A closer look at devaluation |30 June 2005

Mr. Yakub has been working as an IMF Technical Advisor specializing in assisting IMF and UN member countries with their fiscal reforms, after first serving a few years at the Executive Board of the IMF. His consultative field work brings him in contact with Heads of State, Ministers of Finance and Central Bank technical staff, dealing with the practical, hands-on budgetary and macroeconomic problems of a number of developing countries namely in Africa, the Indian Ocean region and the Pacific islands. He is also on an international panel of fiscal experts attached to the Fiscal Affairs Department of the IMF in Washington DC.

We decided to ask him a few general questions about a topic that has been  much talked about by the Seychellois public for some time now. The subject is “Devaluation” and, as introduced by SBC in its new “Face-a-Face” programme last night. Mr Yakub, who likes to keep a low profile, reluctantly gave us the interview, extracts of which are published below.

Seychelles Nation: What is devaluation?

Mr Gafoor Yakub: Devaluation is when a government, through its central bank, decides to reduce the rate at which its local currency is exchanged for another in international currency markets. It’s essentially a fixed decline in the value of a currency to a new level determined by the authorities.

A Government may choose to devalue its currency when a chronic imbalance exists in its balance of trade, which is part of the overall balance of payments. A nation’s balance of trade is the difference between the value of its exports and that of its imports.

Devaluation occurs when a country has been maintaining a fixed exchange rate relative to other major foreign currencies like the Euro, US$ or £ sterling etc. But when a flexible exchange rate is maintained by a country, the currency values are not fixed but they are set by market forces, depending on the trade patterns and exchange transactions of the country. So a decline in the value of the local currency is known as a depreciation.

S.N.: Give us an example of a successful devaluation.

G.Y.: One example is China. In the past, China had a fixed official exchange rate of about 1.5Yuan : 1US$ while its market (swap) rate was as high as 15 Yuan to 1 US Dollar. In 1994, China decided to unify its exchange rate to stabilize its currency. When the authorities did that, China experienced a devaluation of 50% of its local currency. Currently, I believe it is pegged at around 8.23 or 8.30Yuan:1US$.

China has been very successful in promoting its exports to the rest of the world, creating low-cost jobs domestically, and making use of its excess domestic capacity to produce and to export. Furthermore, the country is politically stable. So, China has made a success of devaluation. But of course, lately, both America and the EU have been pressurizing China to revalue its currency because Chinese exports have become too cheap and they can no longer compete with China on the same footing and they risk social unrest from their own citizens losing their jobs to Chinese imports. But that’s another matter altogether.

S.N.: Why would a Government want to devalue?

G.Y.: The main reason for a Government to devalue is to increase its country’s external competitiveness. Another reason for devaluation is to make its imports more expensive in the hope that people will switch their consumption to other domestic goods and make exports more profitable thus encouraging export activity.

But imports can also be made more expensive by higher import taxes and duties. So you might ask, why devalue then?  The reason for that is that this mechanism is not as efficient or effective. How come? because if the government spends that tax revenue, then the gain to the Balance of Payments (BOP) is lost. So the Government has to tighten its expenditure if it decides to raise import taxes. But historical evidence shows that most governments often tend to have difficulty in doing so.

Normally a government would devalue its currency because the interaction of market forces and policy decisions has made the currency’s fixed exchange rate untenable.

In order to sustain a fixed exchange rate, a country must have sufficient foreign exchange reserves, i.e. dollars, euros, etc. managed by its central bank, and it must be both able and willing to use them to purchase all offers of its own currency at the established exchange rate. So if a balance of trade deficit exists, the central bank may sell some of its reserves of foreign currency in order to bolster the value of its local currency.

Because a country’s forex reserves are limited, the government may choose to correct an imbalance by officially readjusting the value of its currency by a legislative or administrative order. So, when the central bank is unable or unwilling to back its own currency, then the government would be expected to devalue its currency to a level that it is able and willing to support with its forex reserves. But it does not always happen that way. Some governments may choose to adjust fiscal policy and/or other aspects of their macroeconomy rather than tamper with the exchange rate itself, as devaluation is a tough decision to take. However, experience has shown that eschewing an exchange rate correction or realignment can sometimes worsen a situation.

S.N.: What impact can devaluation have on the people and the economy?

G.Y.: There are a number of positive and negative impacts that any Government has to weigh and evaluate before deciding to devalue. As with most economic arguments, there are always two sides to an argument and there are often “trade-offs” in economic policy actions. And also there might sometimes be a caveat  to an economic argument.

One key impact of devaluation is that it makes the domestic currency cheaper relative to other currencies. That means your local currency is worthless in value terms vis-à-vis another international currency. There are two basic implications of devaluation: First, devaluation makes the country’s exports relatively cheaper for foreigners. Second, devaluation makes foreign imports more expensive for domestic consumers.

