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18.04.2000 Feature Article

The Falling Cedi: Is it a Paper Tiger or Toilet Paper?

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With the carouses blooming and the birds beginning to chirp to signify the end of Rawlingstocracy - a momentous era in our nation's political history - it is probably appropriate to take a look at some of the legacies Rawlings has bestowed on the country. One of such Rawlings bequests is the falling Cedi. Nowadays, talk about the falling value of the Cedi dominates most conversations and discussions. Since the early 1990s when the Rawlings government, under the aegis of the International Monetary Fund, decided to float the Cedi, the value of the Cedi has been going kerflooie, and like the once fashionable obey-the-wind Afro-hairdo of yester-years, nobody seems to know where exactly the wind of devaluation will take our currency to. Like hapless and helpless kapok we can only hope that some where along its wind-driven journey, the Cedi would pick up a friendly jet stream and land on a fertile soil. And this year being an election year, with a high probability that the government would increase money supply to "buy" votes, it seems that there would be more pressure on the value of the Cedi to slide further, so my fellow Ghanaians, put on your "Cedi belts". Sooner or later the Cedi will be googolplexed! To most people, the falling of the value of the Cedi has been unfolding before their very eyes like a movie. The Cedi is now, more or less, like baha - that spongy stuff made from the stem of plantain trees and used sometimes by rural folks to wipe off..Never mind. (If you do not know what baha is, then this is a perfect chance for you to study your Rural Ghana Sociology 101. Hint: toilet paper). The pathetically painful thing, however, is that while baha may still play its useful centuries-old social function in our rural communities, one cannot say, ex cathedra, the same thing about the Cedi and its socio-economic functions. And come to think of this: the late General (Oops..Colonel) Ignatus Kutu Acheampong (his full name is really romantic and conjures up a lot of nostalgia especially for Ghanaian womanhood about the quid pro quo Fa woto begye Golf and for "Third Worlders" about Yentua) overthrew the legitimate government of the late Dr. Busia because I.K. could not see the wisdom in the mild devaluation of the Cedi by the Doc. In the same vein, Flight Lieutenant Jerry John Rawlings (also a romantic name for its J's and R's and conjures up nostalgia about "Rawlings Chain" and Yorko Gari) overthrew the democratically elected government of the late Dr. Limann partly because J.J. thought he knew better than the Doc. as far as the Economics of the Devaluation of the Cedi was concerned. One has to wonder why the sword (the green khaki-clothed guys) was (and has been) mightier than the pen (the Docs.), in both cases contrary to what the sages say. Or is it that the sages were not sagacious after all? If one juxtaposes the current rate of depreciation of the Cedi vis-à-vis the rate of devaluation in the days of the two Docs that "warranted" their overthrow, one can only ask: Is Ghana an interesting country or what? Well, let me talk about some economics behind the falling value of the Cedi. Exchange Rate Dynamics Before we deal with the hard questions about our Cedi, it is appropriate to explain the fundamental issues about exchange rate. A lot of confusion surrounds exchange rates because most people fail to understand what is being sold in currency exchange transactions. Fundamentally, the currency markets operate exactly like the goods markets, say the market for plantain. The price of plantain at Makola at any point in time is determined largely by the amount of plantain being supplied and demanded - the so-called market forces of demand and supply. Any time the amount of plantain supplied at Makola is less than the amount demanded by consumers, the price of plantain would go up. Buying and selling plantain, though involves our local currency the Cedi. However, Ghanaians need foreign currency - American dollar, British pound, Japanese yen, Nigerian naira, Togolese franc, etc - to buy foreign goods and services and to buy foreign assets. Foreigners also (theoretically) need our Cedi to buy our goods and services and our assets. Thus, the exchange rate is the price of one currency in terms of another currency. The exchange rate is the price (in Cedis) per unit of foreign currency. For example as of last month, the exchange rate was ¢4,200 = US$1 and ¢6,700 = UK£1 in terms of Cedi/US dollar and Cedi/British pound respectively (Source: The exchange rate undoubtedly has very strong influence on the current account balance (the difference between exports of goods and services and imports of good and services), and other macroeconomic variables, and thus is among the most important prices in any open economy like ours. In addition, the exchange rate is also an asset price, so it is governed by the same principles that govern the behavior of other asset prices such as stock prices. As said earlier, the exchange rate is determined by demand and supply forces. The demand curve for American dollar