The economic impact of a falling exchange rate
A fall in the exchange rate is known as
depreciation in the case of a floating exchange rate regime, as exists in
Mozambique (as opposed to a fixed exchange rate regime). Mozambique’s floating
exchange rate adjusts on a daily basis (sometimes only by a fraction of a
Metical), and it could appreciate (gain value) or depreciate (lose value). When
it depreciates, the Metical is worth less compared to the currencies of other
countries, notably the US dollar. When there is depreciation and more Meticais
are needed per US dollar, the immediate effect is that imports will become more
expensive, and exports will become cheaper. Therefore, in principle, a
depreciation of the Metical makes Mozambican goods (not only exports but also
so-called nontradables, like restaurants that attract tourists) more
competitive, because domestically-produced goods are demanded relatively more
by locals as well as by foreigners since they have become relatively cheaper
compared to goods produced abroad. However, as shown below, the debt scandal
has wiped out any of the benefits of depreciation, since it has destroyed
confidence in the Government’s economic policies. At the microeconomic level,
with depreciation the man on the street is paying more for imported goods.
Imports (excluding imports for megaprojects, which respond to a different
dynamic) accounted in 2014 for 38% of GDP, which is substantial and means that
the impact of higher prices of imported goods is being felt throughout most
areas of consumption. A consequence of this is that people will start
purchasing less since their income is limited; this, in turn, means their
standard of living will suffer. The higher cost of imports is exacerbated by
the impact of the depreciation-caused inflation on locally produced goods: to
the extent that such goods use imported inputs, their prices will increase as
well, and demand for them will also decrease. There also is a demonstration
effect: even if locally produced goods do not use, or use only few, imported
inputs, their prices are also bound to increase because producers will take
advantage of the upward creep in prices of similar goods that have a greater
import component. At the macroeconomic level, higher import prices will cause
demand to fall across the economy. This will reduce demand for foreign
exchange, but it will also lead to a reduction in economic growth (GDP will
grow by less), because higher prices of inputs will make companies produce less
overall. The fall in aggregate demand will help improve the current account
balance of payments (and therefore reduce the pressure on the exchange rate),
but it affects the real sector because of a lower growth rate.1 But there is an
even worse effect: both the companies that import and those that produce local
goods with imported inputs will sell less. At the extreme, they may not be able
to cover their costs anymore since consumers, given their inelastic income,
will quickly cut back on purchases if prices rise too fast. This will affect
employment as those companies that are producing less will start to lay off
workers. As a consequence, there is an additional negative effect on GDP
growth, and on the standard of living, as people lose jobs. Finally, there is
effect of falling confidence, which clearly is the case now in Mozambique. The
secretive handling by the Government of its external financial transactions
(starting already with the EMATUM loan of 2013) has now increased to crisis
proportions, where economic agents do not believe that the Government can soon
return the economy to a macroeconomic equilibrium. This has been exacerbated by
donors suspending all budget support to the Government. With a lack of
confidence, the demand for foreign exchange will increase no matter what
government policies are announced, as economic players do not give credence to
the Government’s commitment to better policies. By expecting a further
deterioration of the availability of foreign exchange, more is demanded than is
actually needed for operational purposes, and with speculation setting in,
depreciation may even accelerate beyond economic fundamentals.
Manifestations of inflation
The additional debt service payments that the
Government needs to make have caused the Metical to depreciate. As shown above,
depreciation results in higher prices of imported goods as well as of locally
produced goods, and therefore increases overall inflation. Thus, at present,
inflation in Mozambique is driven overwhelmingly by exchange rate depreciation.
Inflation can also be driven by other factors, such as increases in salaries or
removal of subsidies, notably of petroleum products; however, that is not the
case currently in Mozambique. Inflation is considered a “regressive tax”, because
it affects all economic agents in the same way. Poor segments of society have
to deal with the same rate of inflation as do the rich segments.However, since
poor people have less financial resources, they suffer more.2 The sudden need
by the Government for more foreign exchange, as a result of its unprogrammed
debt service payments, is causing depreciation of the Metical and an increase
in inflation, which creates a direct link to the common people. Through no
fault of their own, they suddenly face an effective decrease in their income,
because the things they buy cost more. Inflation for the twelve months May 2015
to May 2016 has reached 18.3%, compared to 1.3% for the twelve months May 2014
to May 2015. Because the payments on the debt are bound to be higher in the
second half of 2016, inflation is expected to increase further in 2016.
Issuing money
Money is created (“pumped into the economy”)
in two ways: by the Central Bank, when it gives credit to the Government for
financing the budget deficit, and by commercial banks, when they give loans.3
When a bank makes a loan, it credits the customer’s bank account with the
amount of the loan. At that moment, new money is created. Obviously, commercial
banks have immense power if they can create money at will. This power is
controlled in 2 ways: structurally, by regulations as to the amount of loans
banks can give based on their capital and deposits (including by a central bank
tool that requires banks to freeze some deposits with the Central Bank, called
“reserve requirements”); and operationally, by adjusting the relative cost of
making loans through interest rates. In Mozambique, in the 12 months from April
2015 to April 2016, the Central Bank accounts show that domestic credit
(virtually equal to the increase in money) increased by 86,4 MMT (44%), with
the Government accounting for 54,3 MMT and the private sector for 32,2 MMT. The
day by day control of the growth of money is one of the key functions of the
Central Bank because of the effect issuing money has on inflation and the
exchange rate. Central Banks often “anchor” their monetary policies on an
inflation target. In developed economies, Central Banks control the growth of
money by issuing bonds, which take liquidity out of the market, and by
adjusting key interests rates. In Mozambique, the Central Bank has been relying
on adjusting key interest rates. Needless to say, with domestic credit growing
by 44%, the Central Bank has not been terribly successful in anchoring its
monetary policy. And there is one important reason why that may be so: as the
Central Bank raises its benchmark interest rate, the interest rates on all
other loans, also rise. Importantly, higher interest rates affect productive
activities, and when companies that need loans to be able to produce more have
to pay more interest, it affects their profit calculations. This may lead
companies to not borrow, affecting domestic production and the GDP growth rate.
The Bank of Mozambique raised its benchmark interest rate twice in recent
months. But since money still grew by 44%, it means that the increases were not
sufficient to maintain a stable macroeconomic environment. This highlights the
dilemma between fiscal and monetary policy: if the Government assumes a lax
fiscal policy, as evidenced by its large share in creating new money for
Mozambique’s economy, then the Central Bank is limited in its use of monetary
policy: it can raise interest rates only so much before the real sector, i.e.
productive activities, is affected in a major way that can cause massive
unemployment. Contrary to intuition, the money created is overwhelmingly in the
form of deposits in bank accounts, not banknotes and coins. At end-April 2016,
only 7.8% of “total” money (“money and quasi-money,” the latter being time
deposits) was in the form of banknotes and coins. The need for money in
day-to-day transactions (as opposed to deposits) is referred as the
“transactions” demand for money. To the extent that people use more and more
ATM and credit cards, as well as checks, tangible money that you can touch has
been decreasing world-wide. In fact, in the United Kingdom, tangible money
represents only 3% of total money. As to the effect on demand for foreign
exchange or for goods, it makes no difference what form money takes (tangible or
bank deposits), since the payment mechanisms work smoothly no matter what the
medium is. There is, however, one situation where the form of money makes a
noticeable difference: the case of hyperinflation. Banknotes and coins have to
procured or produced by the Central Bank, and that costs money. (C.I.P.)
