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Wednesday, September 28, 2011

Six popular fallacies of currency appreciation



  
They also mean six deathly fears of depreciation

The last week’s My View titled ‘Appreciating Exchange Rates: Not a Boon Always’ (available at:http://www.ft.lk/2011/09/12/appreciating-exchange-rates-not-a-boon-always/#more- 47364) had provoked many a reader of this paper to bring their comments and views to my notice.
Some were appreciative, some were inquiring and some were critical. Whatever the tone or the intention of the submissions, it has established the evidence of readers’ desire to engage in a free and frank discussion. Such free and frank discussions engaged by a wide spectrum of the readership are appreciably a welcome sign and should be encouraged by all means.
However, deep buried in these comments were some popular fallacies of the desirability of allowing a currency to appreciate against other currencies or in exact inverse, six deathly fears of currency depreciation.
Central bankers too aren’t free from the fear of depreciation
This is not uncommon. Even when a central banker is asked to list the two most fearful events that would bring him nightmares, invariably the ready answer maybe ‘inflation’ and ‘depreciation’.
Inflation is the long term continuous erosion of the domestic value of a currency when exchanging it for domestic goods and services. Depreciation is the erosion of its international value when it is used for acquiring other currencies to buy goods and services from foreigners.
Naturally, a central banker should be worried about both erosions. That is because he is mandated to preserve its value and either erosion would mean his failure to do so. But he should not be elated when the opposite takes place, namely, deflation or decreases in domestic prices and appreciation or strengthening of a currency, unless there have been improvements in productivity in the economy to sustain such deflation or appreciation.
In this article, we look at only the issue of currency appreciation or depreciation against foreign currencies.
There have been six popular fallacies of the desirability of currency appreciation so that the community can overcome the deathly fears they harbour about its depreciation.
Fallacy 1: The Government can fix the external value of a currency or the exchange rate at any level it wishes.
Fallacy 2: An appreciated currency or an exchange rate is a sign of the strength or the preserved dignity of a country.
Fallacy 3: The currency appreciation helps the Government to fight inflation since depreciation is a cause of inflation.
Fallacy 4: The currency appreciation is a boon for the Government budget since it helps the Government to keep foreign public debt repayment under control.
Fallacy 5: It is only the exporters who hate currency appreciation and everyone else loves it.
Fallacy 6: By allowing a currency to appreciate or preventing its depreciation, a country can increase its per capita income or the average income per person in US Dollar terms.
Fallacy 1: Ability to fix the exchange rate
An exchange rate is a price and here the price is the expression of the value of one currency in term of another currency. For instance, the price of the US Dollar in terms of Sri Lanka Rupee is that one dollar is equal to Rs. 110. At this price, for any Sri Lankan to buy a dollar, he should spend Rs. 110. Conversely, for any foreigner to buy a rupee, he should bring nearly one US cent.
The popular fallacy is that the Government can fix this rate at any level it wishes. For instance, if the Government wishes, it can fix the rate of the dollar at Rs. 100 or even below. Can this be done? The answer is both yes and no.
‘Yes’ if the domestic purchasing power of the rupee has improved against the dollar so that anyone who has acquired a rupee has the same purchasing power as a holder of a dollar at the new rate.
This was presented by the Swedish economist Gustav Cassel nearly 100 years ago in a celebrated theory known as the ‘Purchasing Power Parity’. What he said was that when there are two different price levels in two different countries, the exchange rate moves appropriately to make the purchasing power of the two currencies equal to each other, or in other words, to make operation of the purchasing power parity.
‘No’ if the true purchasing power parity is not what the government has mandated its currency to have as its international value.
This could be understood by examining the following simple example:
What is a rupee to a foreigner? It is an entitlement to buy a basket of goods and services from Sri Lanka’s economy of the worth of one rupee. That is determined by the domestic price levels. Similarly, a dollar to a Sri Lankan is the entitlement to buy a dollar’s worth of goods and services from the US economy.
