Devaluation of Birr and it's effect in the economy

The Reporter

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Dr. Wolday Amha has been president of the Ethiopian Economic Association (EEA). for the past six years. He would be vacating the post today. The outgoing president spoke to Asrat Seyoum of The Reporter on the economic implications of the devaluation of the birr.

Excerps:

Beyond the current case of devaluation in Ethiopia, what is the basic concept of the policy prescriptions in  economics literature? 

According to the textbook definitions of the devaluations policy prescriptions in the economics, it is nothing but a conditions whereby the country tries to encourage exporters and do the reverse to the importers. In the free market set-up, the question of currency valuation is not a matter for the government. Rather, it is the market for imports and exports that determines it. If I were an exporter in Ethiopia, let us see how I can benefit from the devaluation. Imagine that I was selling coffee in the internationalPublish Post market. If 800 kg of coffee were sold, charging one dollar for a kilo then I will be receiving some 10800 birr, according to the old exchange rate. 

However, the new rate will result in a receipt of 13200 birr, without any change to the export volume or price of my product. Now, as a rational exporter, my next move would be to go for more gains in the export market, which, if others follow it, would be a benefit to the country.

On the other hand, the policy also would discourage importers, as the price of imports would rise for us. Yet, it should be noted that the policy does have its own disadvantages and, at the end of the day, it would be one of those cost-and-benefit-weighing decisions.

Related Article

Positive and Negative effects of Devaluation of Birr

Considering all the benefits and the cost, can we confidently say at this particular juncture that the policy benefits the country?

In effect, the devaluation directly touches those products that are tradable in the international market. The sectors that are not as such traded in the international arena are not likely to feel the effect. 

The stylized facts in the Ethiopian economy had been the same in the past: which are fewer export commodities and more imports every year. As a result, the balance of payment is always under pressure from this severe imbalance.  Devaluation is a policy designed to correct this deficit in the balance of payments. It is easy and simple to implement. So developing countries use it to correct the shortfall in the in external sector. 

If you are asking me how successful the policy prescriptions, in Ethiopia, at present is, as an economics I would be required to conduct a proper study on the matter. In a nutshell, the economic literature states that the success of devaluation, in general, depends on the respective elasticity of both the import and the export. These figures do require  proper study.   

Some of the professionals in your discipline are expressing their fear that the policy would bring the risk of imported inflations with it. How do you explain the risk? 

I think we are already witnessing the phenomena in the market. For instance, some of the products, are actually experiencing a price increase of up to 30 percent, while some are hording the products, speculating soar prices in the future. At some of the markets the price has been raised in the products that landed in the country prior to the policy of devaluation came into effect. Increasing the price on the already existing stock is a very speculative behavior, and hence hurts consumers.

Personally, I feel that the price increase is not the direct effect of the devaluation; rather it is the panic and shock playing their speculative role in the already vulnerable market. Some had unexpected bonanza, while the others lost big time. What I meant by the already vulnerable market is that at the moment the market is already high in price from the problem in the letter of credit (LC) administrations in the import sector. The government is rationing the LC to the imports, which creates an artificial price hike in the imported goods.  Of course, the devaluation by itself, could be inflationary to the economy. 

We are dependent on the import of fuel, fertilizers and other machineries. So it would be naïve to think that the devaluation is not inflationary. But the cumulative effect could really hurt the economy. What I suggest is that the government should at least try to relieve the artificial inflationary tendency by correcting the LC problem in the country. Hence, it would be the net gain of the policy that really matters. 

On the other hand, what we should not forget is that the policy of devaluation has a psychological dimension whereby the devaluing country is perceived as being economically weak. It is hazardous, as it would erode the confidence in the currency and shifts tendencies to store value in other ways. It jeopardizes the credit-worthiness of the nation.

You have explained that apart from the export-encouraging effect of the policy, it also discourages imports. However, we depend on the import of some strategic goods ourselves. Hence, in a way, are we not making it expensive on ourselves?   

I think it has to be clear that discouraging imports is not is not an end by itself, since, as you have motioned it in your question, we do need the import. The aim of the policy also anchors instituting import-substituting industries to fill in the demand gap for goods that we use to import. 