or British pound (the two most sought-after currencies in Ghana) is downward sloping like any normal good, because as the exchange rate falls (in real terms, which is to say if the Cedi appreciates), American (British) goods and services become less expensive to Ghanaian consumers. The lower the price of the dollar (pound), the more American (British) goods and services Ghanaians can buy, and the more dollars (pounds) they will need to make their purchases. The demand curve will shift in response to changes in Ghana's real gross domestic product, GDP, (or national income), Ghana's price level relative to the U.S. (British) price level, Ghanaians taste for American (British or foreign) goods, relative interest rates in Ghana, and the expectations about future exchange rates. The supply curve for American dollar or British pound is upward sloping because as the exchange rate rises (depreciation of the Cedi), Americans (the British) will get more Cedis for each dollar (pound) traded. Which is similar to saying that Ghanaians will get fewer dollars (pounds) for each Cedi traded. This makes Ghanaian goods less expensive to American (British) buyers - or American (British) goods more expensive to Ghanaian buyers. As Americans (British) buy more Ghanaian goods, they will need to supply more dollars (pounds) in order to get Cedis. Among the variables that will shift the supply curve include U.S. (British) GDP, relative prices in Ghana, Americans' (British) taste for Ghanaian goods, relative interest rates in Ghana, and the expectations about changes in the interest rate. This is it! This is all that you need to know about exchange rates! But is it not very confusing? Let us see if we can minimize the confusion and drive home the factors behind the determination of exchange rates with a simple illustration or two. Suppose Ghana and the US trade in beer - we could exchange a certain amount of Star Lager Beer (SLB) for a certain amount of Budweiser (Bud). Suppose that in terms of value, one six pack of SLB could be exchange for two six packs of Bud. Man, Star tastes great and smooth! Suppose that one six pack of SLB costs ¢18,000 and that one six pack of Bud costs $3.00. Thus we can calculate the exchange rate as follows 1 six pack of Star Larger Beer = 2 six packs of Budweiser; at ¢18,000 per six SLB and $3.00 per six Bud Thus ¢18,000 = $6.00 Which means ¢3,000 = $1.00 or ¢1.00 = $0.00033. Given the prices of the 2 types of beer, now suppose that somehow the value of Bud increases while that of SLB stays the same, such that 1 six pack of SLB exchanges for 1 six pack Bud. Then the new exchange rate is 1 six pack of Star Larger Beer = 1 six pack of Budweiser; at ¢18,000 per six SLB and $3.00 per six Bud Thus ¢18,000 = $3.00 Which means ¢4,000 = $1.00 or ¢1.00 = $0.00025. Thus from our example, as a result of the relative increase in the value of the American good (Bud), the value of the Cedi declines (the value of the dollar increases). How does inflation affect the exchange rate? Let still use or SLB-Bud example above. In the absence of inflation, and given the respective prices of SLB and Bud, the exchange rate (from our simple example) was ¢3000 = $1.00 Now suppose that there is inflation in Ghana and that the price of SLB increases from ¢18,000 to ¢24,000 while that of Bud remains the same. Then the new exchange rate can be calculated as 1 six pack of Star Larger Beer = 2 six packs of Budweiser; at ¢24,000 per six SLB and $3.00 per six Bud Thus ¢24,000 = $6.00 Which means ¢4,000 = $1.00 or ¢1.00 = $0.00025 Thus because of inflation in Ghana, the exchange rate changes from ¢3000 = $1.00 to ¢4,000 = $1.00. Which means the value of the Cedi declines (the value of the dollar increases) because of inflation in Ghana. The above simple exercise has been undertaken under the assumption of a floating exchange rate regime. A floating exchange rate is freely determined by the forces of supply and demand, without government intervention. When the exchange rate floats, equilibrium occurs at the price where the quantity of foreign currency (dollars or pounds) demanded equals the quantity supplied. In this case an increase in the demand for dollars (pounds) or a decrease in the supply of dollars (pounds) leads to an appreciation (in increase in the value) of the dollar (pound) and a depreciation (decrease in the value) of the Cedi. A decrease in the demand for dollars (pounds) or an increase in the supply of dollars (pounds) on the other hand leads to depreciation of the dollar (pound) and an appreciation of the Cedi. There are other types of exchange rate regimes, namely the fixed exchange rate and "dirty" float or managed float exchange rate regimes. Under manage float, a country's central bank buys its own currency to prevent depreciation, and sells its own currency to prevent an appreciation. Countries may choose to intervene in the foreign exchange markets when high exchange rate (appreciation) makes their goods more expensive and thus harms export-oriented industries; when falling exchange rate (depreciation) leads to a general rise in domestic prices (inflation); and when volatile exchange rates make trading and investment arrangements risky. There are three types of exchange rate