Therefore, when a country announces its exchange rate, it tells the rest of the world to ‘come and buy a rupee’s worth of goods and services from our country by exchanging your currency for ours’. Hence, when the exchange rate is fixed at an appreciated value, it tells the rest of the world that they should bring more foreign currencies to buy those goods and services. It is a way of raising the value of domestic goods and services to foreigners.
Suppose for example that a potato seller at Delkanda Pola announces that his potatoes are sold for Rs. 10,000 per kilo. Can he sell his potatoes at that price? Yes, if the potatoes are sold for the same price in other polas as well.
But if potatoes are sold for Rs. 100 per kilo at Nugegoda and the transport cost and other inconveniences to travel to Nugegoda are simply Rs. 10, a buyer would move to Nugegoda and buy his potatoes. The Delkanda Pola potato seller is therefore forced to bring down his price to a level of Rs. 110 per kilo to make his potatoes as equally attractive as those at Nugegoda.
This is ‘purchasing power parity’ and according to it, price differences could occur in two different markets only to the extent of the existence of transportation costs and other inconveniences commonly known as transaction costs.
Let’s now apply this analogy to the exchange rate. Suppose that the Government announces to the rest of the world that the value of the rupee is on par with the dollar, that is, anyone wishing to get a rupee should bring a dollar with him. Suppose further that the domestic price of tea is Rs. 500 per kilo. Then, for an American to buy a kilo of tea, he should bring $ 500. This is like the Delkanda Pola potato seller announcing that his potatoes are priced at Rs. 10,000 a kilo.
Will the American buy tea from Sri Lanka? Yes, if tea prices in all other places are $ 500 a kilo. But since the American can buy a kilo of tea for $ 4.50 from neighbouring India, for him to buy tea at $ 500 a kilo from Sri Lanka, he should be an extremely stupid person.
So, to make Sri Lanka tea as attractive as Indian tea and induce foreigners to buy Sri Lankan tea, the exchange rate should be depreciated to Rs. 111 a dollar. This is sad and frustrating, but unavoidable as long as domestic tea prices remain at Rs. 500 a kilo.
Since a country produces a variety of goods and services, it is not a single price like tea that would apply, but the general price level that represents the prices of all the goods and services. This is measured by consumer price indices and their increase over a long period is known as ‘domestic inflation’. Hence, for a government to maintain an appreciated exchange rate, it should necessarily keep its inflation lower than that of other competitive countries.
If domestic inflation is at a higher level, as is the present case in Sri Lanka where inflation runs on average at seven per cent per annum according to the latest data but has been on average at around 11 per cent per annum over the past three-and-a-half decades, any artificial appreciation of the exchange rate through other means will not be sustainable.
Fallacy 2: Stronger currency brings strength and dignity
Another popular fallacy is that an exchange rate appreciation is symbolic of a country’s improved strength and dignity. This is not necessarily so.
I say ‘necessarily’ because under certain circumstances it may. If a country has continuously acquired new and modern technology, its workers have become more efficient and productive, it has a resilient and flexible economy to wade through difficult times known as negative shocks, its inflation rate is low over a long period, its education system is creative and innovative and it uses its capital productively and efficiently, then, of course, it earns a competitive edge over its rivals. It is a sure way for its currency to appreciate against other currencies.
Hence, the strength and dignity of a country comes not from its currency, but from a host of other factors. Without these factors in the background, a mere exchange rate appreciation does not bring dignity and strength to a country. It is like a person acquiring a bogus higher degree certificate without actually labouring to earn it and presenting himself as a learned person. The real recognition of his erudition comes from hard earned academic credentials and not from bogus paper certificates.
Hence, allowing a currency to appreciate through artificial means or holding onto the value of a currency when there is enormous pressure for it to depreciate does not bring prestige to a country. Instead, it creates so many other problems. That is why China, despite the mounting American pressure for it to appreciate its currency, Renmimbi, resists the move and allows only a minuscule and controlled strengthening of the currency at a time.
Similarly, Switzerland, as we have described in the previous My View, made an announcement two weeks ago to put an effective halt to the recent market appreciation of the Swiss Franc.
