This post discusses how over-valuation of the exchange rate – established here and here – might adversely affect the Papua New Guinea economy based on a review of international experience.
When the exchange rate appreciates, exporting industries suffer because they get less domestic currency in exchange for their foreign currency. Businesses that compete with imported goods also suffer because imports become relatively cheaper. This is bad for economic growth and employment as these sectors often have the fastest advances in productivity growth. These industries include sectors like agriculture, which is still the major employer of Papua New Guineans, and particularly the poor.
World Bank research suggests that exchange rate misalignment is strongly correlated with low per capita GDP growth, low productivity, low export growth and low agricultural sector growth. Overvaluation misallocates resources, reduces economic efficiency, increases capital flight, and often leads to calls for protectionist yet economically inefficient policies such as tariffs.
A 2002 World Bank paper surveyed the global experience with and lessons from exchange rate overvaluation. The paper notes that the group of West African countries with exchange rates fixed to the French Franc, known as the ‘CFA Zone’, experienced relatively steady growth till the late 1980s, in many cases outperforming other sub-Saharan countries. However, due to commodity price shocks combined with an appreciation of the Franc, their economic performance began to suffer.
Research cited in the paper suggests that the average overvaluation of exchange rates in CFA countries in this period was 31 per cent in 1993. When coupled with the fact that many other African countries had currency devaluations over the same period, this led to substantially lower international competitiveness. Capital flight occurred and export earnings collapsed as a result of diminishing terms of trade. Côte d’Ivoire saw an increase in its poverty rate from 30 per cent to 60 per cent. The zone as a whole saw no economic growth between 1986 and 1994.
In 1994 a devaluation of 50 per cent to all countries in the CFA zone worked to spur economic growth. From 1994 to 1997 these same countries saw annual economic growth average 5.1%.
Another example explored in the World Bank paper concerns the economic progress of Chile. Chile, like other countries in Latin America, relied on imports for industrialisation, which led to slow export growth, growing inflation, and balance-of-payments problems. In a phase from 1979 to 1982 Chile used a nominal exchange rate ‘anchor’ to limit inflation. The exchange rate appreciated, and when it became apparent that the rate could not be sustained, substantial capital flight occurred. From 1983 to 1984 Chile fell into recession. After a number of failed policies, including increasing tariffs, the government moved to a more export-oriented strategy. Focus was given to the real exchange rate, and substantial depreciation occurred, spurring export growth. Cuts in government spending, privatisation of state-owned firms, and strengthening of bank regulation then stimulated economic growth. Chile is a modern development success story, and though its success cannot be solely attributed to these policies, including depreciation, it could not have occurred without them.
The sort of foreign exchange rationing (discussed in the first post in this series) that PNG has introduced is also damaging for local businesses. It discourages business from importing and investing.
According to these researchers, foreign exchange rationing was common in developing countries from the 1960s to the early 1980s. It is still evident in some countries. For example, to keep its exchange rate high, the National Bank of Ethiopia relies on foreign exchange rationing, which is reported to have deterred foreign investment, and increased the risk of money laundering, Egypt is another example of foreign exchange rationing. According to The Economist of October 24 this year, this is hurting business, and has contributed to a sharp slowdown in growth.
What should PNG do? Suddenly letting the exchange rate drop to a market rate may be undesirable as a rapid increase in the cost of imports (particularly staple food imports like rice) may cause serious strain for urban consumers, and might also cause a loss of confidence. However, eventually the market rate needs to be reached, and the longer this is postponed, the more rationing will slow down the economy, and the harder it will be for other export industries, such as tourism and agriculture, to expand in line. The IMF has suggested an increase in the rate of depreciation, noting that the current pace will be insufficient to meaningfully reduce excess demand for foreign exchange as it incentivises exporters to delay sales and encourages importers to demand more foreign exchange.
There is no alternative to depreciation. Just as government spending unfortunately needs to fall, and has now been cut, so too the exchange rate needs to depreciate at the end of a resources boom. We don’t know by how much, but significantly more depreciation will be required. Although it will create pain through higher import prices, depreciating the exchange rate – and eventually allowing it to float again – is better than allowing domestic businesses and the poor to suffer.
