Apr 2016 Financial News

Treat adjustment as PERMANENT

Apr 28, 2016

The mission chief of the International Monetary Fund (IMF) to T&T, Elie Canetti, says the biggest problem with the government’s decision to use mainly higher taxes and lower spending to reduce aggregate demand in the economy is that it is “less growth friendly” than depending on an exchange rate depreciation.

Canetti was speaking to the Business Guardian in an interview in Washington DC during the spring meetings of the IMF and the World Bank earlier this month.

Asked what were the downsides of attempting to deal with a terms of trade shock by mainly fiscal means, Canetti said: “The biggest problem is that it is less growth friendly. If you do a fiscal adjustment it is all about contracting demand domestically. But, if you do a depreciation, it is really about reducing demand for foreign goods.”

The IMF staffer said engineering a successful depreciation requires that inflation be held in check, so the positive benefits of the measure are not eroded.

“But the contraction in demand, as a result of a depreciation, falls on foreign goods and foreign services and so, in that sense, it is not as damaging to domestic growth.”

Canetti referred to the statement in the IMF’s press release following its March Article IV visit that T&T had undersaved and underinvested, which means that the country does not have the savings necessary to adjust by drawing on those.

He said it is hard to estimate the extent to which the fiscal measures announced by Finance Minister Colm Imbert on April 8 will impact on the country’s growth—called the fiscal multiplier—because the data is “just so weak.”

Asked to outline the IMF’s thinking about the use of exchange rates in countries that suffered dramatic terms of trade shocks— meaning a collapse in the prices of their main export and foreign exchange earners—Canetti said T&T has experienced what is being treated by the Central Bank as a more or less permanent wealth shock.

Given the global energy picture, and the fact that oil prices began to collapse almost two years ago, Canetti said that it was “pretty unlikely” that the global price of oil would return to US$80 a barrel any time soon.

The IMF staffer said there are three main adjustments that countries have used when they experience sharp terms of trade shocks: fiscal, monetary and exchange rate depreciation.

“In terms of countries that are significant energy exporters, and have some parallel to T&T’s situation, essentially there are several thing that have been done.

“The worry is that you have much less US dollar inflows coming in and, to balance that, countries either need to generate more export revenues to substitute for the loss of US dollars from the previous revenue earner or to contain demand for US dollars.

“Generating more exports is a long-term process that requires a great deal of investment and this is something that T&T has had as a goal, although there has not been much success.

“The challenge is how to address the problem of the dramatic decline in export earnings in the short term and that probably come down to finding ways to curb the demand for foreign exchange. “The first policy lever, and the one that most countries have pursued, is that they have to do fiscal adjustment.

“There are times when countries can get by without much fiscal adjustment, but given the scale of the shock and given T&T’s starting position, I don’t think that is an option for the Government. If the country had been running a fiscal surplus of three to four per cent before the shock, then it would have built up enough fiscal space or fiscal cushions to let the shock be absorbed by running s small deficit. But the country came in with a small deficit and is now faced with a very large deficit.

“Fiscal adjustment is the first line of defence. But the problem with fiscal adjustment is that it is very pro-cyclical. It is difficult to take demand out of the economy by increasing taxes and cutting expenditure if the country is slowing down.

“The second tool is to attempt to contract demand through monetary policy by increasing interest rates. That was done proactively by the T&T authorities as the Central Bank tightened monetary policy substantially in late 2014 and throughout 2015. The motive was not so much to adjust to the balance of payment shock, but to get ahead of the US Federal Reserve and to address concerns about the flow of capital out of the country.

“I am not even sure you would call it capital flight, because that connotes people escaping their countries out of fear that their capital could be confiscated. That certainly is not the case with T&T. The vast majority of the capital outflows have been motivated by some combination of better return and more investment opportunities outside the country.

