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

Plus
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

Plus
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.

5 comments:

  1. You have highlighted another very crucial issue that our business sectors and the economy at large have been experiencing for quite sometime. There indeed will be no straight forward answer to this issue either, a nation cannot just give up their currency and opt for a dollarized economy, nor can they just shift their focus from a pegged regime to a flexible regime (managed or independent)! What we all could agree though is that no matter what regime a nation chooses, long-term success depends on commitment to sound economic fundamentals and more importantly a strong banking sector!

    Your article had actually highlighted a significant element that the common man on the street needs to understand. I see that in Maldives lots of people have this “i-know-it-all” attitude, and this very attitude can basically kill the spirits, enthusiasm and strong beliefs of people like yourselves. As you have quite rightly pointed out, look at the significant difference between the current rate of 1USD (MRF12.75) to its equilibrium Mrf25.5 approx. I think we need to look at these numbers in more detail before we could move forward. Given a change of focus from a pegged to the flexible regime, our nation would see a drastic change in the prices of goods and services doubling! The question that then becomes, can Maldivians afford this change? Can we sustain this change?

    I think the problem of these very issues can be dug deeper to understand the real reasons behind such a drastic change in price levels and only then could we even begin to talk about the solutions (be it temporary or otherwise).

    Lets look back at our economy three to four decades back and see how the economy had functioned. I think by having a clear understanding of our economy then, we might be able to learn some very important lessons. I’d like to highlight this point because I believe that a nation who wishes to grow (in todays open and global market place) must first ensure the fundamentals of a strong economy is locally present! Only then can we stand up on our own foot to deal with the tough times.

    To ensure a strong economy, as I said we need strong fundamentals locally. We need to be a self sustaining nation to some degree. Years back, when our then government was pregnant with the new future of our nation (i.e tourism), Maldives did manage to live. We did manage to be happy. We did manage to buy fruits such as Mangoes, bananas, water melons, passion fruits and many more. We did ensure that we made full use of our coconuts from drinking it as a refreshing juice to use it as an ingredient to our hedhikas and spicy curries. Availability of fish was no different from now, but the striking differences lies in everything else that I have just described. And I believe there lies our major weakness. These people who supplied us these very basic items (and more) is dubbed as the Farmers all around the world. But when our government gave birth to the new future and named him/her as Tourism, all our focus was changed to that newly born.

    What then happened was quite interesting as well. With the birth of Tourism, we started realizing the potential of this market. Not only did our thinking was directed at this new industry, but resources and attention of everyone on the streets. People then began to plan their future business ideas by first taking into account this very tourism sector. I don’t blame them either, cos once you see an avenue of making a quick profit, why not!
    Look at the picture today. Due to showing our backs to our farmers, we import almost everything. Tourism was priced in USD because that’s what we thought was the best practice all around the world, we relied on it immensely. More than 60% of our foreign exchange comes from this industry. Nearly everything our economy demands is imported and we have ended up being actually worse than what our economy was 30 to 40 years ago!!! If you describe a person’s wealth by how much it earns and through its liabilities, trust me guys, we are living the worse times in the history of our nation. Who knows whats yet to come. Who knows what 2009 is going to hold. I am not being overly pessimistic here, but I guess I am highlighting reality with the light of facts. Good news though is, we have people like Naseer who have the knowledge to beat the mistakes we’ve made before. These very people can speed up our recovery processes or perhaps build a fine economy backed with good economic fundamentals.

    If we had relied on our Farmers and if the governments backed them, gave them subsidies, used the islands not to just Tourism, but to even grow our agriculture industries, we would have greatly reduced the strong reliance on USD and its result less demand and downward movement of the equilibrium price. To ensure this downward movement continues, we need to ensure the demand for MRF is strong. Its too late to talk about what ifs yeah? But I tend to disagree with that as well. Unless we talk about the what ifs, we wouldn’t be learning the lessons and the mistakes we made then.

    My argument really then is, we need to talk about economic fundamentals before we start talking about the exchange rate regimes. The problem is not the availability of USD or lack of it. The problem is not the foreign exchange reserves or lack of it. Its seriously not tourist arrivals and the current financial global melt down either. To me these are all symptoms of a much bigger and fundamental issue. If we give solutions to the symptoms, the problem still remains. We may be able to overcome the dollar shortages or perhaps even move to a new exchange rate regime. Those are again the solutions to the symptoms. I think what our country needs is seriously rebuilding what once was the future of our nation. We need to focus giving them the same chance as we gave Tourism! We need to give them the same resources as we gave to the Tourism. It might take another 30 to 40 years for a man on the street to get overly excited about his new business venture in the country’s most profitable industry, i.e. Farming (of some sorts)!!!!

    ReplyDelete
  2. I couldn't agree with you more. We do need to develop many other sectors instead of over-reliance on tourism.
    Even in the case of the tourism sector, there is a huge outflow from the country due many factors like imports of food items, and huge expatriate labor force. Unless we adopt a FDI friendly approach and encourage foreign investments in other ares of business, we may not be able to diversify the economy like the way we talk about.

    ReplyDelete
  3. Yes! Finаlly sοmething about seo sеrvіces in indіa.



    My homеρagе; dallas tx seo

    ReplyDelete
  4. Appreciate the recommenԁation. Wіll try it out.


    my webpаge ... http://www.realestateva.org

    ReplyDelete
  5. I've been exploring for a little for any high quality articles or weblog posts in this kind of space . Exploring in Yahoo I ultimately stumbled upon this web site. Reading this info So i am satisfied to exhibit that I have an incredibly good uncanny feeling I discovered exactly what I needed. I so much definitely will make certain to don?t fail to remember this website and provides it a glance on a continuing basis.

    Look into my page; houston realtor virtual assistant

    ReplyDelete