Should the BOJ care about firms’ forex losses?

Exchange rate risk is one of the most pernicious of business risks and academics have documented its negative effects on firms’ profitability, cost of and access to capital, and strategic decisions such as resource allocation, investment, and capacity utilisation.

Hence, it might have been surprising that when it was brought to the attention of the BOJ Governor that some firms have experienced foreign exchange losses because the Jamaican dollar strengthened due to Bank of Jamaica’s tight monetary policy, he responded: “To the extent that [firms hold] foreign currency and have not reaped devaluation gains, well, too bad,” as reported in the business section of The Gleaner on August 24.

It had been a while since I last heard a representative of the private sector bemoaning foreign exchange losses due to the relative strength of the JMD. Should this be a concern for the BOJ?

I think the Governor’s statement could be understood as ‘regrettably, some firms did not foresee exchange rate stability as a possible outcome of tight monetary policy and did not (or were not able to) protect themselves from this eventuality’.

The Governor’s statement, however we understand it, simultaneously highlights a possible lack of foresight by the affected firms regarding the implications of the BOJ’s stated monetary policy stance on exchange rates, a victory for the BOJ in the fight against inflation, and an indictment of the relatively limited financial development of the financial sector.

Lack of foresight

In some sense, Jamaican firms earning foreign currency have been spoilt by the near certainty that if they keep a reserve of US dollars, they will earn a foreign exchange gain as there is a high probability that the JMD will depreciate relative to the USD in the future. That is, each USD received today can generally be exchanged for a greater number of JMDs in the future, relative to the number of JMDs that would have been received today.

As I wrote previously, the JMD depreciated in 34 of the last 40 years.

Given the above, we would be tempted to conclude that the firms that experienced foreign exchange losses had not envisaged that higher local interest rates in the short term would cause an appreciation of the JMD. Countries with higher interest rates than those of their main trading partners over the medium to long term usually have weaker currencies because the high interest rates are likely a reflection of relatively higher inflation.

However, this is usually not the case in the short term. Given Jamaica’s success over the last decade in reducing inflation and, hence, interest rate, a shift to higher short-term interest rate to fight inflation would, holding other things constant, have been expected to strengthen the JMD.

While non-financial firms that are dependent on external financing, such as bank loans, find it difficult to avoid the higher interest cost arising from tighter monetary policy, firms whose cash flows are sensitive to changes in exchange rates can reduce the negative effects, even if the market for risk management is underdeveloped.

This can be done by making changes to some aspects of their operations (operating hedges) and using bank loans (money market hedges). For instance, an exporter that fears that the JMD could appreciate by an economically meaningful amount by the time it expects to receive an inflow of USDs could protect itself by borrowing USDs today and converting them to JMDs. This would lock in a higher number of JMDs relative to waiting to receive the USD inflow. Upon receiving the USD inflow, it repays the USD loan plus interest.

For financial firms and others requiring more sophisticated risk management, that typically comes with greater financial development, which I discuss below. Hence, it is not clear if firms that experienced exchange rate losses simply did not protect themselves or were not able to do so.

Victory for the BOJ

We should not take lightly threats to the success of private firms given their roles in the country. Nonetheless, foreign exchange losses could be reflecting the emergence of a greater good arising from BOJ’s tight monetary posture. Large foreign exchange losses arising from a stronger JMD can reduce firms’ spending capacity. On the flip side, even if in more normal circumstances a stronger JMD would have induced an increase in the volume of imports, it is not likely to do so now given consumers’ spending constraints and, in any case, imports should sell at lower JMD prices.

Both outcomes augur well for lower inflation.

More broadly, the BOJ’s resolve to maintain its policy stance despite the negative effects on the private sector may be signalling that the BOJ is solidifying its independence, improving its inflation-fighting credibility, shifting the trajectory of the JMD from near constant decline to a more stable path with meaningful changes in both directions, and disincentivising the push to convert local savings to US dollars.

Taken together, it appears that the BOJ is achieving some policy successes, which will influence the duration of the tight monetary policy. The unanswered question then is, how far is the BOJ willing to go?

Limited financial development

An unfortunate consequence of the near unidirectional change in the JMD over time is the underdevelopment of the market for managing exchange rate risk because private firms have little incentive to offer some types of risk-management services in this situation.

More generally, the financial sector in Jamaica has failed to reach its potential over the last 40 years and is currently significantly underdeveloped (see the IMF financial development index), despite episodic indications to the contrary. This suggests that firms might not have been able to obtain risk protection.

So, although firms should, in principle, be responsible for managing their risk exposures or face the consequences if they choose not to, it is evident that they face impediments that are a function of financial underdevelopment. However, central banks’ ability to successfully conduct monetary policy generally increases with local financial development.

This is because greater financial development enhances the transmission of monetary policy to the productive sectors by its timely impact on financial institutions, financial market participants, and widely held financial assets. For instance, as central banks increase interest rates and the values of stocks and bonds decrease, investors’ consumption demand also declines, and this has greater positive effect on inflation if the participation rate in the financial markets is high.

Since monetary policy can also affect financial development and the BOJ has some discretion regarding the use of specific financial instruments to effectuate monetary policy, the BOJ can take additional steps to improve local financial development. This would require another article, but I have previously suggested that the BOJ could issue inflation-indexed securities to reduce demand-driven inflation and provide liquidity support for short-term lending aimed at managing exchange rate risk. These would immediately improve financial development and aid the inflation fight.

The exchange rate exposure of private firms should not be a prime concern of the central bank, and private firms should be responsible for managing their own risks.

Notwithstanding, the BOJ needs to be sensitive to the fact that firms have limited options – pun intended – for the management of risks in Jamaica.

Delroy M. Hunter, PhD, is the Serge Bonanni Professor of International Finance at the University of South Florida.

dhunter2@usf.edu