Wednesday, December 31, 2008

US Dollar please...

Maldives had a free floating exchange rate between 1987 and 1994, and the exchange rate of US dollars in terms of rufiyaa ranged between 8.50 and 11.50. In 1994 Maldives moved to the pegged exchange rate regime that we have at present, where the value of rufiyaa is pegged to the US dollar, and exchange rate of rufiyaa in terms of other currencies are determined depending on the cross rates between dollar and those currencies. Many other emerging economies adopted a similar exchange rate regime, their currencies pegged to the US dollar, since the formation of the Bretton Woods institutions, as the dollar became a safe reserve currency.

On July 25, 2001 the rufiyaa was devalued by about 9% and a result nobody is allowed to sell US dollars at a higher rate than 12.85 and not allowed to buy at a lower rate than 12.75 rufiyaa. Recently we have been facing with a shortage of US dollars and as a result there are reports of a parallel market where US dollars are bought and sold at rates as higher as 14 rufiyaa. Some have questioned the effectiveness of the current exchange rate regime, asked about the possibility of moving towards a free float of rufiyaa.

Economists make use of the term real exchange rate (rer) and nominal exchange rate (ner) when trying to determine the equilibrium exchange rate. The 12.75 rate we see advertised is the nominal exchange rate of US dollar in terms of rufiyaa. So what is the real exchange rate of rufiyaa? It has to be calculated using the price level (inflation) of Maldives and the price level of our trading partners. The rer can be calculated using the following formula:

rer = ner x P/P*

where P* is the price level of foreign countries, and P being the price level of Maldives. In this case, if suddenly the price level doubles in Maldives (high inflation), then the real exchange rate will be twice the nominal exchange rate. If the nominal exchange rate is 12.75, then the real exchange rate would be 25.5.
It means there will be a mismatch or a pressure of the rufiyaa to depreciate towards 25.5 if it was left to the free market to decide, because one dollar is actually worth 25.5 rufiyaa.

On the demand and supply side, the exchange rate is influenced by the demand for and supply of US dollars in Maldives.

We earn US dollars through:
tourism revenue,
export of fish products, and
export of little amount of jet fuel

Grants and loans from abroad

We spend these dollars on:
import of goods,
expatriate workers’ remittances
pay back our overseas loans, and
holidays (trips) abroad

Repatriation of profits by foreign companies

In order to avoid a liquidity mismatch in the foreign exchange market, the total demand for US dollars must not exceed the supply of it. In other words, the amounts we spend on imports and other uses mentioned must not exceed the inflows.

According to the available statistics, Maldives had a deficit in the current account exceeding $100 million since 2004. We are spending more than we earn from tourism receipts for our imports and travel abroad. This means, at any given time, our demand for US dollars exceed the supply of it from tourism and exports.
However, we have not felt a shortage of US dollars in the last few years because foreign agencies have always been very generous and been giving us grants and loans, so that there is an inflow of US dollars.
Private companies have also been borrowing heavily from overseas banks, so that there have been US dollar liquidity in the economy. The branches of foreign commercial banks in Male’ (like SBI, BOC) have been supplying the local businesses with US dollar loans through borrowings from their head offices overseas. The reality: the mismatch between US dollar demand and its supply has been met through temporary solutions; that being; grants and huge loans by government and private entities, for the last 5-6 years.
This cannot continue for very long. When the government and private debt reach to unsustainable levels, we cannot continue borrowing. We would have to spend from what we earn, once again.

When the central bank announces an exchange rate for the rufiyaa as 12.75 and 12.85 for its selling and buying rate respectively, then it has an obligation to buy any amount of US dollars presented to them at the announced rate, and to supply any amount of dollars at the buying rate. In this process, the central bank may be actually depleting its reserves, given that the announced exchange rate is nowhere near the equilibrium exchange rate in the free market, which depends on the actual demand and supply of US dollars.

The equilibrium exchange rate as I have said depends on the relative price levels between Maldives and our trading partners, and the demand and supply of US dollars in the market.

