An Evaluation of the Devaluation

By: Sam Vaknin, Ph.D.


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A Minister of Finance is morally right to lie about a forthcoming devaluation and a woman has the right to lie about her age. This is the common wisdom.

Rumours about a devaluation of the Macedonian Denar versus the major currencies were in the air during the last few weeks. Still, no government official had to lie. The market just did not believe it. The unofficial exchange rate stayed put at 27 MKD to the Deutschmark even as the devaluation was taking place.

This is strange. Devaluation rumours are usually reflected in the street exchange rates. The MKD has held its turf against other currencies in the last three years. A devaluation seemed like a reasonable proposition - or was it?

Why do governments devalue their currencies? They do it mainly to improve the balance of trade. A devaluation means that more local currency is needed to purchase imports and exporters get more local currency when they convert the export proceeds (the foreign exchange that they get for their exports). In other words: imports become more expensive - and exporters earn more money. This is supposed to discourage imports - and to encourage exports and, in turn, to reduce trade deficits.

At least, this is the older, conventional thinking. A devaluation is supposed to improve the competitiveness of exporters in their foreign markets. They can even afford to reduce their prices in their export markets and to finance this reduction from the windfall profits that they get from the devaluation. In professional jargon we say that a devaluation "improves the terms of trade".

But before we examine the question whether all this is true in the case of Macedonia - let us study a numerical example.

Let us assume that we have a national economy with for types of products:

Imported, Exported, Locally Produced Import Substitutes, Locally consumed Exportable Products. In an economy in equilibrium all four will be identically priced, let us say at 2700 Denars (= 100 DEM) each.

When the exchange rate is 27 MKD/DM, the total consumption of these products will not be influenced by their price. Rather, considerations of quality, availability, customer service, market positioning, status symbols and so on will influence the consumption decision.

But this will all change when the exchange rate is 31 MKD/DM following a devaluation.

The Imported product will now be sold locally at 3100. The Importer will have to pay more MKD to get the same amount of DM that he needs to pay the foreign manufacturer of the product that he is importing.

The Exported products will now fetch the exporter the same amount of income in foreign exchange. Yet, when converted to MKD - he will receive 400 MKD more than before the devaluation. He could use this money to increase his profits - or to reduce the price of his product in the foreign markets and sell more (which will also increase his profits).

The Locally Produced Import Substitutes will benefit: they will still be priced at 2700 - while the competition (Imports) will have to increase the price to 3100 not to lose money!

The local consumption of products which can, in principle, be exported - will go down. The exporter will prefer to export them and get more MKD for his foreign exchange earnings.

These are the subtle mechanisms by which exports go up and imports go down following a devaluation.

In Macedonia, the situation is less clear. There is a great component of imported raw materials in the exported industrial products. The price of this component will increase. The price of capital assets (machinery, technology, intellectual property, software) will also increase and make it more difficult for local businesses to invest in their future. Still, it is safe to say that the overall effect of the devaluation will favour exporters and exports and reduce imports marginally.

Unfortunately, most of the imports are indispensable at any price (inelastic demand curve): raw materials, capital assets, credits, even cars. People buy cars not only to drive them - but also in order to preserve the value of their money. Cars in Macedonia are a commodity and a store of value and these functions are difficult to substitute.

But this is all in an idealized country which really exists nowhere. In reality, devaluation tends to increase inflation (=the general price level) and thus have an adverse macro-economic effect. Six mechanisms operate immediately following a devaluation:

  1. The price of imported products goes up.
  1. The price of goods and services, denominated in foreign exchange goes up. An example: prices of apartments and residential and commercial rentals is fixed in DEM. These prices increase (in terms of MKD) by the percentage of devaluation - immediately! The same goes for consumer goods, big (cars) and small (electronics).
  1. Exporters get more MKD for their foreign exchange (and this has an inflationary effect).
  1. People can convert money that they saved in foreign exchange - and get more MKD for it. A DEVALUATION IS A PRIZE GIVEN TO SPECULATORS AND TO BLACK MARKET OPERATORS.
  1. Thus, the cost of living increases. People put pressure on their employees to increase their salaries. Unfortunately, there is yet no example in history in which governments and employers were completely successful in fending off such pressures. Usually, they give in, wholly or partially.
    Certain countries tried to contain such wage pressures and the wage driven inflation which is a result of wage increases.
    The government, employee trade unions and representatives of employers’ unions - sign "economic pacts or package deals".
    The government undertakes not to raise fees for public services, the employers agree not to fire people or not to reduce wages and employee trade unions agree not to demand wage hikes and not to strike.
    Such economic pacts have been very successful in stabilizing inflation in many countries, from Israel to Argentina.
    Still, some of the devaluation inevitably seeps into the wages. The government can effectively control only such employees as are in its direct employment. It cannot dictate to the private sector.
  1. Inflation gradually erodes the competitive advantage awarded to the exporters by the devaluation which preceded it. So devaluations have a tendency to create a cancerous chain reaction: devaluation-inflation followed by more devaluation and yet by more inflation.

