What determines the level of a country’s exchange rate? Traditional economic theory focuses on a set of financial variables, plus some ‘contextual’ characteristics of a country, all of which go into setting the relative advantage of one currency over another. These variables are well set out as follows:
1. Inflation differentials: Generally, a country with a consistently lower inflation rate has a rising currency value, as its purchasing power increases relative to other currencies. Countries with relatively higher inflation typically see depreciation in their currency in relation to the currencies of their trading partners. This is also usually accompanied by higher interest rates.
2. Interest rate differentials: Interest rates, inflation and exchange rates are all highly correlated. By adjusting interest rates, central banks or monetary authorities can influence over both inflation and exchange rates; changing interest rates affects inflation and nominal currency values. Lenders in an economy with higher interest rates get a higher return relative to other countries. So, higher interest rates attract foreign capital inflows and pur pressure on the exchange rate to rise. However, the effect of higher interest rates is mitigated, if inflation in the country is much higher than in others, or if additional lower interest rates–i.e., lower interest rates tend to decrease exchange rates.
3. Current account deficits: The current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends. A current deficit shows the country is spending more on foreign goods and services than it is earning, and that it is borrowing capital from foreign sources to cover that deficit. Hence, the country needs more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the country’s exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests.
4. Public debt: Countries use deficit financing to pay for public sector projects and governmental funding. The borrowing stimulates the domestic economy, but nations with large public deficits and debts are generally less attractive to foreign investors. Why? A large debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real foreign exchange in the future. In the worst case scenario, a government may print money to pay part of a large debt, but increasing the money supply inevitably causes inflation. Moreover, if a government is not able to service its deficit through domestic means (selling domestic bonds, increasing the money supply), then it must increase the supply of securities for sale to foreigners, thereby lowering their prices. Finally, a large debt may prove worrisome to foreigners if they believe the country risks defaulting on its obligations. Foreigners will be less willing to own securities denominated in that currency if the risk of default is great. For this reason, the country’s debt rating (as determined by Moody’s or Standard & Poor’s, for example) is a crucial determinant of its exchange rate.
5. Terms of trade: This ratio compares export prices to import prices, and is related to current accounts and the balance of payments. If the price of a country’s exports rises by a faster rate than that of its imports, its terms of trade have improved. Increasing terms of trade shows greater demand for the country’s exports. Consequently, this results in higher export revenues, which provide increased demand for the country’s currency (and an increase in the currency’s value). If the price of exports rises by a lower rate than that of its imports, the currency’s value will decrease in relation to its trading partners.
6. Political stability and economic performance: Foreign investors prefer stable countries with strong economic performance in which to invest. A country with these positive attributes will draw investment funds away from other countries perceived to have more political and economic risk. Political turmoil may cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries.
The exchange rate of the currency in which a portfolio holds the bulk of its investments determines that portfolio’s real return. A declining exchange rate obviously decreases the purchasing power of income and capital gains derived from any returns. Moreover, the exchange rate influences other income factors such as interest rates, inflation and even capital gains from domestic securities. Exchange rates are determined by numerous complex factors that often leave even the most experienced economists baffled.
While that may appeal to the fancy of the media, it needs to be put into context.
In recent years, Jamaica’s government has done much to repair decades of damage to its finances. With support from the IMF, the so-called ‘economic fundamentals’ are on a sounder footing. That should help the exchange rate avoiding being dumped at a rapid rate. However, while inflation is down, debt stock is down, and debt payments are being made on time, the economy is far from fixed. For example, the debt-to-GDP ratio is falling, but still well over 100 percent. No right-thinking person, especially one thinking of investing in Jamaican assets would regard the Jamaican economy as fixed.
The economy remains ‘misaligned’, as economists would say, on several other fronts. An indicator of that is the continued negotiations that have to take place over the size of the public service, which is deemed to be a drag on economic performance. Things that drag the economy, like a bloated public service, have a negative effect on sentiment towards the exchange rate.
For all that Jamaica is seeing increasing tax revenues and a streamlining of tax affairs, plus a shift to try to broaden the base of tax payers by moving away from direct to indirect taxation, Jamaica remains severely burdened by too many people avoiding their share of the tax burden. Put that differently: our informal way of doing many things, though full of convenience at a personal level, leaves the country poorly placed to pay for its many services and obligations. Though it may be impossible to write an equation that measures that aspect, it is the sort of thing that weighs negatively on the mind of people thinking of holding Jamaican dollars.
We have seen that Jamaica is divided politically, as demonstrated by a tight national election and the winning party having the slimmest of margins–one seat. For some, that demonstration of sound democracy also opens the door to a unknown world of political fragility. Such uncertainty has a negative effect on the exchange rate.
