Postby xtech » March 15th, 2016, 7:46 pm
Twenty three years ago, over the Easter weekend in April 1993, top executives of the Central Bank gathered with the leaders of the commercial banks at the offices of the Central Bank. It was an historic weekend in the annals of economic policy-making and public-private sector co-operation in this country. Trinidad and Tobago moved from an exchange rate system which had been pegged to the US dollar since 1976, and before that to the pound sterling, to one which would be allowed to vary.
Previous Policy Disasters
The move was fraught. Ten years earlier, the country’s foreign exchange reserves had begun a rapid decline as oil prices collapsed and fiscal deficits mounted. In the face of the seemingly unstoppable fall in reserves, the Bank, not without trepidation, considered the possibility and the modalities of devaluation as a means of dealing with the problem.
Initially, the George Chambers administration would not countenance touching the exchange rate. Instead, the Bank reluctantly agreed to expand exchange controls to merchandise imports with the introduction of the EC-Zero system. That proved to be a bureaucratic nightmare and a policy disaster. In another ill-advised move, a dual-exchange rate system was implemented in December 1985. The country’s foreign exchange reserves plunged from over US$3 billion in 1981 to less than US$500 million in December 1986, at which point the People’s National Movement (PNM) was swept ignominiously from power and the National Alliance for Reconstruction (NAR) took over the reins of government. The NAR administration unified the exchange rate at $3.60 in January 1987 and then devalued to $4.25 in April 1988.
But in April 1993, confidence was still low and battered following the terrible recession from 1984, which had caused massive erosion of wealth and incomes due to the devaluations, cuts in the salaries of public servants, the debt restructuring, the conditionalities imposed by the International Monetary Fund (IMF) programme, the introduction of value added tax (VAT) and, by no means least, the attempted coup in July 1990.
Liberalising the Capital Account
Returned to government in 1991, the PNM had included in its manifesto the “abolition of exchange controls”. When the Bank was asked to operationalise this, it sought clarity on what the government understood by “the abolition of exchange controls”. The Bank was told that all exchange controls were to be abolished, on both the current and the capital account, though it seemed to me that the implications of capital account liberalisation were not fully appreciated by the politicians.
To appreciate the enormity of this challenge, while many countries had adopted floating exchange rates since the breakdown of the Bretton Woods system in the 1970s, most retained controls on the capital account, that is transactions involving the movement of capital into and out of the country, for example, the ability to acquire a company overseas or even buy shares on stock exchanges abroad.
Japan, one of the largest economies in the world, maintained capital account controls at that time. Barbados maintains exchange controls on the capital account up to today. Movements of capital could exert significant changes in a freely floating exchange rate over a short period of time, with adverse impact on local prices of food and essential goods and could engender speculative pressures on the exchange rate.
How to Float?
If all exchange controls were to be abolished, how then was the exchange rate to be established from day to day? The Bank was of the view that the exchange rate could not be permitted to float freely. It would become a one-way bet and the exchange rate would plummet. While the country’s foreign exchange reserves were beginning to recover, they would not be enough to defend an exchange rate in free fall.
Intellectually, the Bank’s research department was fairly well prepared. We had done extensive research on exchange rate regimes, developed effective exchange rate indexes and studied the flows of foreign exchange into and out of the economy. Amoy Chang Fong, then director of bank operations, had an excellent grasp of the dynamics of the operation of the foreign exchange market. I myself had had a close look at the Jamaican system and was clear that it was not to be emulated.
Standard IMF prescriptions for a free-floating exchange rate would lead to disaster. We had had enough policy disasters in respect of the external accounts.
The critical difference between our foreign exchange flows and those of, say, Jamaica was that based on an arrangement made in 1969, long before floating was contemplated, oil taxes in Trinidad and Tobago were paid by the companies in US dollars. The Central Bank gets the US dollars and credits the government with the TT dollar equivalent. The Central Bank therefore holds a large proportion of the country’s foreign exchange reserves and is a net seller of foreign exchange to the commercial banks.
The second important institutional fact was that we had a small number of commercial banks who could easily be assembled around a table. In addition, our commercial bankers had historically been very co-operative and compliant in their dealings with the Central Bank, based in no small measure on the authority established and exercised over the banks by Victor Bruce in the early years. It helped, of course, that the Central Bank, as net seller, could exercise significant leverage in the foreign exchange market as well.
Based on these institutional facts, the new exchange rate system was constructed over that Easter weekend, trading in foreign exchange having been suspended for a week, from April 7 to 13. It involved firstly, an immediate adjustment of the exchange rate from $4.25 to $5.76, an adjustment that was thought to be sufficiently large and credible. The new exchange rate had to stick. A small adjustment would have lacked credibility and caused pressure on the exchange rate from the very outset. Too large an adjustment could reignite inflationary pressures. But the rate agreed on with the bankers was not arbitrary. The work done by the Bank’s research department had suggested a range for the real and nominal exchange rates which would be conducive to export promotion and the medium-term stability of the balance of payments.