Rohan Fox is a Lecturer and Research Fellow in the University of Papua New Guinea Division of Economics, and a Research Associate of the Development Policy Centre. Stephen Howes is Devpolicy Director. This post is a modified excerpt from a paper presented at the 2015 PNG Update and 2015 Pacific Update. Read the first and second posts in this series here and here.
Hello Richard,
Thanks very much for the detailed and well thought through response. I appreciate the reply. I will try to address your points, see what you think.
You are right in saying that no matter what the exchange rate is there will be winners and losers. (However I do think you are underestimating the costs to exporters like coffee and oil palm, exchange rates definitely matter to them!). We know that if the exchange rate were 100 times lower, or 100 times larger there would be winners and losers. So then, if every exchange rate has winners and losers, what should the exchange rate be? How do we compare the benefits of any particular exchange rate for some, with the costs of that same exchange rate for others?
The two alternatives are for the government to control the rate, or for the market to set the rate. There are benefits and costs to these kinds of regimes. Though over time, the evidence suggests that the best way to maximise the benefits, and minimise the costs is to use a market rate.
In this case, the government set rules around the rate, but not long afterwards, commodity prices fell massively. While PNG’s competitors’ exchange rates fell (sometimes dramatically), the Kina did not. If you compared the kina market rate at 1 June 2014 to 1 June 2015, it had actually increased over the course of the year. This is not good for competitiveness.
The recent Article IV put out by the IMF (page 15) shows that even if you don’t include the large appreciation of 17% in June 2014, the Kina has still depreciated slower than other regional currencies, this is despite the fact that PNG relies far more on commodities for foreign exchange.
http://www.imf.org/external/pubs/ft/scr/2015/cr15318.pdf
In this case, it is possible that the government had a good reason to introduce the trading rate bands. However, what is not clear, is that, when coming to the decision to introduce the bands, that the costs of overvaluation were as clear as whatever benefits to overvaluation there were. These costs were then exacerbated by the commodity price falls.
Perhaps I am an optimist, but I do feel that most in the government want to do what is best for PNG and it’s people. This article (and the previous two) aims to provide evidence to suggest that, when you use tools to try and take in to account all the winners and the losers, we find that overall PNG would be better off with a faster reduction in the exchange rate, rather than a slower one.
In a future article, I will be looking at whether the rate of depreciation has indeed actually sped up.
This is not a doomsday scenario, but at the same time it is not a positive one either. Many are not affected in their day-to-day life by the exchange rate. Many are, both directly and indirectly. (Though those who are not affected would also not be affected by depreciation).
Opponents of the government and others will gladly sensationalise articles such as this. People will always try to use research to achieve political ends. However, it would be inaccurate to say that the article is suggesting that the economy is at a stand still. Many of those using informal markets will be unaffected, however this does not invalidate the evidence that suggests that the economy is growing slower than if the rate of depreciation of the exchange rate was increased.
This is something I thought through very much before writing. It is a fine line to balance trying to get people’s attention to risks associated with various policies, to providing a tone that can be misinterpreted (wilfully or not).
Around the most recent MYEFO, the boss of ANZ put out a statement that deftly avoided talking about some of these issues, and instead focussed on the long-term future. Many thought that this meant he rejected the negative analysis, which was not true; the ANZ actually favours further depreciation. Most articles I have seen are positive on PNG’s long-term future and this is a sentiment I share.
What I hope the article is suggest that the benefits of a market rate are greater for PNG than the benefits of an overvalued rate. And as such, if the government sped up the depreciation that this would be positive for the people of PNG. Ultimately, this is what I feel we are all working towards, the best future for PNG.
Hey Rohan,
Great research on a critical issue for the PNG economy. It’s very interesting to see what’s happening in PNG from an international perspective and to have a more comprehensive understanding of what the literature says about the impact of exchange rate manipulation in developing countries.