movements: very short-run changes, short-run changes, and long-run trends. In the very short-run, exchange rate changes are caused by decisions by banks and other financial institutions to move billions of currency from one country to another. These decisions to move "hot money" are made in split seconds in response to changes in relative interest rates and expectations of future exchange rates. In the short run exchange rate changes is caused by economic fluctuations (particularly fluctuations in GDP). In the long run, according to the purchasing power parity (PPP) theory, an exchange rate will adjust until the average price of goods is roughly the same in (both) countries. The PPP theory (in its absolute form), in simple terms states that the exchange rate between two countries' currencies equals the ratio of the countries' price levels, as measured by the money prices of a reference commodity basket. However, the existence of non-tradable goods (such as haircut), high transportation cost, and artificial barriers to trade does not allow for such smooth price adjustment between countries. An important economic implication of PPP theory is that the currency of a country with a higher inflation rate will depreciate (lose value) against a country whose inflation rate is lower. Given this background in Economics 101, I hope our understanding of the driving forces behind the value of our currency is enhanced. If we think we need to strengthen the value our Cedi we just have to take policy actions that address the demand and supply forces of foreign exchange. Let me reiterate some of the factors here: high inflation rates, current account deficits, persistent government budget deficit, capital flight, negative or low interest rates, increased money supply etc. These factors are complexly intertwined with one another. For example, increased money supply (without a corresponding increase in output) causes inflation, which in turn can have a negative impact on interest rates etc. The bottomline is that the value of any currency is determined by economic fundamentals - sound macroeconomic management. Some Gain, Some Lose It must be said that exchange rate depreciation can have both positive and negative effects on an economy. It can encourage exports and discourage imports. That is why a country like Japan (and most Asian economies) that is export-oriented winks and frowns whenever the Japanese yen appreciates because the appreciation of the yen makes Japanese goods more expensive in the world market. Thus essentially, depreciation (or devaluation) is used as export-oriented macroeconomic strategy. So why are Ghanaians so worried by the depreciation of the Cedi? Well, it all depends on the nature of your exports and imports and the elasticities of demand and supply of the exports and imports. Shhh.. Economics is full of jargons, I could here you grumble. Elasticity just means how demand and supply respond to small changes in prices (of imports and exports). Since we import virtually everything, it makes our demand for imports price inelastic - that is changes in prices is unlikely to let us change our demand for imports in any perceptible way. And remember, to buy imports from say America, we need American dollars, and this puts so much pressure on the value of the Cedi. What about our exports? Who needs so much cocoa? And there is some much cocoa in the world market. If we increase the price of our cocoa, consumers will shift to Ivorian cocoa, or simply other substitutes like tea or coffee. And if we reduce the price of our cocoa, which we must through depreciation in order to be competitive in the world market, consumers are not going to increase their consumption of cocoa because of that. Think about it this way: are you going to consume more salt because the price of salt has declined? Absolutely not. So even though we decrease the price of our cocoa, the demand does not increase much to make up for the decline in price. The supply of foreign currency from the sale of our exports is thus low, and this makes the value of the Cedi depreciate. The Dilemma of the Ghost Ghana thus faces a big dilemma: to allow the Cedi to depreciate or appreciate. In a 1992 study, economist David Dollar found out that if Ghana adopted the trade and real exchange rate regimes of Bangladesh, Ghana could add almost 5 percentage points to its growth. Similarly in my 1993 graduate study thesis I developed a macroeconometric model of Ghana (available on request). In spite of its imperfections, the model closely predicted the real economic growth of Ghana (an average of 3.84% for the period 1989 - 2000, which is similar to what Ghana has been achieving during that period). In this model, I found out that if the Cedi appreciated by 40 points, economic growth declined from 3.83% to 3.61% for the period 1989 - 2000, while real export growth declined from 3.80% to 2.05% in the same period. The implication of such studies is that keeping the price of the Cedi right is imperative for economic development of Ghana. Depreciation (devaluation) of the Cedi may have two significant advantages: first it may act as incentive to producers to produce for export; second, it may increase the country's competitiveness