Cost and benefits of 'devaluation'

Edward Seaga

Once again, price movements are disrupting the country. Jamaicans have come to recognise that whenever the exchange rate is 'devalued'/depreciated, they can look out for price increases and howls of protest, particularly about the most essential items, food and drink.

The International Monetary Fund (IMF) is currently in a four-year agreement with the Government of Jamaica. The agreement is structured to overcome the two intransigent financial deficits that have been bringing the Jamaican economy dangerously close to ruination. These two deficits measure the health of the domestic budget and the foreign exchange balance, of which the imbalance of foreign exchange is the more critical and difficult.

The strategy of the IMF is to devalue the exchange rate to enable exports to be sufficiently price competitive to achieve a surplus, or a tolerable deficit. This outcome would earn foreign exchange to take the weight off borrowing, which would drive up the national debt. Because the indebtedness of Jamaica is one of the highest worldwide (140% of GDP), the single most important objective of the IMF agreement is to reduce the debt to a tolerable level.

Depreciating the exchange rate to a competitive level to increase export earnings and increase import prices to cut foreign-exchange expenditure on imports is a standard policy prescription. It works for many countries with a dominant export trade, which only need small price adjustments to make export prices competitive. Jamaican exports are not in that category because price is not the only factor that makes Jamaican goods non-competitive.

There are other formidable challenges which determine the cost and benefit of 'devaluing'/depreciating the exchange rate:

Manufactured Jamaican goods are heavily reliant on imported raw materials, which, after 'devaluation'/depreciation, make the products more costly. This reduces competitiveness.

To put manufacturing in a stronger competitive position, factories would require replacement of obsolete equipment (as Trinidad has done), to significantly lower the cost of production. Efficiency on wide-scale heavy investment would be required;

Agriculture could benefit because most of the raw materials are local. But this benefit would depend on how much imported fertiliser and spray have to be used to counter disease and generate growth.

The tourism and mining sectors do not benefit directly from 'devaluation'/depreciation as their products are already denominated in American dollars. But they benefit indirectly because their US-dollar earnings convert to more Jamaican dollars to meet the higher local costs (electricity, transportation, wages and salaries). This allows them to run their operations from the extra Jamaican dollars received through conversion.

The other major earner of foreign exchange is remittances from Jamaicans overseas for the benefit of family and their investment in Jamaica. Remittances get the benefit of nearly full conversion of foreign to Jamaican dollars, since there is little offsetting external cost. Their benefit is some $2 billion of foreign exchange which flows into the Jamaican economy.

Further in the list above, there are some fundamental policy contradictions with the policy proposals outlined for achieving economic goals:

The planned reduction of electricity costs would be affected by the increased price of oil resulting from 'devaluation'/depreciation. This would have real impact on growth in the economy.

Cost increases in goods and services created by 'devaluation'/deprecation will increase inflation contrary to the policy direction which is to create low-inflation growth.

It is futile to quote low inflation rates when everyone knows that the prices of groceries, clothing, hardware, medication and other imports are increasing regularly. The more the prices of imports increase, the higher the cost of import expenditure, the more foreign exchange is required to pay for imports. This will push up the national debt.

'Devaluation'/depreciation would require much more Jamaican dollars to service the increased value of the external debt held by the Government of Jamaica. This could prejudice reduction of the debt service rate, a prime target, and revive the original heavy debt problem.

All these would be prejudicial to the outcome of the IMF-GOJ Agreement, making achievement much more costly to Jamaica and more burdensome to the people. What this means is that the IMF agreement will require more sacrifice to overcome the added burden and greater determination by the people to succeed.

The above rough summary of the cost and benefit of the 'devaluation'/depreciation strategy of competitiveness makes it clear that there is more to lose than to gain. Given the critical importance of this central strategy to the future of the economy, the position should be tackled empirically by doing a deeper assessment to determine what level of exchange-rate adjustment would be required to achieve competitive exports. It may turn out that the gap to be closed for competitiveness would require too great an exchange-rate adjustment, with the consequence that this strategy would be too costly and counterproductive to the economy. But this is the only way to ensure whether the strategy employed would be positive.

Of course, if 'devaluation'/depreciation continues with further watering down of the value of the Jamaican dollar, pushing up costs on basic goods in particular beyond the level of affordability without corresponding increases in exports, a crisis point could be reached putting the IMF agreement in jeopardy. At this point, with the movement of the Jamaican dollar to J$112:US$1, there is no crisis yet.

It will be argued that with a less painful strategy available by pegging the exchange rate to avoid the pain, this wise course has not been taken. But an academic study of the choice between pegging the rate and allowing it to move with managed control was commissioned by me to be carried out by Professor Vanus James for the Edward Seaga Research Institute (ESRI). The ESRI was established recently by me to research selected critical national problems, among which was the choice of exchange rate policy. The results are very interesting, even surprising.

I will use findings from Professor James to spell out his argument, which can be summarised as follows:

The real exchange rate has a greater bearing than the nominal exchange rate on the state of the economy. The nominal rate does not take into account price increases (inflation); the real exchange rate does.

The study shows that a 1.0% depreciation of the real exchange rate increases prices by 0.08% and produces a net positive impact on the growth of the economy of 0.064%.

These ratios are more meaningful when raised by a factor of 5.0, resulting in a 5% depreciation of the real exchange rate, producing a mere 0.4% inflation and 0.32% positive change in economic growth.

As these figures are relatively small, the conclusion can be drawn that depreciation of the real exchange rate of the Jamaican dollar has minimal effect on inflation and the growth of the economy. It is, therefore, a useful tool for stabilisation of the economy. This is consistent with the model used by the Bank of Jamaica, which has for years resulted in little increase in inflation or growth.

But this is not the end of the argument. It cannot be denied that depreciation of the Jamaica dollar is distressing because it increases the cost of all foreign goods and services. Any layman, housewife or businessman can confirm that. The question arises, therefore, as to which is the correct version: the academic study, or the layman's view.

There is another argument that policymakers must consider. Depreciation of the real exchange rate, which is variable and, therefore, open to movements in the cost of Jamaican export goods and services become cheaper and more marketable in the export market. This would, theoretically, increase foreign-exchange earnings for the Jamaican economy. But it would also add to the cost of imports. On balance, however, it is considered that the increase in volumes of cheaper exports would outweigh the price increase on imported goods and services. In other words, the volume effects are greater than the price effects.

When the positive and negative positions of the real exchange rate variable model are considered, one must take note of the vital role monetary policy plays in stabilising the economy. Indeed, monetary policy is the key tool to securing the stability of the system, contracting/expanding the economy, and even discouraging capital flight when needs be. On balance, therefore, it would offer a more secure regime than the pegged rate.

Finally, the exchange rate in this model has only marginal impact in affecting real prices or growth. Hence, if this is the economic model that will continue to be used over the next three years of the IMF programme, there would be ineffective economic stimulation to penetrate the relatively stagnant growth which has prevailed for more than 20 years.

This is consistent with the projections used in the IMF agreement, which indicate growth of only between 1%-2% annually. The country should, therefore, not expect any substantial growth over this period. At the end of the three years of stabilisation, a new model would have to be developed, structured on strong investment to produce growth. If stabilisation is successful over the next three years, significant growth could follow.

Edward Seaga is a former prime minister. He is now chancellor of the University of Technology and a distinguished fellow at the UWI. Email feedback to columns@gleanerjm.com and odf@uwimona.edu.jm.