An Economist, Jason Van Bergen said ‘aside from factors such as interest rates and inflation, the exchange rate is one of the most important determinants of a country’s relative level of economic health. Exchange rates play a vital role in a country’s level of trade, which is critical to most free market economy in the world.’ For this reason, exchange rates are among the most watched, analyzed and discussed economic indicators not only by government officials, business community but many other people even the less informed market women sometimes get interested in the debate.
What is an Exchange Rate?
An exchange rate is the rate at which one currency can be exchanged for another. In other words, it is the value of another country’s currency compared to that of your own country. If you are traveling to another country, you need to “buy” the local currency. Just like the price of any asset, the exchange rate is the price at which you can buy that currency.
Our country has never witnessed the kind of general interest and public discuss that Ghanaian exchange rates development has received in the last one year compared to the seven years of post re-denomination which can be likened to biblical seven years of plenty.
This is one particular issue that brought even some influential ‘men of God’ into the debate, also recommending ways of finding a lasting solution to the debacle. Some of them pleaded with us that we should seek divine intervention by praying to God for the value of our currency to appreciate and bounce back. Some social critics did not see any reason for that. They said we should take God out of the debate, that this is purely economic issue that has nothing to do with churches or God.
It got so serious to the extent that even some concerned individuals came up with suggestion that Ghana should jettison her local currency (Ghana cedi) and adopt US Dollar as the country’s official legal tender. They justified their assertions by citing examples of some countries who took similar decisions in the past after experiencing a comparable economic/exchange rate crisis. They said these countries, when they couldn’t find a way out of their exchange rate logjam, adopted another country’s currency as their national currency. That was the level the issue got to.
There was another twist to the whole issue, which happened when the central bank was accused of manipulating the exchange rates position of the country. At this point it seems everything has gotten out of hand, and it’s becoming quite embarrassing for the people in the authority. Every one is getting agitated and apprehensive as to when will this free-fall of the cedi will stop.
The Three Dimensions
There are three dimensions to the issue of exchange rate imbroglio that brought all of us to this standstill position before the recent recovery we are currently experiencing as a result of two loans contracted by the government recently.
The first dimension to this whole confusion is the issue of Bank of Ghana and its commercial banks. The second can be traced to the initial exchange rate we adopted for the cedi at the time of redenomination in 2007.
The last one can be looked at from the macro economic factors that usually affect volatility of exchange rate whenever the economy is over-heated, either by excess public expenditure or uncontrolled imports. This I will try to explain in details as we go on.
The BoG and Commercial banks angle
In recent times there have been allegations saying the monetary regulators, the Bank of Ghana (BoG), the apex bank, is manipulating exchange rates in the country. In the first place, one can look at such allegations as not well informed since they were coming from an opposition party. The reason may be just a cheap political talk, which is common in our part of the world, to discredit the current administration that they are not competent to handle the economic destiny of our nation. On the other hand, when such weighty allegations comes from no less than a former deputy governor of the central Bank, who is well-informed and supposed to know better than most of us as a former insider, you cannot but take a critical look at the allegation. Dr. Mahamadu Bawumia is an astute economist of international pedigree.
As if that one was not enough, a member of the Parliamentary Select Committee on Finance, Kwaku Kwateng also came up with similar damaging allegation buttressing the initial accusation of the central bank by his fellow party- member. He claimed that BoG is engaging in massaging or window-dressing the forex figures it publishes for public consumption. In his words, the reality in the market is at wide variance with what Bank of Ghana carries on its website as interbank exchange rates.
According to Dr. Bawumia, the BoG created a false impression that the exchange rate data has remained fixed over the last three months. In a swift reaction, the BoG Governor denied the alleged malpractices. Dr Kofi Nwankpa was quoted as saying, “we believe the rates in the market are also affected significantly by speculative activities, which is thriving on the shortage of forex in the market. So those who have the forex try to play on the market by asking for the highest rates and the ones who to buy because of desperation, also tell their banks to buy at any rate, so you see that gap.”