What I learnt during my years as an economist is that the Ethiopian economy is in  transition from a simple, harvest dependent one, to gross import demanding one, hence, making the import play a vital role in the economy. Of course, it would take time to do that and until then the government should fight inflationary tendencies with ardent policy measures. And to begin with, it would help to remove the artificial inflation that we talked  about earlier. As a measure setting the right track for import substitution, the devaluation would really help.

It is known that both the International Monetary Fund (IMF) and the World Bank are staunch supporters of the devaluation move. Did their rationale for suggesting the policy differ from what you have explained above? 

No, actually the policy justification is the same. They say that if developing countries are to grow, they should devalue and encourage their export. We started the policy as early as two decades back. However, apart form all the justifications, we have to meet their demand to get their support.  

The devaluation came in the immediate aftermath of the announcement of the Growth and Transformation Plan. However, some say that the plan is not realistic. What is your view on this issue? 

We at the EEA believe that it is not right to debate whether the plan is achievable, ambitious or otherwise. What is critical is to point out the resource base that would bring about such a growth. The economy of this country has been dead for more that half a century. As far as doubling the output is concerned, we should look at it from the point of view that what were our initial points. It is always easy to grow 100 and pus percent as long as we start at the lower point. A small push would result in a big leap. Even in my field of specialization, in microfinance, the number of people seeking credit now is not even comparable with what it was five years ago. I believe the culture of thrift is growing in the economy; hence saving rates as well.  The focus of the government in the plan should be on the resource that is available locally. We should mobilize the saving potential of the country to finance our five-year plan; still it would be difficult to attain the finance at least for a year or so.

Positive and Negative effects of Devaluation of Birr

Devaluation of the Birr: A layman’s guide

Prof. Seid Hassan – Murray State University–

Devaluation is associated with fixed or pegged exchange rates systems whose value is not being determined by the normal (free) mechanics of supply and demand.  In general, devaluation reflects the existence of serious macroeconomic problems (imbalances) and also reflects weaknesses of the government which is devaluing its currency.

When it comes to Ethiopia, the economic weakness is reflected by several of the resource gaps: the savings-investment gap, the balance of payments gap which in 2009 escalated, total exports and imports amounting $1.657 billion and $7.093 billion, respectively, according to the CIA World Fact book. Ethiopia is also afflicted by other gaps such as a continuous budgetary gap, a skilled human resource gap, a significant agricultural (food security) gap, a dire foreign exchange gap, technology gap and most importantly a good governance gap[1]. By just looking at the solvency issue, that is, the balance of payments and budgetary balance gaps and the alarming foreign exchange shortages, one is led to believe that the birr is overvalued and devaluation is necessary.

Related Article : Devaluation of Birr and it's effect in the economy



When I wrote the popular article titled as the “The Causes of the Soaring Ethiopian Inflation Rate,” a few years ago and suggested that the birr was overvalued, some of my readers were perplexed by such an expression, informing me that I was wrong.  They did so partly because they thought I was agreeing with the government that devaluing the birr would serve as a panacea for the structural problems that the Ethiopian economy was facing and partly because they thought the theoretical possibilities were applicable to Ethiopia.  All that I was saying was this: using standard economic reasoning and rationales of devaluation, the fact that there is a parallel market (black market) with the birr buying less dollars/euros means that the birr was overvalued. The fact that the government has been facing foreign exchange shortages and is unable to meet the lowest required foreign exchange reserves (which is supposed to be not less than a 3-month import coverage, but the actual coverage at times being less than six weeks of import coverage) and the fact that the IMF has been warning the government that it would face financial difficulties implies that the birr could collapse, sooner or later. Moreover, the fact that even some domestic firms were suspending their operations and unable to import the necessary intermediate inputs from overseas due to the lack of foreign exchange also indicate a balance of payments disequilibrium (that is, the exchange rate between the birr and other currencies has become untenable). It also means that, with disequilibrium in the exchange rate in existence, the government will be unable to carry on its new 5-year “Growth and Transformation Plan.” It is for these already existing realities and inherent weaknesses why I argued the birr was overvalued long ago. I also believed that were it not for the continuous influx of donor assets (estimated to be $3 billion in 2009) and remittances (the National Bank of Ethiopia reporting total remittances just for the first two quarters of 2009 being $1798.8 million), the value of the birr would have been much lower than what it was then and what it is now as well.