“Monetary policy can work to contract demand but there is so much excess liquidity in T&T’s banking system that I don’t think raising interest rates has had much effect on how monetary policy is transmitted to the economy. So some monetary policy action was taken and the IMF mission team thought it was appropriate to pause in January because the Central Bank had done a great deal of tightening in a short space of time and it was appropriate, in the context of a slowing economy, to pause to establish the impact of the higher interest rates.

The third channel of adjustment is the exchange rate. Many countries, in T&T’s situation, have depreciated their currencies quite substantially. Energy-producing countries like Russia, Mexico, Norway, Colombia and Angola have all used exchange rate depreciation as a tool of adjustment.

“People in T&T told me that the country has really used the exchange rate and it is a significant depreciation.

But for a country that has had a defacto fixed exchange rate for a long time against the US dollar, it is within one or two per cent of $6.40, which may seem like a large move, but relative to other energy exporters, it’s been a relatively small move.

“The main way exchange rate depreciation work is on the importcontraction side, which might sound like it is not a great thing but the country has much less wealth and fewer US dollars to spend, so it really needs to find a way to contract its imports. Raising the price of imports across the board—which is what a depreciating exchange rate does—is probably a quite effective way to do that. It tends to work.

“And then, over time, the nice thing about an exchange rate depreciation is that it makes Trinidadian products cheaper for the rest of the world, so it does help stimulate exports and, ultimately, stimulate non-energy jobs.

“Some economists have been guilty of being over-optimistic about the impact of an exchange rate depreciation on exports, but there are many other factors that go into increasing exports, such as making it easier to start a business and clearing customs. There are some big reforms that are coming, such as the reform to the procurement legislation and we have said many times that the labour market is distorted and not as effective as it could be. That’s an area that businesspeople see constraints.

“There are many things that have to happen to allow the country to diversify its export base, but a depreciating exchange rate would help that.”

He added that apart from constraining demand for foreign exchange, a depreciating currency also helps in the fiscal situation “because any revenues received in US dollars get converted into TT dollars at a higher rate, so it actually helps the fiscal adjustment itself by bringing in more revenue, but it also reduces the burden on fiscal measures in terms of carrying the weight of the overall adjustment.”

Canetti noted out that the current administration has opted to do “more action on the fiscal side” by raising taxes and cutting subsidies, compared to other countries that have used exchange rate adjustments “as a significant element in the strategy.”

Responding to the arguments made by some local economists that because T&T is a small, open and import-dependent economy, exchange rate depreciation increases the cost of imported manufacturing inputs, Canetti said the argument was a correct one.

“But I think the question is how far it goes. Over time what you would like to happen is that you generate local businesses so you get some import substitution. Other things being equal, a more open economy has less of a positive growth impact from a depreciation.

But, the other way to argue it is, a more open economy means that a depreciation should also reduce total imports. It all depends on whether the imports are consumption goods or inputs into production. If it’s the latter, it is going to help your competitiveness less than if the production inputs were produced domestically.

“Part of the answer is that a depreciation in the exchange rate helps provide more incentives for inputs to be produced domestically, within certain limits.”

Canetti argued that the food production sector could be stimulated if more of the value-added is produced domestically. He said it is hard for people in T&T to envisage how a depreciating exchange rate works because the country has had a fixed exchange rate for so long and been so dependent on the energy sector as the source of foreign exchange.

“People have seen agriculture dry up over the years and while it is hard to imagine the counterfactual, if you set the right price environment and incentives, clever people will seek profit in production for export. But you also need to remove the obstacles in the way of developing businesses.”

He said the government’s strategy of depending on higher taxes and reduced spending with an additional 3.5 per cent depreciation can work.

Asked where have such measures worked, Canetti said that it was too early in this chapter of an unfolding story to say where a preference to using fiscal measures rather than exchange rate has worked. He cited Latvia, Estonia and Saudi Arabia as countries that have done serious fiscal adjustments. He agreed that Barbados was an example of a country that had used fiscal adjustment to the exclusion of exchange rate adjustments.

 

Source:
ANTHONY WILSON
anthony.wilson@guardian.co.tt
Business Guardian, BG4
Thursday April 28, 2016