For some of the close industry watchers, the reason the BoG boss gave seems not to be very convincing, although there was nothing to fret about in the assertion. I think the public expect more clarifications than just the speculative angle as the reason for the static nature of the cedi rate for a period of three months on their website. I will try to explain to our readers’ how the exchange rate market works within the banking system. I am not an expert in the forex market, though but I do have a reasonable understanding as to what determines the price a bank buys or sells foreign exchange to its customers.
Basically, there are about five main foreign exchange sources that are open to any commercial bank in the country. It may be more than that depending on the ingenuity of the bank and their aggressiveness. First, BoG sells forex to banks whenever it has excess reserves, there is also cash- importation by banks on their own, which was recently re introduced after a two-year ban by the central bank. The third one is through export proceeds from banks’ customers who engage in exporting goods or services.
There are inward remittances through money transfer operators like Western Union, Money Gram etc. which banks receives on behalf of the recipient which they pay the local currency equivalent in exchange. The last one is through foreign direct investment, either from a customer that is starting a new investment in the country by routing the money through a bank or an existing company that is increasing its capital base or the bank itself when they want to raise additional capital either through private placement or contracting a loan from foreign lenders. In all of the above sources, the only one Bank of Ghana have full control over the determination of the rate is the one BoG sells to the banks. All other sources, commercial banks are at liberty to fix the rate at which they want to sell or convert the hard currency into local for their customer which is within a particular interbank- determined range.
When a bank is in short supply of forex, the bank will arrange with other banks through interbank forex market to buy either for itself or on behalf of customer at the going market rate. There is no fixed rate for this you may have to talk to two or more banks to get an idea of what is going market rate for the day is. We must not forget that these banks are profit-conscious just like every rational investor. They also operate like a cartel. They look at the trend in the market to learn what demand -pattern is before fixing their rates. You can see this profiteering tendency reflected in the results most of the banks are declaring on regular basis, particularly the big-guns.
Blaming the central bank for the fixed nature of the exchange rates on their website may not be out of place, because they cannot be excused for not being on top of their supervisory or regulatory oversight functions. They are working with outdated or incorrect figures from returns filed by these banks profit driven banks. These banks give BoG whatever exchange rates they like, since they know that bank of Ghana is not on ground to know what rate is ruling among the banks in the market at a particular time. Therefore, the banks can do whatever they like. That is the reason why BoG can be accused of massaging figures and you think that is very correct but the real massaging is coming from its ‘over pampered children’ which the father seems not to have enough control over.
The story is like that of the bible that says in the book of Ezekiel 18:2 ‘The fathers have eating sour grapes, and the children’s teeth are set on edge.’ But in this case it is the opposite. The children have eating sour profits and the father’s hands smells of feces.
These commercial banks have seen the loop holes in the system; they capitalized on the lax control of the forex market by the BoG. They are milking the economy by declaring super profits when the whole economy is anguishing in pains of economic hardship. This is what happened to the exchange rate market in the country, because someone was not on top of the situation. We allowed it to get out of hand and the bankers are smiling while the nation is crying.
Cedi redenomination of 2007
Looking at the redenomination angle to this exchange rate hiccup, one may argue that in 2007 when the country took the decision to redenominated its currency from the old cedi to the new Ghana cedi, we all agreed that it was a sound economic/political decision, there was an aspect that was not properly considered then, which was ‘what should be the realistic exchange rate for the cedi?’ I am sure if the people that took the decision to slash those three zeros from the previous 1,000 cedi were do a retrospect, they would realize that inadvertently or unconsciously they over valued the country’s currency as at that time. At the time of redenomination, cedi was made to be trading at 0.97 to a dollar. Technically, what we are saying with that robust exchange rate then was that Ghana cedi was far stronger than a US dollar or better still, our economy’s fundamentals was almost at par with the US economy.