Regarding the political aspect of the weakness, in general, devaluation comes as a result of the realities of economic mismanagement and the push (many people like to call it- coercion) by the International Monetary Fund (IMF). In general, a greater portion of a country’s citizens whose government bows to IMF’s pressure is considered to be a weak one. Second, since those firms who are engaged in the production of exportables tend to benefit the most from the devaluation of the birr, it indicates the increasing lobbying power of those firms (groups) which are able to turn policy decisions towards their favor. In the Ethiopian case, given that several of the TPLF- controlled conglomerates organized under EFFORT and REST (in collaboration with Sheikh Mohammed Al-Amoudi’s MIDROC Ethiopia) have seized the state, it is only them who stand to benefit from the devaluation. The fact that powerful elements are able to gear government policies towards their favor in turn reflects the weakness of the government which is supposed to look after for the interests of the country and the general populace.

Conventional Paradigm of and Justification for Devaluation

The economic reasoning behind the devaluation of the birr as a means of improving a country’s trade balance is that a decline in the birr would cause exportables to be cheaper relative to other countries. This would then lead to an increase in the volume of exports, other things equal. With the cheapened birr, imported goods become more expensive thereby leading to an improvement in the country’s trade balance. The expected reduction in the trade balance depends, of course, on the exact amounts of imports and exports, their respected price elasticities and a number of other factors which I illustrate some of them below. [Read the full article, PDF]
Birr pic source Laugh in Amharic Facebook group

Ethiopia: Controversy of Undervaluation of Yuan

Ethiopia: Undervalued yuan, currency wars and their implications
By Seid Hassan,

Part I. Undervaluation and stylized facts

Introduction

As a result of my recently published article dealing with the devaluation of the birr (Ethiopian currency), some friends of mine and students wondered if the controversy surrounding the undervalued Chinese currency, the yuan renminbi, is similar to devaluation or have the same effect as a devalued currency.



Even though both an undervalued currency and one that is being devalued have two common characteristics, specifically their direction of change (their current values being lower than their previous ones) and both being members of a family of fixed (managed) exchange rate systems, there are significant differences between them. An undervalued currency, just like the Chinese yuan, is one whose value is kept lower than where it should be and its value could rise absent of manipulation. To keep a domestic currency below its market value, the central bank needs to intervene in the exchange rate market more often than devaluation would require.


A devalued currency is one whose value is suddenly downwardly altered (and usually its value never to come back up to its previous position) from its official value by the relevant authorities (the central bank of the country with consultation of political leaders.) Currency devaluation is less frequent and such a measure is taken only when the economic fundamentals of a country are in serious trouble. As a result, the economic and political effects of a devalued and an undervalued currency are also drastically different.

The second reason which prompted me to write this article is the acrimonious debate over the undervalued yuan which escalated after the U.S. House of Representatives voted last September threatening to levy tariffs on Chinese imports unless China allows its currency to appreciate. By delving into this acrimonious debate, I briefly present the methods used to keep the yuan undervalued, the pros and cons of an undervalued currency and its economic implications to its trading partners, particularly the U.S. I am sure that readers will find this issue in particular, and the concept of exchange rates, in general, being interesting and applicable to real life situations.

To briefly represent the recriminations over currencies between China on the one hand, and the U.S. and Europe on the other hand, the latter have been claiming that China intentionally kept the value of its currency undervalued in order to sell more goods at the expense of its trading partners. On the other hand, China claims that U.S. policymakers have no moral superiority regarding the handling of exchange rates since it irresponsibly let its unsustainable boom in housing prices and mortgage lending practices corrupt the balance sheets of the world's financial institutions. China also claims that the Federal Reserve's "irresponsible," loose monetary policy is destabilizing world capital markets. What is the truth and why is the undervaluation issue reverberating without an end in sight?

Some stylized facts about the Chinese exchange rate system:

Before 1994, China had followed different versions of fixed (semi-fixed) exchange rate system. Since the beginning of 1994, the Chinese government decided to peg its currency to the U.S. dollar with an exchange rate of 8.28 yuan to the dollar. The pegging remained until July 2005, the time that the Chinese central bank decided to peg the yuan to a basket of currencies- the U.S. dollar, the euro and the Japanese yen being some of the currencies included in the basket. As announced then, the central bank of China was allowing the value of its currency to be partially determined by supply and demand. The value of the Chinese currency has been rising since then (to about 6.65 yuan per dollar today), even though the appreciation is not enough in the eyes of its competitors such as the U.S. and Europe. For some of the reasons I provide below, this appreciation of the yuan is indeed lower than what it could have been. The pegged yuan is now on a “managed float” system in which the central bank of China intervenes in order to change the direction of its value. China’s competitors and some analysts think that China’s intervention is too manipulative arguing that the managed float is a little too dirty.

