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Consider very carefully before devaluation

Monday, November 27, 2017

The Central Bank Governor has recently acknowledged that arguments for exchange rate adjustments (re: devaluation) for countries suffering from terms of trade shocks do have merit.

This coming some two days after the IMF published Article IV consultation staff report on T&T which pointed to an overvalued currency. The IMF models suggest that US$1 should be worth $8.38 and $10.06 instead of $6.78. Is the IMF suggesting a dual exchange rate regime for T&T in which it sets one exchange rate for some transactions and another rate of exchange for other transactions?

Please note that exchange rates can be either freely floating (here we can expect almost daily fluctuations in the exchange rate but the Central Bank having to hold less foreign exchange reserves); fixed (where there is little fluctuation in exchange rate value but the CBank having to keep huge reserves of foreign exchange to prop-up the exchange rate value); or a managed float, as now obtains, where the local currency is allowed to float within a controlled band, with the CB making timely and significant intervention in the currency market.

One possible fall-out of exchange rate devaluation/depreciation is that it can give rise to inflationary pressure as imported goods become more expensive to the consumer and domestic producers who use imported inputs or components in the production process. This is typical in small open economies which import large amounts of finished goods and imported inputs. When this occurs the CB will need to raise interest rates to dampen demand, which has the potential to set the entire economy into a recessionary spiral.

A cheaper exchange rate, assuming that exports are positively responsive to changes in price, may also trigger a need for new products and new markets or an increase in volume of products in existing markets.

The foregoing must of necessity be balanced against the fact that a nation needs to have a relatively stable currency to attract investment capital from foreign investors in the form of FDI because foreign exchange loss triggered by currency depreciation may drive away foreign investors.

The fact that if a country’s debt consists of a significant percentage of foreign currency debt, as is the case in T&T at this time, their principal and interest payments will rise significantly because of devaluation.

This has the potential to squeeze out other expenditures in other sectors of the domestic economy while putting the entire economy into further recession.

The government and in particular the ministry of finance and indeed the CB must consider all factors before making such a fundamental decision because it will have serious economic consequences going forward. We need to do a serious balancing act, especially given the possible negative fall-outs of devaluation on a small open economy like ours which has a huge import bill and terms-of -trade which is skewed in favour of imports as against exports.

Peter Narcis,


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