In principle, this should help reduce the consumption of imported goods in favour of local production and increase exports, thus improving the external current account balance in the BOP. But in reality, if you do not have the means of substituting that importation, i.e. if the demand for imports is price inelastic, like say in the case of fuel for a motor vehicle, then devaluation will bring a lot of hardship to drivers and ordinary citizens as the price of imported goods, including fuel, goes up overnight.

The total impact of any currency devaluation depends on the actual elasticities of the demand and supply for traded goods. In layman terms, elasticities of supply and demand can be described as the degree of responsiveness of consumers and producers to price changes.

S.N.: What are the short-term and long-term effects of devaluation?

G.Y.: The short term effects are that:
-  import prices rise for local residents as do export returns to domestic producers;
-  the cost of external loans is also increased as you need more local currency to pay for the same loan due in foreign exchange;
-  the BOP may deteriorate further because the short-term demand for imports is usually inelastic. There is always a time lag before the export sector can expand output to take advantage of higher returns;
-  Local manufacturing industry and local services face higher costs for their raw materials and semi-finished product imports;
-  Real income in the economy also declines. The purchasing power of the money in your pocket (say, your net salary) becomes lower. Your nominal salary stays the same after a devaluation, if the Government is firm enough not to give in to pressure to increase wages.

But, with that same salary you cannot buy the same amount of imported goods that you used to because prices would have gone up with devaluation whilst your purchasing power would have gone down.

In the long-term, changing volumes of imports and exports should outweigh the effect of changed prices and hopefully lead to a more favourable balance of trade. The extent of this transformation depends on the elasticities of demand for exports and imports.

S.N. In a small country where future export potential is almost non-existent, what are the benefits and risks of devaluation to that economy?

G.Y.: Not much benefit, if you yourself say that its future export potential is almost non-existent. To really benefit from devaluation in the medium to long term, the country needs to have the capacity to export. One of the reasons China succeeded with its devaluation is that it had excess domestic capacity.

Of course, one of the first outcomes of any devaluation would be that hotels and tourism establishments and other export-oriented industries will welcome it. But it’s also possible that hotels or tour operators may not necessarily adjust the prices of their rooms to pass on that benefit to the end-consumer overseas. They might want to keep that “windfall gain” for themselves and try to justify it by saying they need to save for a rainy day or for future capital asset replacement.

Also, there might be a risk of social unrest when prices of imports go up overnight after a devaluation, if there has not been any other adjustment, like say on the import duty rates or taxes, to compensate for that increase. Any social unrest or crime could affect hotel occupancy and tourism in general.

It’s important to appreciate that devaluation should be part of a package of comprehensive reform measures; it is not, on its own, a magic cure for all your economic ills.

Furthermore, it is not good to have half-measures! For instance, there’s no point liberalizing the import sector if you haven’t tackled the core forex problem or if you have not given much thought to how to redistribute the already scarce foreign exchange resources among the myriad of avid users and importers. By liberalizing while not solving your forex problem, you are just transferring a burden from one sector to another, in this case from the public to the private sector!

There has to be some sort of sequencing or order at the initial stages of liberalization in any small country for essential items like rice, potatoes and other perishables. Leaving it to the markets, imperfect as they are, or the commercial banks to decide, is not only unfair on the banks but it could lead to erratic supplies and/or shortages in essential food items.

Also, there’s no point doing like Russia did in the time of Boris Yeltsin’s leadership, privatizing or selling off public company assets or so-called “cash cows” to benefit only a small group of elites or the privileged few under a system that relied on who you know rather than on what you know or what you are capable of doing for wealth creation. In Russia, they found out to their own detriment that the oligarchs “stripped the assets” of these public corporations, reduced the task force (employment) and then found ways, through creative accounting, to avoid paying taxes at that time ... If a government allows that to happen, then the country and its people will lose out in the end.

S.N.: But then, how can it be successful in a small country? What are the things that should be looked at?

G.Y.: Earlier you referred to a small country with no export potential, which means it must either be having enough domestic resources to sustain itself locally or it must be heavily import-dependent. Devaluation is usually an unpopular policy in small countries that rely heavily on imports of food and other essentials.

For devaluation to have a positive outcome, it has to be undertaken together with other macroeconomic reforms (like fiscal discipline, price stability, tight monetary policy, a depreciation of the real effective exchange rate, etc.) and structural measures (like privatization, promoting transparency, good governance and the rule of law and its enforcement without political interference).

One of the key actions to accompany a successful devaluation is to engineer a depreciation in the real exchange rate as well. Only then can resources be switched out of the non-tradable sector to tradables and exports, and thus hopefully reduce the external current account deficit in the BOP. But, if most imports are price inelastic in that small country, then I’m afraid devaluation could be less effective in closing the gap in the external current account.