Is the yuan really undervalued?

There several things that indicate the yuan has been and continues to be undervalued. For one thing, China has been raking record level of trade surpluses against its major trading partners such as the U.S. Since traders must buy the Chinese currency whenever they want to buy Chinese products, the demand for the Chinese currency must rise, thereby boosting its value. Second, China’s trade surpluses have resulted in a rapidly growing currency reserves for the country. Among other things, large foreign exchange reserves signal financial strength which boosts international confidence for the yuan. Third, China’s economy has been growing at a more rapid rate, with annual GDP growth rates ranging between 8% and 11% per year than those of the U.S., Japan and Europe. This growth should boost investors’ confidence for it currency as well. However, the value of the Chinese currency is lower than what the above fundamentals would indicate, mainly due to the interventions of the central bank of China in the exchange rate market. We turn next to the tools that China uses to keeps its currency undervalued. What are some of the mechanisms that China keeps the yuan undervalued?

There are many ways that a country can keep its currency undervalued, depending on the situation at hand, but some of the options and tools available to China and the ones it is known to have implemented include:

a. Buying dollars using the yuan in the open market in order to keep the demand for dollars high and raise the dollar price upwards relative to its own currency. This increased supply of the Chinese yuan effectively decreases its value. According to economist Peter Navarro, China first sells its bonds at about 4% and uses the revenue to buy U.S. Treasury bonds at about 2%. He says: “China is willing to endure these losses because it views them as a small price to pay for creating new jobs in Chinese export industries, albeit at the expense of American workers.” [ ]

b. Increasing the money supply in order to keep domestic interest rates lower than what they would otherwise be. Lower interest rates increase domestic investment spending while at the same time being less attractive to foreigners who could have wanted to make many by putting their assets in Chinese banks.

c. Preventing Chinese citizens from taking their investments abroad or putting a cap on the amount of foreign assets Chinese citizens could invest abroad. This latter action has the potential to decrease the demand for the dollar (thereby making it cheaper relative to the yuan) while at the same time maintaining or increasing domestic spending. All of these actions depress the value of the yuan while at the same time (artificially) increasing the prices of foreign currencies and/or foreign currency-denominated assets. The effectiveness of such policies depend from country to country but given that the Chinese economy is relatively large and the country sits on huge amounts of foreign currency reserves and surpluses, the effectiveness of the policy could be dramatic.

Many policymakers such as the members of the U.S. Congress also complain about China’s managed (fixed) exchange rate system which they claim to have given Chinese exporters undue advantages. They say that China’s use of a fixed (pegged) exchange-rate system allows it to keep the yuan within narrow trading band while at the same time the values of its competitor’s currencies such as the dollar, euro and yen are being determined in free exchange rate market with minimal or no interventions (or are at the mercy of the free market system).

Part II: The real and potential costs and benefits of an undervalued yuan to Americans

[For an extensive discussion and analyses, the reader can refer to the following one of two studies to the U.S. Congress: or ]

To summarize some of the points made below, even though the Chinese currency is undervalued and the complaints about this undervaluation are valid, the undervalued currency is not the main culprit behind our growing bilateral trade imbalance with China. Rather, it is China’s ability to produce certain products at lower comparative costs than its competitors. The reader will also understand why the complaints made by American and European policymakers about the undervalued Chinese currency have not succeeded so far. For those who may not know, the 1988 U.S. law requires the Treasury to identify and submit to Congress, twice a year, if a major trading partner is manipulating its currency in trying to boost its exports and if a retaliatory measure is warranted. But neither the Bush nor the Obama administration have been hardly successful in ascertaining the negative effects of the currency manipulation on the U.S. In fact, and to the contrary, the Treasury’s Semi-Annual Report presented to the Congress in July 2010 and earlier suggest that China is not a currency manipulator, indicating only that the yuan is undervalued. These studies (reports) are contrary to the political posturing made by U.S. and European authorizes, which in turn should indicate to us that the issue is more complex than what meets the eye. Our trade deficit may indeed be unsustainable and something must be done to rectify the problem, but jumping on the China-bashing bandwagon, just like we did it against Japan in the past, will not solve the problem unless we address the real culprits. It is also important to understand that resolving the bilateral imbalance does not mean that our overall trade deficit will find a solution, for the same trade deficit could be maintained as long as we continue to buy more goods from the rest of the world than we sell to them.