Secondly, the commercial banks were not allowed to set a selling rate above a level signalled by the Central Bank. Doing so would prompt a very early call from the Central Bank. Thirdly, the banks got a very generous spread between the buying and selling rates. Fourthly, bureaux de change could be established on the grant of a licence by the Bank. This was intended to create an alternative source of foreign exchange to the banks but, in fact, has never been needed. Fifthly, banks were allowed to establish US dollar accounts in local banks for any individual or company. Sixthly, anyone could now legally establish a bank account overseas since exchange controls were abolished.
In addition to these institutional chan ges in the foreign exchange market, interest-rate policy and fiscal policy had to be supportive of the new regime. The differential between local and foreign interest rates had to be large enough to act as a meaningful disincentive to portfolio capital outflows, and fiscal surpluses would be helpful in restraining aggregate demand as the new regime settled down.
A Rare Policy Success
In this underachieving society, we have not had very many exemplary policy successes. The Pt Lisas strategy directed by Ken Julien in the 1970s was one, as was the introduction of VAT in 1989, architected by Selby Wilson and Michal Christian. The (managed) flotation of the TT dollar over that Easter weekend in 1993 was, in my estimation, one of the best planned and executed policy interventions undertaken since Independence. There were no leaks of what the Bank was planning. The details were kept within a very small group within the Bank. Of course, when the bankers were requested to cancel their plans for that Easter weekend and keep their top executives available, there was naturally much speculation. But there was little or no capital flight in the run-up to the suspension of trading and the meetings over that fateful weekend.
The managed float has also turned out to be highly successful, both on its own terms and compared with the experience of other developing countries which floated before and since. When the United National Congress (UNC) administration came to power in 1995, no attempt was made to interfere with the new regime. The nominal exchange rate has moved to $6.41 today, and while there are so-called “queues” for foreign exchange, the system has functioned well and remains stable. The country’s foreign exchange reserves today are high at US$11 billion. Moreover, foreign currency accounts in local banks held by ordinary citizens and companies now total over US$3 billion. Whether the real exchange rate is still appropriate is a complex question for another time.
This is an important 23rd anniversary which might perhaps otherwise pass unnoticed. Marking it can be a reminder that we are capable of doing things well in this country. Hopefully, this account of the floating of the TT dollar may also be a source of inspiration to those who even now may be trying to steer policy-making away from the voops, vaps and vikey-vie approaches of the last ten years, which have served us very poorly indeed.
Recently one of the ways of increasing the attractiveness of TT-dollar assets was by the Government placing some more high-quality state-owned or affliated companies on to the local stock market. That point was made due to the fact that the Governor of T&T’s Central Bank had noted that “US dollar assets are more attractive than TT dollar assets, prompting movements of portfolio capital in search of higher yields.”
As various authors have noted, one of the ways of treating with “the movements of portfolio capital” out of the country is to allow the depreciation of the domestic currecy as countries as diverse as Canada, Norway, Mexico, Nigeria and Colombia have done. It is noteworthy that T&T’s current foreign exchange system is nominally a floating currency, the purpose of which is that the TT-dollar is supposed to depreciate when the economy is weak and appreciate when the economy is strong.
The fact is that the Central Bank has taken a conscious policy decision to prop up the TT dollar by flooding the country with as much US dollars as prudence and watchfulness over the stock of foreign reserves dictate. Some describe this as a “dirty” float. It is, however, not the only option.
Another option would be for the Central Bank to moderate its interventions in the foreign exchange market and allow the TT dollar to find a level that more accurately reflects current macro-economic realities. One of the advantages of allowing a currency like the TT dollar to depreciate is that it would allow the Government to generate more TT dollars for the US dollars it earns from taxes on energy exports.
For example, for the 2015 financial year, the Government expects to earn about US$3.5 billion in taxes from the energy sector. At the current exchange rate—the commercial bank buying rate of $6.25 to US$1—that works out to be about $21.9 billion. If the TT dollar were to depreciate by 20 per cent—that is from $6.25 to $7.5 to US$1—the amount of TT dollars generated from the US$3.5 billion in energy taxes would be $26.25 billion.
But with sharp declines in the prices of oil and natural gas, it is quite likely that T&T will not earn US$3.5 billion from energy taxes during the 2015 financial year. If taxes from energy revenues declined by 20 per cent—that is by US$700 million from US$3.5 billion to US$2.8 billion—at the current exchange rate, the amount of energy taxes collected would decline to $17.5 billion. This would increase the Government's fiscal deficit for 2015 from $6 billion to $10.3 billion.