in its exports by making the prices of Ghana's exports cheaper in terms of foreign currencies. The key questions are that to what extent can the Cedi be allowed to depreciate? What level of exchange rate reflects the economic fundamentals of the country? These are really hard questions that require answers from lot of studies. I hope the Ministry of Finance and or the Bank of Ghana is/are commissioning such studies. If they are not, they need to do that. It must, however, be said that relying on depreciation (devaluation) alone to promote exports may not be effective, especially for a country like ours that exports primary commodities whose demand is low and face severe competition even from synthetic substitutes. It may take the support of other policies such as concrete incentives (such as export subsidies) to exporters who put value to their products before export, gradual liberalization of imports, and the maintenance of positive interest rates and low inflation to encourage savings and discourage investment in unproductive "inflation hedges" and speculative activities. What can be done? Well, it seems to me that there is nothing, or very little Ghana can do to arrest the decline in the value of the Cedi in the short-run as so long as we take the path of floating exchange rate. The Bank of Ghana or the monetary authority apparently does not have enough reserves to intervene in the foreign exchange market. In the long run, our only hope in stabilizing our currency along this chosen path is through SOUND MACROECONOMIC MANAGEMENT: deal with inflation, cut down government deficits, shore up interest rates, export more but add value to our exports, address the current account deficits, etc. Why have we not learned that by now? Have we? In addition, Ghanaians abroad may have to increase the remittances to their relatives (it turns out that this is a very good source of foreign currency supply in Ghana). Not only should Ghanaians resident abroad send remittances, they should be encouraged to invest in Ghana in productive activities or buy Ghanaian stocks and bonds and save in Ghana. While on remittances from Ghanaians abroad, let me make one suggestion in that regard. I think Ghana should consider entering into Tax Treaties with some of the developed countries, especially Britain, Germany, Holland and the North America (US and Canada) which host most Ghanaians abroad. Such treaties should allow Ghanaians working abroad to pay a portion of their taxes, for example 50%, to Ghana. I intend to write in detail about this proposition in another article, time permitting. Other Options There are two other options available to Ghana that can be pursued to ensure exchange rate stability. These are "dollarization" or "poundization" (adopting the dollar or the pound as our currency) and entering a monetary union or a currency board such as the CFA with our Francophone friends in the sub-region. A currency board and dollarization are not very different - technically they are substitutes. The basic difference between the two systems is that under dollarization (poundization) a country loses seigniorage (the profit from issuing the monetary base) to the United States (Britain) whereas under a currency board it retains the profit. In the light of this, I would like to restrict the discussion to explaining the basics of dollarization (poundization). Ironically, because of the lack of confidence in our Cedi, Ghana is already dollarized in an unofficial sense. While the Cedi is still the medium of exchange, it has virtually lost its other functions, particularly as a store of value. Under official dollarization (or poundization), all Cedi notes and coins (do we still have them in Ghana?) would be replaced by dollars/pounds, and all Cedi assets, liabilities, and prices would be converted into dollars/pounds at the exchange rate of 1 Cedi = 1 dollar/pound. Ghana's monetary system would become like that of Panama, the best known dollarized system of today and like Ecuador and 27 other countries and dependent territories that use only foreign currencies. Dollarization (poundization) promises a way of avoiding currency and balance of payments (BOP) crises. Without a domestic currency there is no possibility of a sharp depreciation. Besides, sudden capital outflows motivated by fears of depreciation (devaluation) are ruled out. What are some of the benefits of dollarization/poundization? One major benefit of dollarization (poundization) would the re-adjustment of interest rates in Ghana. With no Cedi-dollar (Cedi-pound) exchange rate, currency risk would be eliminated, and the spread in interest rates between Cedi and dollars (pounds) for loans within Ghana would be closed. The elimination of sharp exchange rate adjustments will, it is expected, bring about significantly more stable international capital flows. The elimination of the risk of currency crisis would lead to a reduction of country risk premia, and a consequent lowering of interest rates. Consequently, lower interest rates and more stable international capital movement would lead to a significantly lower cost of servicing the public debt, and also lead to a higher level of investment and economic growth. There are other expected benefits