Economic Effects of an Undervalued Currency to Different Group of Americans: in Brief

Consumers: The groups of Americans who benefit the most from an undervalued yuan are the consumers. The undervalued Chinese currency allows American consumers for their dollar to buy more goods than would be otherwise, effectively raising their purchasing power and standard of living. American consumers also benefit from the increased variety brought to the market.

Exporters and Import-Competitors: An undervalued currency has the potential to make China’s exports cheaper and imports into China more expensive than they would be under free market conditions. By giving China a competitive edge, the undervalued dollar puts pressure on American exporters and import-competitors and creates job losses. One should not forget, however, that most of the goods that America imports, such as textiles, toys, furniture, shoes etc, are highly labor intensive products and require fewer skills. China has more abundant unskilled labor, which has become increasingly scarce in America. It is also important to remember that most of the stuff that is being imported from China was already being imported from other countries such as South Korea, Taiwan, Singapore and other countries. On the other hand, the undervalued yuan also has the potential to force American import-competing and exporting firms to work harder and be more innovative and creative, which in the end helps them to be more viable and competitive than they would be otherwise.

Domestic (American) manufacturers, particularly those importing capital (intermediate) goods also benefit from the undervalued yuan. By lowering the cost of their inputs, the undervalued yuan helps American producers to be more competitive in world markets than they would otherwise be.

U.S. Government and the U.S. as a whole – The undervalued yuan also has an effect on U.S. government and the U.S. economy as a whole. America benefits when China uses the surplus of funds that it accumulates and buys U.S. Treasury notes, which have the effect of lowering U.S. interest rates. Since the major cost of investment capital is the interest rate, lower domestic interest rates allow American borrowers, businesses and consumers alike, to increase their spending, which in the end increase the size of the U.S. economy. America also benefits from the flow of capital from China when China and/or its citizens buy our assets.

Finally, it is important to understand that a strong and stable Chinese economy is in the national interest of the U.S. in the same way that a strong and stable American economy is in the best interest of China. Since these two economies have become increasingly interdependent, the destruction one implies the destruction of the other – an important and pragmatic principle well-known in the military circles as MAD (mutually assured destruction.) Jumping on the China-bashing bandwagon and trying to make China a beggar of the world nations is not only counter-productive, it could also be downright dangerous. Emphasizing the point I made earlier, my fellow Americans should note that, unless we understand and recognize the real culprits behind our bilateral or multilateral trade deficits, such as our reckless overconsumption and increasing appetite for cheap products, and the increasing dependence on foreign financial resources to finance our debts, our overall trade deficits would stay the same even though those goods that we currently import from China may not come from that country.

I admit that China (and many other countries) has become too dependent on U.S. consumers. The undervaluation of the yuan could be construed this way, even though it is not the major culprit behind U.S. ills. It is, therefore, in the interest of China to let its currency float. A floating yuan would also ease the inflationary pressure which builds up as a result of China’s economic expansion and increased demand for its products from abroad. On the political side of the issue, China has to understand that the mounting domestic political pressure arising from high unemployment and lackluster economic recovery is making U.S. lawmakers increasingly jittery, forcing them to look for a scapegoat. China’s attempt to flex its muscle by restricting its shipment of crucial minerals to the United States, Europe and Japan shows that the country still in its old militaristic (communist) mentality. China has to understand that its remarkable growth hugely aided by international trade and investments made by its trading partners. China’s bizarre acts (embargoes) show that, unfortunately, the economic benefits of trade to a nation are only fully understood by industrial (grown-ups) countries. It is time for China to act one. Given the consequences, industrial nations need to be careful not to lead us towards a trade war.
Seid Hassan is a Professor of Economics at Murray State University
Source EthioGuardian.com