While a great deal of attention has been paid to how the fiscal deficit could be reduced to a sustainable level, until very recently, rather less attention has been paid to what appears to this writer to be growing signs of an unsustainable balance of payments (BoP) deficit. Could it be that the Barbados dollar is overvalued? Would devaluation make us great again?
Types of Devaluation
Under a fixed exchange rate regime, if, because of increasing scarcity of foreign exchange, a major portion of foreign exchange transactions is conducted on a parallel market, this is called a de facto devaluation. This may eventually force the authorities to change the exchange rate by increasing the price of foreign exchange. This is called a passive devaluation. Finally, if the authorities conclude that the economy is losing international competitiveness because of an overvalued exchange rate, they may devalue the currency in order to assist in restoring BoP equilibrium and growth. This is called an active devaluation. In other words, the exchange rate cannot be fixed by fiat alone. For example, in the 1980s, because of a law that established parity of the peso with the US$, which the Parliament refused to rescind, the Dominican Republic was forced to conduct most of its international financial transactions on a parallel foreign exchange market. The term ‘foreign exchange rate’ was reserved for the official rate. The unofficial rate was called the prima.
Is the Barbados Dollar Overvalued?
There can be two reasons why a country would devalue its currency:
- To reduce effective demand for imports as part of an adjustment/austerity program
- To improve external competitiveness
Devaluation as an expenditure reducing policy. The Barbados Authorities rely almost exclusively on fiscal policies to reduce effective demand (consumption) and restore fiscal balance. So far, fiscal measures have yielded only modest results: successive fiscal targets have not been met, and this has contributed in no small measure to the fact that foreign exchange reserves (FX) are under stress. Whatever else a currency devaluation will or will not do, it will raise the price of imports across the board. This suppresses demand for imports by raising their price. Unless the trend of falling FX levels is reversed, the Authorities could be forced to adopt a passive devaluation as a response to FX scarcity. This is so because a fixed exchange rate will survive only as long as the authorities have FX adequate to defend that rate. Devaluation and External Competitiveness. An active devaluation is one which is undertaken for the purpose of improving external competitiveness. The fact that we are currently forced to use FX to cover the deficit left from the combined current and capital accounts of the BoP is prima facie evidence of BoP disequilibrium. If FX are not to become so low that individuals and institutions actively seek to hold their cash balances in foreign exchange, rather than in local currency, we either have to export more goods and services than we import, or attract enough foreign capital to cover the difference and avoid having to depend on a drawdown of FX to balance the account. In theory, devaluation would change the price of exports relative to imports in such a way that we would import less and export more. We would attract more tourists and import fewer or less expensive TV sets and cars, for example. In addition, currency devaluation would probably be more effective in reducing real wages than nominal wage cuts, which are in any event prohibited by our Constitution. The Central Bank does not believe that the net gain from a change in the relative price of exports and imports would be to our advantage, because of the relative elasticities of supply and demand for our imports and exports (so-called elasticity pessimism). The Authorities have employed instead commercial policies to improve the balance between imports and exports. Import tariffs on cement and subsidies (tax exemptions) to Sandals are examples of the use of commercial policy to reduce the deficit in the current account of the BoP. On capital account, foreign exchange controls, incentives to make Barbados more attractive to foreign investment, the sale of assets such as the Barbados National Bank, the Insurance Corporation of Barbados, and the proposed sale of the Barbados National Oil Company have all been used in an attempt to cover the difference between imports and exports. The situation is not helped by the fact that the prospects for foreign borrowing are severely limited by an already high debt.
The Politics of Devaluation
One way of looking at a persistent deficit in the BoP is that it represents a collective decision by the society to consume more than it produces. This situation can last only as long as FX are not exhausted. If the standard way of dealing with an overvalued currency (currency devaluation) is to be avoided, the Authorities must double down on alternative policies for restoring the balance between consumption and production. Or face a fiscal and balance of payments crisis. The choice is a political one.