Another factor that must be weighing against any further devaluation is the elephant in the room of interest repayments to government debt held in foreign currency, notably USD. With on-budget interest repayments, which don’t include the controversial [http://www.smh.com.au/business/energy/ubs-papua-new-guinea-deal-respected-figures-question-pm-peter-oneills-role-20151012-gk78zo.html] UBS loan, already swallowing up 10% of the 2016 budget any further depreciation would likely push that number up even further. Who knows what would happen to off-budget debt but there’s clearly a lot of political interest aligned with keeping it propped up. It will be interesting to see how the Government addresses questions on the exchange rate from potential investors when going after their proposed Sovereign Bond.
Cheers,
Jonthan
I just read a tweet stating “Exchange rate brings the economy to a stand-still” and a link to this article.
Some comments if I may …
Which economy are we talking about? The markets seem to be thriving and of course the other parts of the informal sector that most live in. One resilient thing about PNG is that the bomb could drop and life would go on as normal for many. And it hasn’t (yet) to pay for huge social security entitlements and suchlike that other economies are chained to.
Do you mean the Mining sector – well, commodity prices might have something to do with that? And I believe the LNG boast that PNG is already one of their lowest costs producers. Hence a competitive advantage.
Do you mean the Agricultural sector – well, oil palm producers say low or high – the exchange rate is a double edged sword. If low – the price of importing fertilizer/spare parts etc. is a killer, if high – the PNG costs of production are greater. Or are we talking coffee? With the ongoing drought, not to mention ongoing structural factors like roads, it’s hard to see a lower exchange rate making much of a difference. Anyway, consistent “quality” to my mind would ensure high demand for this commodity. It’s already a good price.
Are we talking the Transport sector? The low price of fuel currently must be a real profitable boon for all transport providers, not to mention others who have fuel as a major cost i.e. PNG Power. Will a lower exchange rate make a difference?
Is it Tourism? Again personal security, fear of malaria and suchlike as well as structural & visa issues – seem to be the root cause of slowness in this sector. One bright light does seem to be the recent endeavours in this area though and invest in the sector. Australian tourists I speak to already seem to think that the rate is pretty good i.e. K2 fo $1. How low is low?? I remember when K1=$1.
Or perhaps Construction? Imagine the prices of hardware and building materials (most imported) if we have a large devaluation. Will that be good for the economy? Certainly not for anyone thinking of buying a house.
I haven’t mentioned Manufacturing as I’m not sure what we manufacture that has a significant impact on the economy. Tinned fish?
Forestry? Surely you’re not implying a lower exchange rate would help the loggers become more competitive and that would be a good thing. I’m pretty sure they can sell their product. Likewise with Fisheries.
Anyway, every graph I look at has shown a steep decline in the PNG rate against US since BPNG’s actions 18 months or so ago. It is devaluing in a seemingly controlled way and the ridiculous profiteering and exploitation by currency traders has also been managed – as has any wild swings in exchange rates that could happen if hedge funds and that like cast their eye on PNG.
If the fact that the rate against the AUD$ and others has held its own is the issue – is that such a big deal? Haven’t those currencies been largely overvalued for some time and they too are depreciating as the US gains strength.
If there is capital flight – perhaps it might have something to do with alarming analysis!
As for large multi-nationals finding it difficult to send funds out for purchases or other reasons – I’m pretty sure they have repatriated their profits for some years and can’t believe they don’t have ways and means of paying the bills if they really want to during the hard times. These companies move funds around all the time. If they have to keep a larger amount in the country for a period, sobeit.
The economy is, after all, growing (faster than Australia’s I believe) – with perhaps some big projects around the corner. All our jobs are to keep it growing and steer through these stormy seas.
Sorry, you seem to be wearing De Bono’s black hat and I thought I’d put on some other colours for the sake of advocating another point of view and to challenge some assumptions. Not based on international experience but from more micro observations within the PNG context and from living and doing business “on the ground” here. Happy to be wrong – just thought I’d comment in case there is any group think going on.