Arguably, the worst effect of a devaluation is the psychological one.

Macedonia has succeeded where many other countries failed: it created an atmosphere of macro-economic stability. It is a fact that the differential between the official and non-official exchange rates was very small (about 3.5%). This was a sign of trust in the macro-economic management. This devaluation had the effects of drugs: it could prove stimulating to the economic body in the short term - but it might be harmful to it in the longer term.

These risks are worth taking under two conditions:

  1. That the devaluation is part of a comprehensive economic program intended to stimulate the economy and mainly the export sector.
  1. That the devaluation is part of a long term macro-monetary plan with clear, OPENLY DECLARED, goals. In other words: the government and the Central Bank should have designed a multi-year plan, stating clearly their inflation objectives and by how much they are going to devalue the currency (MKD) over and above the inflation target. This is much preferable to "shock therapy": keeping the devaluation secret until the last minute and then declaring it overnight, taking everyone by surprise. The instinctive reaction is: "But if the government announces its intentions in advance - people and speculators will rush to take advantage of these plans. For instance, they will buy foreign exchange and put pressure on the government to devalue by dilapidating its foreign currency reserves".

If so, why didn’t it happen in Israel, Argentina, Chile and tens of other countries? In all these countries, the government announced inflation and devaluation targets well in advance. Surprisingly, it had the following effects:

  1. The business sector was able to plan its operations years in advance, to price its products properly, to protect itself by buying financial hedge contracts. Suddenly, the business environment became safe and predictable. This had an extremely favourable micro-economic effect.
  1. The currency stabilized and displayed qualities normally associated with "hard currencies". For instance, the New Israeli Shekel, which no one wanted to touch and which was immediately converted to US dollars (to protect the value) - became a national hit. It appreciated by 50% (!) against the dollar, people sold their dollars and bought Shekels - and all this with an inflation of 18% per year! It became a truly convertible currency - because people could predict its value over time.
  1. The consistency, endurance and resilience of the governments in implementing their macro-economoic agendas - made the populace regain their trust. Citizens began to believe their governments again. The openness of the government, the transparency of its operations and the fact that it kept its word - meant a lot in restoring the right, trusting relationship which should prevail between subjects and their administration.

That strict measures are taken to prevent the metamorphosis of the devaluation into inflation. The usual measures include a freeze on all wages, a reduction of the budget deficit, even temporary anti-import protective barriers to defend the local industries and to reduce inflationary pressures.

Granted, the government of Macedonia and its Central Bank are not entirely autonomous in setting the economic priorities and in deciding which measures to adopt and to what extent. They have to attune themselves to "advice" (not to say dictates or conditions) given by the likes of the IMF. If they fail to do so, the IMF and the World Bank will cut Macedonia off the bloodlines of international credits. The situation is, at times, very close to coercion.

Still, Macedonia could use successful examples in other countries to argue its case. It could have made this devaluation a turning point for the economy. It could have reached a nationwide consensus to work towards a better economic future within a national "Economic Agenda". It is still not to late to do so. A devaluation should be an essential part of any economic program. It could still be the cornerstone in an export driven, employment oriented, economy stimulating edifice.

Interview granted to Nova Makedonija, May 2012

1. What is your opinion about fixed exchange rate regimes?

 

A. Fixed exchange rate regimes are useful in crisis circumstances, when the restoration of stability and the trust of citizens, investors, and speculators is essential. Such harsh measures, usually coupled with capital controls, should be short-term and lifted immediately when the economy had picked up and expectations have settled.