Many signs suggest that Jamaica has serious problems with corruption, despite hardly any cases going to court or people being imprisoned. The smell of corruption lingers. Investors wont come flocking to countries with such a smell. So, while some capital may flow in to be risked on projects in Jamaica, most ‘well-thinking’ investors are avoiding the country. That has a negative effect on the exchange rate.
These elements are part of what I would call a ‘risk premium’ that plays on the exchange rate, despite the good economic policy. How much? Good question. But, that premium is being demanded, and the declining exchange rate is a flashing warning light. I would say it’s amber, not red, which is better than it was or could be. But, it’s there, whatever politicians may want to tell you. It’s the same kind of warning light that the pound sterling has had blipping over its head since the referendum vote to leave the European Union. The UK did not suddenly become a basket case, but its prospects seemed to worsen and the heightened uncertainty has seen sterling take a pounding–sorry for the obvious pun.
But, the exchange rate is only one indicator of what people think about Jamaica. If I were a Jamaican politician, I’d think about what some other composite indicators are telling me about my country.
The Jamaican stock market outperformed the world in 2015 (read Bloomberg report) and continues to perform strongly. That feature, and the results of various surveys, national and international, suggest improving confidence in Jamaica and improvement in many economic areas. Now, the stock market is more limited in its picture than the foreign exchange market, but its array of companies are generally the stronger and larger ones in the economy, whose performance drive many economic indicators. What the stock market tells me is that betting on Jamaican companies is seen as smart. In other words, the sky is not falling.
But, what the exchange rate tells me, in its vague and hard to measure way is that ‘contextual’ problems that afflict Jamaica continue to exact a price of all of us, via the declining value of ur money. Those problems are well-known: corruption (stop pretending it’s not there and widespread); violent crimes (if you thought you might need to flee in a hurry, would you prefer to have your assets in Jamaican dollars or in US dollars?); slow implementation and a still-too-prevalent ‘no problem’ approach to that. Odd though it may seem, one of the worse examples of that last point is how politicians and public agencies go about what they do:
- Look at how Parliament runs itself. Do you think that politicians who seem to slack off on their work sends a positive image to the world? Do you think that people rush to hold currencies of countries whose politicians routinely do everything late, including attending Parliament?
- Look at how some public agencies seem to constantly find themselves in financial hot water. They may not understand that in the mind of traders, these are signs of a sick country and must be negative for the exchange rate. People don’t generally like to hold currencies where lots of it keep disappearing into black holes.
The last IMF staff report (see box 4) informed us that Jamaica is becoming more dollarized (my stress): ‘June 2016, with more than 45 percent of deposits denominated in US$, Jamaica’s deposit dollarization is one of the highest in the region, accompanied by dollarization of investment portfolios too. Likewise, the three-year-long freeze of the domestic bond market, which resulted in greater reliance on external capital markets resulted in higher dollarization of public debt.’ So, government action forced portfolio managers to hold more foreign assets (buy more foreign exchange). So, understand who is forcing this process and putting pressure on the exchange rate: it’s the financial sector and government. So, when Finance Minister Audley Shaw sits down with the working group he’s established to ‘deal with the devaluation’ of the Jamaican dollar against the US dollar, I hope he understands at whom fingers need to point. The Jamaican government made the J$ a one-way bet! Traders love to make easy money 🙂
Ordinary Jamaicans don’t seem to be running towards the US dollar. I base that on a few anecdotal experiences that all point to general indifference to holding greenbacks: I’ve sometimes no J$ to hand and have asked if the person I need to pay would like US$, and they often say ‘No thanks!’ Whatever the US$ attraction, maybe the transaction costs outweigh other features. Then again, ‘ordinary Jamaicans’ are consumers, rather than savers and investors, so the currency of preference for consumption remains the J$. We still do not see US$ pricing as a standard feature in Jamaica–aside from in parts of the tourist business. I take that as a positive.
It’s a sad reality for highly-indebted countries that they are their own worst enemies, from start to finish. Getting out of the debt bind forces things to happen to seem to make matters worse before they get better. The declining exchange rate is one such effect, and it’s as much arithmetic as anything else.
Finally, what the exchange rate is also telling me is that the promise of better economic prospects has not yet materialized and that must be reflected in the tendency of the J$. Simply put, countries that do not appear to be growing tend to have weaker exchange rates, so decades of anemic growth has built up lots of antipathy towards the J$. However,if the latest data on quarterly GDP growth showing the best results for 14 years is the start of a trend in that direction, I would expect the exchange rate to stop suffering as much.