By the way, in this context, it is also important to estimate how prices will react (i.e. the “pass-through” effect). From experience, I can tell you that prices will react more strongly the higher the share of imports is in the GDP of the country, and the closer the economy is to full employment. At the same time, the fiscal policy stance has to be tightened to reduce aggregate demand. This recipe was actually followed recently in some successful devaluation episodes in South America, i.e. Brazil, Uruguay. Anyway, one way to ease the pain of devaluation in a highly import-dependent small country might be for the government to consider reducing import duties and taxes to counteract the effect of devaluation on import prices. But can the country really afford to do that? This is easier said than done. The chances are that more foreign exchange will flow out if import duties go down because then importation goes up since it will be cheaper to import. Also, if the Government does that, it will end up with a huge budget deficit unless it is prepared to reduce its overall size and its role in the overall economy.

You see, Government will always need a minimum amount of tax and non-tax revenue to provide or deliver its basic public services. So it is likely to find it hard to curtail expenditure in the short-run.

Also, you have to ask yourself: Can the private sector absorb all those extra people being laid of – i.e. public sector jobs and services that are usually provided to the general public? I very much doubt it. Nobody is in the business of doing business to lose money! The private sector companies won’t take on extra staff if there’s inadequate return on their investments. So, there is a serious risk of escalating unemployment which could lead to social unrest, domestic disturbances, crimes, etc.  I’m afraid there is no easy answer or magic wand for dealing with such a situation.

S.N.: Earlier you gave China as an example of a successful devaluation. But has devaluation always been successful in other countries?

G.Y.: No, there are several examples where it has not been successful largely because it has not been introduced properly. Take Zimbabwe for the sake of argument. Some time ago, the Central Bank of Zimbabwe decided to devalue the Zim Dollar to boost its exports of tobacco and fresh meat produce.

But the Government of Zimbabwe has continued to overspend on its recurrent budget. It has not been able to keep inflation in check. And with the controversial land redistribution policy and domestic political turmoil, employment and economic growth are being seriously jeopardized. And just imagine how Zimbabwe, not that long ago, used to be more advanced than South Africa was under apartheid in the 1980s! So a country’s fortunes can change over a relatively short time if it doesn’t care to follow a comprehensive approach to reform.

Another famous case where devaluation was not successful, at least in its initial stages, was Mexico. Back in late 1994 and early 1995, Mexico’s domestic inflation and its peso-dollar exchange rate had left the country uncompetitive. Solution?

The Government, through its central bank, devalued the peso by 20% hoping to bring back the peso’s competitiveness. What happened? The peso fell by more than the 20% that had been forecasted as necessary to restore equilibrium. It actually fell by 50%! Such a large, unexpected drop turned into a financial and economic crisis that had serious “spillover effects” onto other countries especially in Latin America.

But why did that happen? partly because foreign investors feared a default, and they were right. How? The fiscal and monetary policies being pursued by the Government in 1994 were not consistent with the exchange rate rule. Also the National Economic Team was perceived by the general public and foreign investors as incompetent; they did not have a coherent plan at the time.

For example, the replacement of almost the entire short-term government debt from peso-denominated to dollar-denominated instruments increased the risk of default and contributed to the climate of uncertainty at the time as they had not done enough to control their fiscal accounts.

But I am pleased to say that after only a few years of suffering, Mexico has turned the economic  corner.

Unemployment has declined; imports have gone down and exports are up, partly on account of benefiting from the NAFTA (North American Free Trade agreement). Mexico has moved from an external current account deficit  to a current account surplus  and its GDP (economic) growth is steady.

SN: Any Final Thoughts? …
 
G.Y.: I would just like to reiterate that devaluation cannot be looked at in isolation. It is one of a range of policy actions to consider. It cannot simply solve all your problems overnight. If it is ever undertaken, in one form or another, it has to be part of a package of comprehensive and broad-based reforms, not half-baked measures.

In addressing any severe macroeconomic imbalances and structural policy distortions, one has to be prepared to openly review the way things are habitually done. In any country people must be ready to put their country first and stop politicizing everything!

The implementation of devaluation will very much depend on the circumstances of each country.  Each country is of course different; each has its own characteristics or peculiarities. So you cannot apply the same medication for everyone and expect to get the same results.

Any review of a currency peg under a fixed exchange rate system will have to be done in the context of a strategy for macroeconomic and structural adjustment that is well coordinated, and that provides for adequate social safety nets, while at the same time looking at how the forex earnings of the country can be enhanced, and ensuring that these vital earnings accrue (and come back) to the country. This requires transparency in all the foreign exchange dealings.

Whatever is decided upon, it is important to remember that, in today’s world, it would be advisable to obtain the full endorsement of the IMF for a full-fledged adjustment or reform programme in order to gain external credibility and wider acceptance. However much you may detest it, any proposal for debt rescheduling to the Paris Club will not get very far without a ‘nod’ from the IMF these days, I’m afraid. Otherwise the likelihood of success and external donor support for any reform package are rather slim.