What Have We Learnt So Far Regarding DEVALUATION?

The following was posted to FB Senate Page  by Economist Charles Skeete
Central Bank of Barbados

Central Bank of Barbados

  1. The monetary authorities can fix the nominal/official rate of exchange, but not the real rate (reer).
  2. When the nominal rate is fixed, over time there is a tendency for it to become over-valued. This is so especially in small open economies. There is evidence that the official rate of exchange is over-valued (is higher than the reer).
  3. A persistent bop current account deficit suggests we have a competitiveness problem and that national consumption exceeds national production.
  4. A persistent bop current account deficit can be sustained only as long as capital inflows (e.g., FDI and foreign borrowing) are at least equal to the current account deficit.
  5. High debt eventually limits the ability to borrow foreign exchange – except from the IMF.

What can we do?

Option 1: Draw on FX reserves. Unless replenished by a current account surplus, FDI, or foreign borrowing, reserves will be exhausted in short order. Sharply declining reserves will eventually make devaluation and borrowing unavoidable.

Option 2: Reduce the fiscal deficit. Alas recent experience suggests that our heart is not in it. We try to raise taxes we cannot collect and we resist cuts in spending with all our might. Reducing the fiscal deficit is necessary to restore a balance between national consumption and national production. Without credible steps to restore this balance, we will continue to be rated a poor credit risk.

Option 3: We have never been fond of high interest rates, except as a reward for saving. The fact that high interest rates are an alternative/supplement to devaluation as a way to lower consumption is conveniently overlooked.

Option 4: Adopt policies that make the relative price of imports and exports more favorable to earners of export revenues and less favorable to consumers (e.g., devaluation, tax holidays, or other subsidies). We have been willing to use tax holidays and other subsidies to encourage investment in our leading export sector (tourism). This is necessary because we are not price competitive without such subsidies and we have rejected devaluation or a cut in the nominal wage (the standard remedies). As noted above, rejection of these remedies is viable only as long as reserves last.

Concluding Remarks: Restructuring of the agriculture and manufacturing sectors sufficient to restore current account balance are necessary, but are achievable only in the medium and long term. Fiscal and bop imbalance require remedies that will show immediate results. The ability to borrow foreign exchange would give us breathing room. On the whole, I must conclude that an IMF Program is very much in the cards.

Here endeth the final lesson.