The exchange rate is now about right


Wednesday, July 09, 2014

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ON election day, December 28, 2011, the dollar was $86.61 to one US dollar, and is now around $112.50 to one US dollar, testing the resolve of Jamaicans.

Unsurprisingly, the exchange rate has long been an extremely important political issue in Jamaica. As a point of comparison, when my father was head of the Jamaica Chamber of Commerce in the early 1980s, he said people used to complain when he said the exchange rate was overvalued. At the time, the exchange rate was $1.78 to one US dollar. However, when as president of the PSOJ he more diplomatically said in speeches that the exchange rate needed to find its correct value, no one complained. Of course, this period coincided with the exchange rate having already been devalued to the more realistic level of $3.15 on November 24, 1983.

The point of this anecdote is that there is absolutely nothing new about exchange rate overvaluation. In fact, in his 1997 book Jamaica's Export Economy : Towards a Strategy of Export-led Growth, Stanford Emeritus Professor of Economics Donald Harris helpfully calculates the level of real exchange rate appreciation (which we will define below), for the period 1973 to 1977, and 1979 to 1982, as 17.7 per cent and 19.2 per cent respectively. What this shows, completely unsurprisingly, is that the exchange rate was already very seriously overvalued on election day in 1980 (completely corroborated by negative international reserves and the overall disastrous economic situation), but that it was allowed to get even more overvalued until the correction in 1983.

On page 23, Harris, whose analysis only goes up to 1995, comments on the four periods of real exchange rate appreciation. He prophetically notes, "In every case, the deprecation in the nominal exchange rate came after a long period (typically four years) of substantial and sustained appreciation in the real exchange rate."

At this point, it is useful to define briefly the real exchange rate. Put simply, it is the relative price of goods produced abroad, measured in local currency, relative to the price of goods produced at home. Another way of putting it is the number of baskets of Jamaican goods it takes to buy a single basket of US goods. A decrease in the real exchange rate means a fall in the number of baskets of Jamaican goods required to buy one US basket, due to the price of the baskets of Jamaican goods rising much faster than the US basket because of higher Jamaican inflation of eight per cent per year versus the US inflation of two per cent. With a stable currency, and higher priced Jamaican baskets due to inflation, a foreigner with US dollars only gets the same amount of Jamaican dollars, which now buys less baskets. This is called, confusingly, an appreciation of the real exchange rate.

While at first glance this might seem a good thing, what it really means is that overseas customers stop buying the more expensive Jamaican basket -- exports fall and imports rise as foreign goods become more competitive. As night follows day, the merchandise trade balance and, most importantly, the current account deficit expands beyond sustainable levels.

The current account deficit includes goods and services exports and imports, income (employee compensation and investment income such as dividends, profits, re-invested earnings and portfolio income), and current transfers, predominantly remittances in the case of Jamaica. In 2008, the current account deficit as a percentage of GDP peaked at around 20 per cent of GDP, fell back after the sharp devaluation at the end of 2008/early 2009, but peaked again at just under 15 per cent of GDP in 2011. Foreign direct investment in 2011 of US$200 million covered less than 10 per cent of the current account deficit of US$2.173 billion. Indeed, the foreign direct investment figure for 2010 was even lower at US$143 million, although the current account deficit was also much lower at US$1.221 billion, so that it was covered by a higher percentage of "cold" foreign direct investment rather than hot money, the latter being tradable portfolio investment. More importantly, in 2010, there was a huge inflow of central government financing of over US$730 million, meaning the multilateral money of the first IMF programme.

The punch line is that every Jamaican now wants to know where the dollar is going. In their just released article 4 analysis, the IMF projects a further fall in this year's current account deficit from the current 9.5 per cent of GDP, or US$1.344 billion, to eight per cent of GDP, or around US$1.125 billion.

In their report, the IMF state that the remaining overvaluation of three to 15 per cent "appears modest", and is much less than the eight to 22 per cent estimated in April 2013. Both their macroeconomic balance and their external sustainability approach suggest a reduction in the rate of overvaluation to three per cent from eight and 10 per cent respectively.

However, some newspaper headlines have emphasised that the IMF's equilibrium real exchange rate approach indicates a currency overvaluation of 15 per cent. This uses an econometric model that relies on historic numbers but takes no account of current or future policy adjustments (the fiscal surplus would be a notable policy adjustment), an approach the IMF itself argues one should treat with caution.

Determining the level of overvaluation is in any case an imprecise science, as according to Bank of Jamaica Governor Brian Wynter, the margin of error in the IMF model is plus or minus seven per cent. He notes that the Bank of Jamaica uses the same model as the IMF, with marginal tweaks. Indeed, in the Governor's view, of greater importance is the collapse in the current account deficit by roughly 75 per cent, from over US$400 million in the first quarter of last year to a bit over US$100 million in the as-yet-unpublished first quarter this year. He projects foreign direct investment conservatively at around US$450 million or three per cent of GDP. This suggests that when Madame Lagarde said the level of overvaluation was "not much", she meant that the level of overvaluation was indeed closer to three per cent than 15 per cent.

Perhaps more importantly from a short-term perspective, Jamaica's net international reserves, which had fallen to US $1.164 billion at the end of May (gross reserves of US$1.8 billion), rose to US$1.376 billion at the end of June, or a rise of US$211 million. This is before the US$800 million recently raised, which the Governor advises should be received tomorrow, and should increase it to just under US$2.3 billion (with the more important gross reserves likely approaching the US$2.8 billion mark). This is approaching the high of over US$2.5 billion in net international reserves (and over US$3.4 billion in gross reserves) after the receipt of the multilateral money in 2010, and suggests that Jamaica now has the wherewithal for the turnaround in confidence required to stabilise the exchange rate.

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