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:
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.