Import penetration and the current exchange rate pressure
On In Business Review |
I have written over ten columns on the foreign exchange (FX) market since 2009. These essays are direct in the sense that they address explicitly the question of what is determining the exchange rate and the quantity traded in the local market. In 2017, I wrote a six-part series to address some of the issues that have again been raised in the past two weeks. For example, I wrote a column titled: “Making sense of the depreciation of the Guyana dollar: the Jagdeo shock?” (SN: May 10, 2017). There I explore the “dem-boys-seh” analyses on blogs, Facebook and in some quarters of the press that alleged that Mr. Jagdeo and his “Newly Emerging Private Sector” (NEP) were sabotaging the exchange rate.
In the same series, I examined another “dem-boys-seh” belief that the new government has been able to clamp down on the ubiquitous drug dealers and as result there is an FX shortage (See SN: May 3, 2017). The question of general political contest and the ex post exchange rate was discussed in the subsequent column: “Recent trends in the foreign exchange rate: could politics muck it up?” (SN: March 23, 2016).
At least ten other columns indirectly addressed the FX market. Exchange rates in the global market are perhaps the most informationally sensitive set of prices in the world. The Guyana-US$ exchange rate, in the local market, is also quite sensitive to changes in news, perceptions and information – except that prior to recent years the Bank of Guyana did not allow the rate to vary significantly when information and perceptions change. Therefore, events taking place in the broader political and social environment could also explain the increasing rate.
Several past columns addressed the question of economic stability, which is reflected in the G$-US$ rate given its function in corralling information. For example, the following columns explored how political stability and the very nature of the economy could engender economic outcomes and therefore the FX rate: (i) “Social cohesion, distributional conflicts and the 50% salary increase” (SN: Oct 21, 2015) and (ii) “Why Guyana dodged the 2007-08 financial crisis? – Part 3” (SN: Jan 12, 2011).
I believe the themes discussed in those previous columns are still relevant in the present context of a further depreciation of rate – mainly at the non-bank cambios. In general, we should always try to distinguish the factors that account for changes in the trend exchange rate versus those that cause short-term deviations from the trend.
Last week it was reported that one non-bank cambio was selling foreign exchange for G$235. The commercial banks are averaging around G$216. These numbers represent a further depreciation of the Guyana dollar. Now, G$235 to one US$ does not make the trend. The true exchange rate is a weighted average representing the rate at all the banks and non-bank cambios. The official statistics indicate that over 90% of all foreign exchange sales and purchases are done through commercial banks. That means that the rate the commercial banks buy and sell will weigh the average down to around G$216, perhaps G$218, to one US$ – still a depreciation from the G$206 of five years ago.
Of course, Guyana is an interesting place with an abundance of speculation. Some have argued that the non-bank cambios account for the greatest share because of the prevalence of drug trafficking and money laundering. I have not seen any serious argument to convince me that the biggest buyers and sellers of foreign exchange in Guyana are the non-bank cambios. Most FX traded, even in Guyana, are bank accounts and cheques of hard currencies, not cash notes. In 2018, the total amount of American dollars sold at all bank and non-bank cambios amounted to US$1.877 billion.
I am sympathetic to the idea that the non-bank cambios are underreporting their trades. But how much are they underreporting? In 2018, non-bank cambios reported that they traded US$55.8 million. If they are the largest traders it means that they are underreporting more than what the commercial banks reported in 2018. The latter reported US$1.724 billion. Are the non-banks actually trading that amount each year? Would a cambio be selling one American dollar for G$235 last week if the non-bank cambios were turning over US$1.7 billion each year? The system would have a surplus of hard currencies, not the present shortage.
I have no reason to doubt that some cambios are participating in the smuggling out of American dollars and other hard currencies from Guyana. It has been reported that Trinidadians, Cubans, Chinese and Surinamese are buying cash notes and taking them out. However, cash notes cannot close the foreign exchange gaps Trinidad and Tobago and Suriname presently face. A few Guyanese businesses are also performing a kind of triangular arbitrage in which one of the vertices of the triangle is valued in goods, not US dollars.
I also have no reason to doubt that some of the Jagdeoian NEP actors might be tempted to fuel the speculation to make the government look bad. The question, however, remains whether the handful of NEP actors can actually move the trend exchange rate. They are at most noise traders. They cannot credibly change the trend rate of exchange. Furthermore, they cannot make a credible commitment to change the trend in favour of devaluation unless they hurt themselves and their own interests.
So, what explains the trend depreciation over the past two years? My previous columns have proposed answers. One point I made is the decentralisation of the source of foreign exchange as GuySuCo peters out. It is becoming more difficult for the Bank of Guyana to capture foreign currencies as it did in past years when there were a few state-owned companies bringing in US dollars. Welcome to the free market!
Another probable factor accounting for the exchange pressure has to be the significant expansion of government current expenditure financed by monetary expansion which is not completely compensated with a sovereign financial security. The expansion of monetary financing would probably increase the demand for foreign goods given that Guyana imports most of what it consumes.
The most important explanation is the substantial increase in the import penetration rate, which for our purpose is defined as the percentage of imports to GDP. There is a slightly more involved formula, but this is good enough for a column. The import penetration rate is not expected to change each year. When a change does occur, it indicates a structural break in the economy. Between 2009 and 2015, the rate averaged 65%. However, it increased to 71% by 2018. This is the highest rate for the Caribbean economies I looked up. In Jamaica the rate is 48%, Barbados 44%, Trinidad and Tobago 41%, Suriname 42%, and the Dominican Republic 28%.
A six percentage point increase is substantial and can result in a significant increase in the demand for foreign exchange. When the import penetration rate is so high it has a bigger multiplier effect on the demand for foreign exchange when the level of imports rise. As everyone knows, if the demand for FX rises it increases the market pressure and, therefore, depreciates the rate.
The data supports this contention. The change in imports of consumer goods from 2017 to 2018 is negligible. However, for the same period, the high import content of the oil and gas sector is driving the precipitous increase in demand for fuels and lubricants, machinery, and other input-based goods.
Yes, some of the capital goods are purchased and paid for overseas. But the foreign companies are not bringing in foreign exchange either. They are financing working capital and even hard capital by borrowing in Guyana. The banking sector data also shows that lending to non-residents has tripled in the past two years. Welcome to the oil-based economy!
The FX market has to be completely redesigned if the government wants to resist IMF pressure to let the rate depreciate. One factor we might be forgetting is the government could be taking the advice of the IMF to let the rate depreciate.
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