.

Devaluation should not be confused with depreciation which refers to a decline in the value of a floating exchange rate currency vis-a-vis other major currencies as a result of international demand and supply of one currency relative to another. The value of floating international (hard) currencies change daily and can also experience an appreciation (an increase) in their relative values.

In order to protect the parity of a fixed exchange rate currency and maintain macroeconomic stability, the country (or monetary/economic union) to which the currency belongs must earn or borrow enough foreign exchange to ensure that it can meet its imports and capital outflow requirements for 12 or more weeks.

Economists refer to a fixed exchange rate system like Barbados’ as an exchange rate anchor. It is well understood that the primary macroeconomic objective in Barbados is to defend (protect) the parity of the Barbados dollar to the US dollar at 2:1.

That is the fundamental objective of all variations of fiscal and monetary policy in Barbados. Another way of looking at it is that the level of foreign reserves determines the parameters of macroeconomic policy making. Therefore, to suggest that one of a government’s achievements was to protect the Barbados dollar in circumstances where the foreign reserves far exceeded the equivalent of 12 weeks of imports is really a case of setting a very low bar. It is nothing more than blowing hot air.

However, such tactics run the risks of undermining confidence and stirring anxiety because it suggests that extraordinary action was warranted to fend off devaluation.

When a country has depleted its foreign reserves, typically it can only source foreign exchange in the form of loans from lenders of last resort like the IMF.

Devaluation is not the only solution to a balance of payments crisis. In fact, as Barbados demonstrated in the early 1990s, there are better (less destructive and disruptive) solutions. In the case of small net importer economies like many of those in the eastern Caribbean, devaluation is perhaps the worse prescription for a BOP crisis. However, it is a legitimate recommendation for countries with credible net exporter potential.

The rationale behind devaluation stems from classical and neo-classical economic thought. The thinking goes like this: economies are more efficient in allocating resources and generating wealth when “free” market forces reign. The invisible hand of free market activity will correct any imbalances that emerge in the economy and equilibrium would eventually be restored.

Therefore a fixed exchange rate system is viewed by classical adherents as an artificial intrusion by government that distorts world trade, undermines wealth creation and produces negative externalities (adverse unintended consequences).

A BOP crisis is seen as an imbalance brought on by (i) demand for foreign currency (i.e. imports) that far exceeds supply (generated by exports), and (ii) supply of the domestic currency in excess of demand. Some economists believe that in those circumstances monetary authorities are propping up an overvalued domestic currency since market forces (i.e. the aggregate of the decisions made by economic agents inside and outside the country) suggest that the price of the local currency (how many foreign dollars you get in exchange for local dollars) should be allowed to fall until the demand for it catches up with supply.

Many IMF advisors believe that devaluation will make exports cheaper and imports more expensive and in the process reduce the demand for foreign currency (imports) while increasing the demand for the domestic currency (exports). These events are expected to restore balance to the BOP and fuel economic growth and prosperity. It works for some countries but not for all.

Since Barbados is a small net importing country with no abundance of natural resources or vibrant manufacturing and agriculture industries a devaluation of the Barbados dollar will succeed in making imports more expensive and in so doing drive up the cost of living and the cost of doing business.

Much of the country’s goods and services exports have a high import content. As a result, the cost of exports will suffer tremendous upward pressure from a devaluation of the Barbados dollar and negate the realisation of any exchange rate savings for foreigners. This is why devaluation has worked for Trinidad and Tobago but has been disastrous for Jamaica and Guyana.

With record levels of foreign reserves, Barbados has not been in any danger of a BOP crisis or devaluation between 1994 and today. As a matter of fact, given the excessive fiscal deficits since 2010, the high level of foreign reserves has been the country’s saving grace. There has been no need to seek IMF assistance or adhere to its advice.

What is true is that the significant fall in the foreign reserves ($200 million) during the first half of this year, the deterioration of government’s financial position and the contraction of the foreign exchange earning sectors have seeming alerted the governor of the central bank and the Government to what many economists have been saying for the past two and a half years.

That is, the Government needs to put its fiscal house in order and change course if the economic declined is to be halted.

Barbados is in no danger of a devaluation of its dollar at this time. The Government and people of Barbados have about 12 months to fix the fiscal problems, restore economic growth and/or borrow foreign exchange before the foreign reserves are in peril.

God forbid, even if the worse case scenario materialises devaluation is not an automatic proposition. There will always be better options for countries like Barbados. Moreover, no one will wake up and suddenly discover that the Barbados dollar has been devalued. The prescription of devaluation would have to be recommended and accepted before it is implemented. Any responsible government will see to it.

* Carlos R. Forte is a Commonwealth Scholar and Barbadian economist with local and international experience.

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