I thought a reasonable and realistic exchange rate of 9.7 to USD would have been appropriate at the time of redenomination. That singular decision could have made more dollars available to develop the economy ten times more than it was then. We are supposed to be reaping the gains of that decision now. The people that enjoyed the windfall then using their small cedis to import plenty foreign goods are unfortunately the same people that are crying about the level of depreciation now. Instead of taking three zeros out at the time of redenomination, we could have taken two zeros and have something that is realistic and manageable. That would have saved all of us these massive headache and finger- pointing we are experiencing today.
In our local parlance we say ‘it is not the same day you abuse that big tree in the forest that it falls on you.’ What we are experiencing now may be a self correcting but bitter pill we must forcefully take to normalize our past ‘undeserved’ excitement as a result of the over-valuation of the cedi is not sustainable with the country’s present economic basics. I am not the only one with this particular opinion. I think a senior economist with IEA (Institute of Economic Affairs) also shared the same view with me.
We have enjoyed the windfall in days gone by; now the big tree we abused in the past is about to fall on us and everyone is running helter-skelter trying to take cover.
We may not be able to take such a bold decision to correct the ills of the past by reversing the initial wrong decision, but we can also allow the system to do ‘self-correcting’ up to the point we think it’s reasonable, sustainable and manageable and thereafter we collectively work hard to increase the country’s productivity level, so that when it reaches this predetermined equilibrium point it will be stable and enduring so that we can all have a sound sleep and forget about the issue of exchange rate.
How do we determine exchange rate in a country?
There are two ways the price of a currency can be determined against another. A fixed or pegged rate is one the government (central bank) sets and maintains as the official exchange rate. A set price will be determined against a major world currency (usually the U.S. dollar, but also other major currencies such as the euro, the pound, the yen or a basket of currencies).
Unlike the fixed rate, a floating exchange rate is determined by the private market through supply and demand. A floating rate is often termed “self-correcting,” as any differences in supply and demand will expectedly be corrected in the market.
The Economic Factors
The third angle to the issue is the economic factors. I will quickly summarize some of the factors that affect or determine the exchange rates of a country. This is not country’s specific. It affects all countries. The only difference between one country and the other is how they manage these factors, this will go a long way to either stabilize or cause the currency to be volatile for a period. They are both monetary and fiscal in nature. Note that these factors are in no particular order. These are issues that have contributed in no small measure to the instability in the exchange rate market in Ghana for some times now.
Differentials in Inflation
A country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. Those countries with 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. Our Inflation rate currently stands above 15%, no wonder the exchange rates and interest rates are very high. There is a strong correlation between inflation rate and exchange rate.
Differentials in Interest Rates
Interest rates, inflation and exchange rates are all highly correlated like I stated above. By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The 91 day Treasury bill is selling at about 26%. We all know that the interest rate in Ghana is one of the highest in the continent. If the Treasury bill rate which is risk free return is above 25% you should expect this type of reaction from the exchange rate because of the correlation angle we explained above.
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 deficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. In other words, the country requires 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
Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. While such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors. The reason? A large debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real dollars in the future.
Terms of Trade
A ratio comparing export prices to import prices, the terms of trade is related to current accounts and the balance of payments. If the price of a country’s exports rises by a greater rate than that of its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater demand for the country’s exports. This, in turn, results in rising revenues from exports, which provides increased demand for the country’s currency (and an increase in the currency’s value). If the price of exports rises by a smaller rate than that of its imports, the currency’s value will decrease in relation to its trading partners.
Political Stability and Economic Performance
Foreign investors inevitably seek out stable countries with strong economic performance in which to invest their capital. A country with such positive attributes will draw investment funds away from other countries perceived to have more political and economic risk. In our own case we experienced some long period of political logjam early last year during the election petition that gave some investors serious worries for about seven months. Such political uncertainty can cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries. This is also the affected the country in no small measure.
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. While exchange rates are determined by numerous complex factors that often leave even the most experienced economists flummoxed.
Criticism has never solved any problem anywhere no matter how constructive the criticism may be. The best approach is productive suggestions and forward looking recommendations that can turn things around for all of us in a short while.