What is the best exchange rate regime for us? I think we need to determine the market rate of rufiyaa in terms of US dollars if it was to freely float in the market. Without knowing the market rate, our true economic fundamentals will not be tested. This can be done by a temporary float of rufiyaa for a few months.

There have also been the idea of pegging rufiyaa to euro instead of the dollar. The basic argument is that we earn foreign exchange through tourists from europe. In that case, tourists can be required to pay euros when they make holidays in our resorts. However, almost all importers have to pay US dollars to their suppliers as the invoice prices are quoted in dollars.

Another option could be full dollarization of the economy, whereby we abandon the rufiyaa and make the US dollar as our currency. In that case, we wont have to worry so much about inflation, as the US economy has been famous for having lowest levels of inflation. However, this might not be a very favorable option politically, as some might put forward the argument of losing our sovereignty. Many European countries have abandoned their currencies when they adopted the euro. Maybe we can us ask them how it felt, losing their sovereignty.

Tuesday, December 30, 2008

Thanks for your comments- Maldive National

Thank you for your thoughtful comments Maldive National. I agree that we have many things that can be done at a micro level to minimise the impact of the crisis on our economy. To be precise, the crisis could be a blessing in disguise in so many ways. When tourism declines, it gives the government and private investors an opportunity to think about the reality of the capital investments and tourism expansion in Maldives.
As you mentioned, the role of fishermen will be much appreciated. In many islands, with the establishment of tourist resorts, fishing has become only the last option as a source of income.
We Maldivians, as you said have become very irrational or reckless in our spending patterns. Let this be a time for all of us to think back, make us realize that spending must be done from what we earn, and as you said wisely. Let the government realize that expenditure must be objective based, and not politically motivated. Let the government realize the danger of wasteful spending.

Sunday, December 28, 2008

Global Economic Recession: Maldives government heading towards insolvency?

The World Bank estimates GDP growth of developing countries to fall to 4.5% in 2009, compared to 7.9% in 2007. Private capital flows are expected to decline from $1 trillion in 2007 to only $530 billion in 2009.

The financial crisis that started in America in 2007 has resulted in failure of many investment banks, insurance companies and now the auto-giants. The World Bank and IMF estimates 2009 as a recession, and there is reason to believe that this could be the worst recession since the Great Depression of 1929-30.

Maldives has an economy which is very much dependent on the revenue from the tourism industry. As major European economies are hit by the economic recession, decline in tourist arrivals is expected. We would also expect a significant drop in tourists’ expenditure in Maldives. All these factors will lead to a fall in foreign exchange earnings, and our GDP.

Are we prepared for such consequences?

Our economy has a relatively huge government expenditure component, with huge government-employed labor force, and major spending on infrastructure development projects. The economic down-turn has unfortunately coincided with the first multi-party election and the change in government for the first time in the last three decades. With this come promises and pledges announced during the campaign. Are these politicians aware of the economic consequences of their various policies, especially those in relation to reducing prices, establishing a transportation network, and decentralization.

The price of oil reached a peak of above $140 in July 2008, with it increased price of many other commodities and services as the costs of production suddenly increased. We also witnessed the surge in global food prices within this year. However, as we end 2008, oil price has declined to as low as $37 a barrel, and America is facing the problem of deflation as the economy is facing a declining demand.

Do we need policies and additional measure to combat increasing commodity prices in Maldives? As the world is headed to a recession and falling demand, we would expect prices of goods to fall anyway. The price of oil has already fallen from $140 to $37, without any action by the government of Maldives. As price of oil and gas falls, commodities and services also will face reductions in prices.

The macro-economic management of Maldives: The recently formulated budget for 2009 by the Ministry of Finance incorporates over 70% as current expenditure. The estimated deficit is Rf5.7 billion. Government has borrowed Rf203 million from the country’s central bank in order to cover a temporary cash flow shortage. Further, media headlines are strongly vocal on government securing some $100 million from the Indian government; part of if being debt finance.