 

Maintaining a fixed-rate regime in the long-term has nefarious and dangerous consequences as the exchange rate diverges further and further from the real value of the currency, adjusted to inflation. This erodes the competitiveness of exporters, renders imports relatively cheap, distorts the price signal throughout the economy (in other words: people don't know what the real value of their currency is abroad). It also leads to speculative attacks on the currency from the outside (if the currency is convertible and traded in free foreign exchange markets) - or from the inside (in the form of a thriving black foreign exchange market.)

2. What is the connection between exchange rate policies and better economic results?

 

A. This depends on how open the country is to the global capital markets and what percentage of its GDP is made up of international trade and various transfers from abroad (such as remittances.) As a rule, the more exposed a country is to the ups and downs of the global market, the more it should have a flexible and adaptable exchange rate policy. A country that exports and imports a lot needs to have competitive manufacturing, services (e.g., tourism), and agricultural sectors. An important part of such competitiveness is having the correct exchange rate which reflects inflation differentials, purchasing power disparities, relative advantages, and structural elements. Such constant adjustment (up AND down, for instance within a band) is excluded by a fixed rate regime. By adopting a fixed exchange rate, the country is giving up on one of its most important automatic economic stabilizers and policy tools, as Greece is discovering now to its great cost.

3. Is a fixed exchange rate good for controlling inflation? Is there a possibility to control the prices and make a correction of the value of the currency?

 

Inflation reflects expectations of the population regarding the future level of prices. These expectations are affected by the level of stability inside the country - but also by factors outside it. In a country that is open to international trade, foreign capital flows, and foreign direct investment, external instability is far more important than internal stability. Indeed, in countries like Macedonia, Israel, and Brazil, most of the inflation comes from the outside via the soaring prices of imports such as energy products, foodstuffs, and raw materials. There is little the monetary authorities can do to affect such imported inflation.

 

Still, it is true that a string of unannounced, arbitrary, unscripted, incomprehensible, and large devaluations will create inflation. The exchange rate policy has to be transparent, predictable, rational, and adaptable. There are dozens of countries around the world with various modesl of flexible exchange rates and, yet, with stable prices: these two are not mutually exclusive. Flexible exchange rates mean that the currency can do down (devaluation) - but also up (appreciation or revaluation.)


4. What happens to an economy if people from abroad stop sending money?

 

Depends on: (1) What is the share of remittances in the GDP; and (2) What are the remittances used for. In most poor countries remittances constitute 10-15% of GDP and they are used by the recipients mostly for consumption. When remittances decline, consumption and GDP are adversely affected, the level of foreign exchange reserves declines, and outlays on social welfare increase.

5. Can a country defeat the trade deficit with a fixed exchange rate?

 

The exchange rate is only one component in the overall competitiveness of the economy. Structural reforms in the public sector and various institutions; infusion of management and marketing skills; innovation; a functioning financial system; new inputs (equipment, information technology, intellectual property under license); focused and up-to- date training and re-skilling; better access to core export markets; the economic conditions in these export markets; level and relevance of the workforce's education; mentality and ethos - all these are as important as the exchange rate alone. Germany and Japan had overvalued currencies for decades and still were able to achieve prosperity and dominate international trade.

 

Interview granted to Nova Makedonija, August 13, 2015

 

China did not devalue the yuan, except for a minor adjustment. It simply allowed market forces to determine its value for the first time in its history. Because the economy is decelerating, the value of the yuan went down.

The MKD is pegged to the euro and the euro has been massively devalued in the past 6 years: it dropped by 30% vis-a-vis the other major currencies. This means that the MKD has also been devalued in international markets (because it is linked to the euro): Macedonia's terms of trade have improved dramatically. There is absolutely no need for a devaluation now.

Competitive devaluation (devaluation of the currency whose sole purpose is to encourage exports) has proven to be effective only when a few other conditions exist:

1. The products of the country are comply with international standards;

2. The productivity of the labor force is high and management quality is high;

3. Exporters regularly invest in international marketing, branding, research and development, and intellectual property;

4. Regulatory hurdles, political interference, and bureaucracy are predictable and low while the judicial system is impartial and functional;

5. The private sector does not depend on the state (is not rent-seeking);

6. The private sector has extensive contacts in foreign destinations;

7. The country is well-integrated into the global transport network;

8. The exports of the country are diversified in terms of product mix (many products and services of different types) and in terms of destination markets.

Macedonia doesn't meet even one of these 8 criteria. A devaluation of the MKD will be of no use unless these 8 points are tackled first.


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