from dollarization (poundization). It is expected that dollarization (poundization) would promote a closer economic and financial integration with the United States (Britain) and the global economy - lower transaction costs and stability of prices in dollar (pound) terms. By rejecting the possibility of inflationary finance, it is argued that dollarization (poundization) might also strengthen institutions and create positive sentiments toward investments. The impact of some of these benefits is highly difficult to quantify though. Furthermore, it can be argued that dollarization (poundization) may make a bank run less likely. With all monetary assets dollarized (poundized) and without significant currency mis-matches in the banks' positions, depositors may be more confident in the domestic banking system. Dollarization/Poundization is expected to encourage a strong presence and active role of foreign banks in the banking system. This would reduce the danger of a weakened lender of last resort (LLR) function of the central bank, because those banks could indirectly bring support from foreign central banks, and depositors' confidence in the financial support of those institutions would likely be higher. But Not Without Its Costs If dollarization (poundization) offers such potentially great attraction because of the benefits a country can obtain from it, why is that countries have not jumped on its bandwagon? Well, like we famously say in Economics, there is no free lunch. In other words, dollarization (poundization) is not without its costs. One of the obvious problems of dollarization is that it would draw strong reaction from political quarters because our currency is our national symbol, a symbol of our political independence and autonomy. To some, the adoption of such a system will be tantamount to giving up our country for re-colonialization. In other words, politically some people argue that dollarization (poundization) constitutes an infringement on a country's sovereignty. Moreover, it is argued that dollarization would limit the country's ability to deal with domestic macroeconomic issues. Thus the country loses the means of coping with external shocks to the economy, because the monetary authority is robbed of the possibility of having an autonomous monetary and exchange rate policy, including bank credit to provide liquidity support to the banking system. Not are these all. A country adopting a foreign currency as the legal tender would forgo its seigniorage rights. Seigniorage is the profits accruing to the monetary authority from its right to issue legal tender currency. For most countries, seigniorage is a very significant source of revenue to the government because currency, and sometimes all base money (the central bank's liabilities) is non-interest-bearing debt. Thus by dollarizing (poundizing), the country loses the seigniorage revenues to the United States (Britain), unless the US (Britain) decides to share part of the extra seigniorage it will obtain. What is more, to adopt the dollar (pound) and withdraw the Cedi from circulation exchanging it for the dollar, the monetary authority (government) would have to "purchase" the stock of Cedi held by the public (and banks). This will require foreign reserves to convert the monetary base into dollar (pound) assets. Does Ghana have the reserves to meet such a challenge? In addition, the adoption of a foreign convertible currency as a country's currency makes that country particularly vulnerable to pressure from the country issuing the convertible currency. Those were some of the pros and cons of dollarization. It must, however, be said that the same beneficial results of dollarization (poundization) could be obtained with a fixed exchange rate system that is supported with appropriate fiscal and monetary policies. Given the persistence of inflation in Ghana, the government's penchant for deficit financing, our inability to diversify and increase our exports, thus saddling us with persistent current account deficits and balance of payments problems, I think that Ghana should give serious considerations to these alternative exchange rate arrangements: pursuing dollarization (poundization) or forming a currency board/zone (with the existing CFA zone) or forming a monetary union with other ECOWAS members. I am not particularly sure if the sub-region is ripe for a monetary union though given the economic problems that belie the individual economies. Obviously, a great deal of studies and consultations are needed to determine whether or not such monetary/exchange rate arrangements would be helpful to our economy. As of now, we do not have enough evidence to make a conclusive decision about these alternative arrangements. One thing is clear though: none of these arrangements is the "elixir of life" for our economy. In effect it should be clear that regardless of the monetary system adopted, there is no escape from the need to implement sound fiscal and prudent monetary policies. THERE IS NO SUBSTITUES FOR SOUND MACROECONOMIC MANAGEMENT.

Maxwell Oteng
Maxwell Oteng, © 2000

The author has 28 publications published on Modern Ghana. Column Page: MaxwellOteng

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