The
recent devaluation of Birr, the Ethiopian currency, has gripped many wondering if
this policy measure has the audacity to achieve the objectives that the
Ethiopian government has since stated in its arguments for the action, and more
importantly, if it may amplify problems or may produce shocks, anticipated or
otherwise, calamitous to the economy. What is more agitating is this action was
introduced at the time when the country has readied itself to embark on a
high-end drive to lift the economy up to the middle-income level – kudos to the
Growth and Transformation Plan – and at the time the service sector has taken
up the driver’s seat in the economy, bettering the traditional agricultural
sector. In other words, this devaluation was made in the face of expansive
economy in the coming five years and the share of home non-tradable being
cemented due to the growing service sector in a mainly import country. Add to
this the stuttering global economy in the wake of the financial bedlam. Despite
the rescue efforts and strong government activism to stimulate the economy in
crisis-hit countries, the recuperative process is still meaningfully weak. These
economic phenomena determine how and how much effective devaluation can be in
absorbing the problems that induced its introduction.
Exchange
rate is the price of a foreign currency in terms of domestic currency and its
increase shows that a foreign currency becomes expensive relative to the
domestic one. Exchange regimes can be of fully fixed, flexible (market-determined)
or intermediate, integrating traits of both fixed and flexible. Which of these
to adopt has remained one of the contentiously debated economic issues to date?
The reasons include, interalia, difficult trade-offs such as stability vs.
monetary policy autonomy we have to make in the choice of a regime, the mixed
empirical foundations of the various regimes in the world. This implies that
the suitability of these various regimes is conditional on the circumstances of
individual countries
Nominal
devaluation, a rise in exchange rate, is associated with a fixed exchange
regime which is a policy variable. It is carried out in an effort to compensate
for the impact of higher domestic inflation on international competitiveness or
to absorb the drainage of foreign exchange reserve (balance of payment deficits).
Yet, it is not a fire-sure way to materialize the objectives. Devaluing a
currency per se may not yield the desired outcome for it is only a component to
the real exchange rate. Real exchange rate, unlike a nominal one, is a rate
adjusted for domestic inflation relative to world inflation and measures the
prices of foreign goods in terms of units of domestic goods. A rise in real
exchange, for example, means foreign goods have become more expensive relative
to domestic goods, raising the likelihood for foreigners and domestic residents
to increase their purchase of domestic goods. Therefore, a mere devaluation of
domestic currency doesn’t necessarily lead to the attainment of the objectives;
it is conditional on several factors such as:
1)
whether a devaluing country has adopted expansionary fiscal, monetary
policies and wage-indexation: if these expansive policies are in place during
the devaluation, the efficacy of devaluation is dented so the probability of
devaluation effectiveness increases only with contractionary policies in home
economy.
2)
Trade elasticity: if devaluation is to succeed, the trade (export and
import) elasticity should be higher otherwise the policy measure may lead to
the deterioration of the situation in stead. This is mainly accrued to the
status and structure of the home economy and the rest of the world.
Therefore,
the manner and timing of the devaluation of Birr is questionable. First and
foremost, the recent devaluation is an addition to similar prior measures,
increasing the frequency of the action and thereby raising its softness.
Softness of a fixed exchange rate raises the scope and likelihood of
speculative attack – the holding of foreign currencies against domestic
currency in fear or expectation of higher domestic inflation and devaluation; this
is because under these events, speculation becomes a virtually risk-free
activity bar transportation cost. If this happens, we may end up in
inflation-devaluation spiral, debilitating the infant financial system and
impairing the real economy through its spill-over effects.
The
Growth and Transformation Plan and its implication to the devaluation are
another fundamental point. The plan is expansionary and well at odds with the
conditions necessary for the success of devaluation. The reason is embedded in
the direct impact that the plan creates on inflation and consequently on
devaluation. Since a rise in domestic inflation makes foreign goods cheaper
relative to the domestic ones, the expansive economy that the plan has eyed
will nullify the positive effect of devaluation and we may find ourselves in yet
greater crater.
The
other reason is the strength and structure of the economy. Ethiopia is a major import country, with its export sector dominated by agricultural items.
Further more, it’s a country in the process of construction and transformation long
after economic morass and neglect. This means that the country is characterized
by low trade elasticity, that is, the export supply and demand, and import
demand responses to devaluation are too low so the country might find its
situations aggravating rather than improving since the valuation effect on the
import bill will be more negative.
These
features lead us to expect that it’s less likely for the devaluation to help
address the problems. I don’t think that the policy makers are not cognizant of
these repercussions; it simply shows the intricacy of the situations in the
country. Given this measure, however, as every cloud has a silver lining, the
trajectory of inflation in the upcoming years will be very instrumental. If
inflation soars, not only does it worsen the balance of payment deficits (BOPs),
it may also precipitate social tensions. The price pressures immediately
following the devaluation are canaries in the mine. So the authorities should
be Argus-eyed to the movements of inflation and take every possible step to
contain it, for instance, by increasing interest rate, by controlling domestic
credit and by sterilizing any money supply effect of devaluation. For countries
like Ethiopia who have been mired in economic and political complexities, it is
very important that a government sometimes take out-of-the-box approach, rather
than relying on the conventional wisdom. A mélange of measures like tax reliefs
or cuts to selected export items, import tariffs on selected commodities,
command and control, pegging different exchange rates to different transactions
and others could have been options. These, nonetheless, offer only temporary
solace to the current BOPs anxiety; the lasting solution piggybacks on enlarging
the manufacturing and export bases of the country and, reversing our dependence
on imports, and having in place vibrant and independent institutions.