The present government has been talking continuously about securing finance from foreign sources for its expenditure. In other words, borrowing from foreign governments and banks, leading to further increase in government external debt and making its debt unsustainable. Most alarming factor is: we are borrowing money in order to cover current expenditures that do not provide any direct economic return! An expansionary fiscal policy during an economic down turn may be justified, as the increased spending will give a boost to the economy. However, in our case, we’ve had a series of budget deficits in the last five years, and fiscal mismanagement during the last three years, leading to unsustainable levels of government debt, and undesirable level of inflation. Further increase in government debt may lead to government insolvency, and in the end international creditors reluctant to lend us any money. We may be forced to revert back to the most traditional way of living. The solution to all this, at a time like this: Spend only what you earn!

Thursday, December 25, 2008

Saving Bank of Maldives

The ownership structure of Bank of Maldives (BML) is as follows: the government of Maldives directly owns 51%, STO 4.2%, MTCC 4.1%, Government Employees Provident Fund 7.3%, Rayyithun Account 4.1%, and general public 29.3%.
Although the government directly controls 51%, since both STO and MTCC are partly government owned companies, it can be said that through the shares owned by these companies the government has an indirect control over the bank. In that case, almost 60% is controlled by the government, while the general public owns only a mere 29.3% of shares.

How is social welfare affected or minimized due to the government ownership and control of a significant share of BML? How much social welfare can be increased by privatizing the existing government shares?
As Bank of Maldives is the only local commercial bank in Maldives, can privatization of BML help in efficient allocation of capital to business enterprises, and further development of the financial sector of the country?
In order to answer these questions, we need to analyze the costs and benefits of the current ownership structure.

The board of directors is entrusted to formulate strategic issues of the bank, and the management is held accountable to the board. The government nominates the chairman, and seven directors to the board out of the 11 directors. Three are elected from the general public. The Managing Director/CEO is also recruited by the government. There is no doubt about the level of influence the government can have on the lending decisions and day-to-day activities of the bank.
The public interest view put forward by many economists states that government control is necessary if the private sector is unable to provide a necessary service (or a public good) to the society, and as a result of government provision, the public interest is maximized.

When Bank of Maldives first started its operations in the country, government involvement was necessary as the private sector did not have the necessary capability to establish a commercial bank, and hence government initiative provided public interest, and maximized social welfare. A similar story goes to government involvement in other major public corporations like MIFCO, Dhiraagu, and MNSL.

However, as Bank of Maldives has become an established commercial bank, reducing government influence may reduce possibilities of corruption, chances of abuse of power, and possibility of using bank’s resources for political advantages. It can also help in better allocation of scarce capital resources, and effective development of the financial sector. A very simple example could be the case of ‘connected lending’, where bank managers lend money to well connected people with poor credit history. When huge loans are made to politically well-connected people, and when these highly concentrated loans become non-performing, could affect the profits of the bank. When this happens, the rights and interests of the remaining share holders from the public are not well protected. Past lending decisions of BML and records on some non-performing loans support this claim. In the past, some directors to the board have been assigned by the government without considering their capabilities or professional capacity. These decisions were mostly politically motivated. This will also affect decision making process of the board of directors on important strategic issues of the bank.

What are the benefits of keeping the existing government shares in the bank? Considering the fiscal revenue to the government, BML paid about Rf119 million as tax from its profit to the government in 2007, in addition to the revenue as dividends of Rf9.3 million that was paid in the same year. Even if all the government held shares are sold to the public, the government would still receive the tax revenue, but would have to sacrifice the dividend revenue. However, with the possibility of improvement in the bank’s performance as a result of less government influence, the gross profit of the bank may increase, leading to higher tax revenue that may compensate the loss in dividend revenue. In that case, reducing government influence may be fiscally much beneficial to the government. If not completely privatizing the bank, reducing the government direct control to at least 36% instead of 51% may also lead to a much efficient outcome, as this will increase the shares held by the general public to at least 44%, and hence improve accountability of the bank managers to the public.
Empirical evidence from most countries in the world also suggests government influence, and connected lending as harmful for efficient capital allocation and development of the financial sector. With effective corporate governance principles and regulation by authorities like MMA and Ministry of Finance, the bank can be held responsible to its shareholders without the government having to have political control over the bank’s operations through direct ownership of shares.