Sometimes, politicians get obsessed with the idea of establishing dignity for their respective nations by raising the value of their currencies. The Soviet Union tried it for more than six decades by holding artificially the value of the rouble at $ 1.85 a rouble despite the visible backwardness in its technology and economic management compared to the developed Western nations.
This obsession on the part of the Soviet leadership is understandable because they wanted to prove to the rest of the world that their socialist economic management was superior to the capitalist economic management in the Western world. But its successor, Russia, had to meet the harsh reality face to face when the Soviet Union collapsed in 1989 and the grip on the exchange rate could no longer be held by the new rulers of Russia. When the market was opened, the rouble fell from 54 kopeks to a dollar to 30,000 roubles to a dollar.
The military rulers of Myanmar too have tried this tactic since early 1990s. Their currency, the kyat, was fixed to the US Dollar at 6.49 Myanmar Kyats. But dollars were not available at this rate through official sources, since like the Soviet Union, Myanmar was short of foreign reserves. Hence, the official rate was just a mockery.
Accordingly, a vibrant and active black market for dollars was developed with the exchange rate rising to 1,400 Myanmar Kyats during the off-tourist seasons and easing to a low level of 750 Myanmar Kyats during the tourist seasons. Though black-marketing in dollars is a severely punishable offence in Myanmar, the black-market rates are daily published by Myanmar newspapers.
Fallacy 3: Currency appreciation is anti-inflationary
A third fallacy is that depreciation is inflationary because it raises the domestic prices of the imported goods. Hence, many countries even though their currencies are under severe pressure for depreciation do not yield to such market pressures at once.
Extending the same argument, it is also viewed that if the currency is allowed to appreciate, it is a salutary development because it does not allow the rising foreign prices to be reflected in the domestic prices. Accordingly, many central banks try to fight inflation not by adopting appropriate monetary policy measures but by allowing its currency to appreciate in the market.
The monetary policy statements issued by some central banks also try to justify the non-action on the monetary fronts on the ground that inflation is to be eased by the prospective appreciation of the exchange rates. These statements supposedly made by specialists knowledgeable of the subject too fuel the people’s popular fallacy of anti-inflationary currency appreciations.
One fact that has to be made clear in this regard is that the depreciation of a currency is not the cause but the result of the continuing high domestic inflation. As we have shown in Fallacy 1 above, when there is a higher inflation in a country than the inflation in competitor countries, the working of the exchange rate toward the purchasing power parity causes its currency to depreciate.
If this is not permitted, the inevitable result is the gradual loss of a country’s competitiveness and erosion of its income and output growth delivering what is known as a negative supply shock to the economy. This will further fuel the prevailing inflationary pressures. Hence, in the long run, a country will be trapped in a vicious inflation – depreciation spiral.
The depreciation of a currency certainly makes a onetime increase in the domestic prices of imported goods, but that is simply an increase in the cost of living and not inflation. For it to become inflation, these increases have to be repeated at the same rate for several years. It happens only when a central bank adopts a loose monetary policy and raises the money supply so as to increase the aggregate demand of the people for goods and services in money terms. But the ensuing inflation is not caused by depreciation but by loose monetary policy which has accommodated, in the terminology of economists, the depreciation.
A carefully-orchestrated monetary policy in such a situation will allow a country to get out of the initial increase in the prices of imported goods by preventing the economy to increase its money aggregate demand continuously. Economists call this ‘short circuiting the process of inflation-depreciation spiral’.
In many cases, when the prices of imported goods increase, if the economy has the capacity to produce them domestically, it incentivises the domestic producers to step up domestic production. The increased supply will then keep an effective check on further increases in the prices of such goods. This process would not take place if the imports are made cheaper by holding onto the exchange rate or actually allowing it to depreciate.
Hence, it is not depreciation which is inflationary in the long run, but holding onto the exchange rate or allowing the currency to appreciate and thereby discouraging domestic production.
The three remaining fallacies will be discussed in the next article.
(W.A. Wijewardena can be reached at waw1949@gmail.com)

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