The real impact of a sliding dollar

Edward Seaga, Contributor

The controversy of a variable versus a pegged exchange rate has been ongoing for a long time. As a believer in the efficacy of a pegged rate, which I used effectively in the 1980s, I have repeatedly called for a research study to settle the issue. This has not been forthcoming. The query on rising prices, caused by a variable depreciating rate of exchange, has, therefore, continued.

A few years ago, I established the Edward Seaga Research Institute (ESRI), a small boutique unit with the capability of dealing with national problems which were not receiving vital research attention. Eventually, I decided to put the ESRI to work on a small number of projects about which I will write another time.

Among the problems was the exchange-rate issue. Accordingly, a well-known academic researcher, Dr Vanus James, adjunct professor of economics at the University of Technology, was asked by the ESRI to undertake the study to determine, among other things, the optimum exchange-rate regime for Jamaica. The full title of the study was Exchange Rate, Economic Structure and Economic Performance in Jamaica.

I raised the finance for the study from private corporations: Jamaica National Building Society, The Insurance Company of the West Indies, and the Pan-Jamaican Trust. The study was completed in seven months, November 2012 to June 2013.

REAL VS NOMINAL EXCHANGE RATE

On July 30, 2013, a round-table discussion was held at UWI on the findings. The guest list was a select group of economists and private-sector finance people. The participants heard the findings directly from Professor James, the principal elements of which can be summarised as follows:

The real exchange rate has a greater bearing than the nominal exchange rate on the state of the economy. The nominal rate does not take into account price increases (inflation); the real exchange rate does.

The study shows that a 1.0% depreciation of the real exchange rate increases prices by 0.08% and produced a net positive impact on the growth of the economy of 0.064%. These ratios are more meaningful when raised by a factor of 5.0, resulting in:

Five per cent depreciation of the real exchange rate, producing a mere 0.4% inflation and 0.32% positive change in economic growth.

As these figures are relatively small, the conclusion can be drawn that depreciation of the real exchange rate of the Jamaican dollar has minimal effect on inflation and the growth of the economy.

Considering that the issue of the damaging impact of a variable depreciating real rate of exchange has been widely attributed to price movements, this finding was shattering. It meant that using the regime of a variable real rate of exchange would not be damaging and, therefore, would be an acceptable model for Jamaica. This is the model used by the Bank of Jamaica.

But this is not the end of the argument. It cannot be denied that depreciation of the Jamaican dollar is distressing because it increases the cost of all foreign goods and services. Any layman, housewife or businessman can confirm that. The question arises, therefore, as to which is the correct version: the academic study, or the layman's view.

The answer to this conundrum is that the two arguments have different justifications. The finding concerning the impact of the real exchange rate is academically correct. But so, too, is the argument based on the undeniably credible impact of the realistic rate of exchange, that is, the nominal rate of exchange, which does not take into account inflation.

The group using the real exchange rate calculates the impact on the national economy, while the other group using the realistic (nominal) rate calculates the impact on the personal economy. Both are correct, depending on the use of the data to support which of the two positions.

There is a second argument which policymakers must consider: Depreciation of the real exchange rate, which is variable and, therefore, open to movements in the cost of Jamaican export goods and services becoming cheaper and, therefore, more saleable to the export market.

This would, theoretically, increase foreign-exchange earnings for the Jamaican economy. But it would also add to the cost of imports. On balance, however, it is considered that the increase in volumes of cheaper exports would outweigh the price increase on imported goods and services. In other words, the volume effects are greater than the price effects.

Yet, this is not so, because if the argument is applied to the three major exports, bauxite/alumina, tourism and remittances, all of which are already denominated in foreign exchange, there would be no gain in marketing to be achieved for depreciation of the Jamaican dollar. As a result, these export areas (bauxite/alumina, tourism and remittances) would not become cheaper and could not be stimulants to the economy.

In fact, the realistic
position is that less foreign exchange could be required to satisfy
inflows for the Jamaican costs of bauxite/alumina, tourism and
remittances. As a consequence, there could be a negative impact on
foreign-exchange inflows into the economy, since, for example, the
depreciated dollar does not encourage more tourism in the form of
increased bookings and purchases of Jamaican
goods.

When the positive and negative positions of the
real exchange rate variable model are considered, one must take note of
the vital role that monetary policy plays in stabilising the economy.
Indeed, monetary policy is our key tool to securing the system,
contracting/expanding the economy, and even discouraging capital flight
when need be. In the balance, therefore, it would offer a more secure
regime.

Finally, the exchange rate in this model has
only marginal impact in affecting real prices or growth. Hence, in this
economic model, which will continue to be used over the next four years
of the International Monetary Fund programme, there would be ineffective
economic stimulation to penetrate the relatively stagnant growth which
has prevailed for more than 20 years.

Of course, all
this changes if there is any heavy injection of investment, such as is
being currently discussed with Chinese developers. Huge project
investments would be a welcome game-changer, with growth prospects for
the future, if wisely negotiated and the funds prudently
used.

It should be ensured that the funds be used to
align complementary industries to multiply the impact. With these
inflows, domestic capital can be rebuilt to supply future expenditure
and investment needs. In the final analysis, national economic strength
will be built on the use of our own earnings, not
borrowings.

Patience is now required to rebuild that
strength on a timely basis if we are to return the growth and jobs which
are in dire need.

Edward Seaga is a former prime
minister. He is now chancellor of the University of Technology and a
distinguished fellow at UWI. Email feedback to columns@gleanerjm.com and
odf@uwimona.edu.jm.