Assuming a 20 per cent decline in energy tax revenues, at the depreciated exchange rate, the amount of energy tax revenue the Government would collect (US$2.8 billion X $7.5) would be $21 billion, which is quite similar to the original revenue estimate. The problem with allowing the TT dollar to depreciate is that it would increase the cost of everything that is imported into T&T.
That would include everything from Carnival costumes to most of the food in supermarkets to big-ticket items like cars and white appliances (refrigerators, stoves, washing machines) and airline tickets. By immediately increasing the cost of most of the food the country imports, a depreciation of the TT currency would have a negative impact on low-to-middle income wage earners, who would immediately see an increase in their food bills and therefore a reduction in their disposable income.
The depreciation in the TT dollar, in theory, would make wheat, oil and rice more expensive, which would automatically increase the cost of some of this country's favourite dishes such as rotis, doubles, bakes and pelau. The cost of eating out would go up commensurate with the size of the depreciation.
Also likely to face immediate increases would be the cost of transportation for people who depend on taxis and maxi-taxis to get to and from work as the owners and/or drivers would argue that the rise in the cost of their spare parts should be compensated by them being allowed to charge more. In that sense, because a depreciation would lead to increases in food and transportation costs, it would be viewed as a negative and politically undesirable.
Allowing the depreciation of the TT dollar, therefore, is not something that any prime minister or political party in power would be able to stomach comfortably in the year of a general election. Especially a prime minister, like Mrs Persad-Bissessar, who seems extremely wary of dealing with anything that may be the least bit controversial.
But on the other hand, faced with sharp increases in the cost of imported products, the rational consumer would switch to locally produced vegetables and food and postpone the big-ticket items (such as the acquisition of the new cars, white appliances and foreign vacations). This may lead, for example, to consumers choosing to buy fewer rotis and pelau (made from imported rice) and choosing instead more locally produced vegetables and rice.
There is also a possibility of the Government providing a direct subsidy to the National Flour Mills, along the lines of the three price discounts that the majority state-owned milling company was mandated to provide in the last 12 months. The response by consumers to higher prices of imported goods and services would lead to a reduction, over time, in the demand for foreign exchange.
It would also spur the production by the domestic manufacturing and service sectors of local replacements of foreign goods and services, as happened when the TT dollar was originally floated in April 1993. By increasing the cost of acquiring US dollars, a depreciation is also likely to mean a slowdown in the capital flight that Central Bank Governor Jwala Rambarran referenced in his now controversial December 1 speech in Chaguanas.
If allied with policies that increase the attractiveness of TT-dollar assets—both bonds and equities—allowing a depreciation of TT-dollar may actually lead to a reversal of capital flight as local managers of portfolios and high-net worth individuals see opportunities to make money. But the question that T&T needs to ask and answer is whether allowing a depreciation of the TT dollar would have a negative and long-term impact on the rate of inflation.
Dr Terrence Farrell, in a newspaper commentary to mark the 20th anniversary of the flotation in April 2013, reminds us that the Arthur NR Robinson administration “unified the dual exchange rate at $3.60 to US$1 in January 1987, and then devalued to $4.25 in April 1988.” This means there was an 18 per cent devaluation of the TT dollar in April 1988.
According to the Central Bank’s July 2006 Public Education Pamphlet on “Inflation,” the inflation rate in 1988 was 7.8 per cent and in the two years following it was 11.4 per cent and 11 per cent. Farrell also notes that the April 1993 flotation led to an immediate adjustment of the exchange rate from $4.25 to $5.76 to US$1—which was a 35.5 per cent depreciation, by my calculations.
The Central Bank document states that in 1992, the year before the flotation, T&T’s inflation rate was 6.5 per cent. It increased to 10.8 per cent in 1993 (the year of the flotation), but declined to 8.8 per cent, 5.3 per cent and 3.3 per cent in 1994, 1995 and 1996.
This seems to indicate that although the T&T dollar depreciated by 35 per cent in 1993, the impact of the price adjustments was only experienced in the year of the flotation and thereafter inflation moderated. (The rate of inflation in 1997 and 1998 was 3.6 per cent and 5.6 per cent).
Deputy Central Bank Governor, Dr Alvin Hilaire, in an April 2000 IMF working paper titled Caribbean Approaches to Economic Stabilisation, compared the approaches of four Caribbean nations, Barbados, Jamaica, Guyana and T&T, to structural adjustment in the 1980s.
Hilaire states that T&T chose discrete devaluations in 1985 and 1988 and then floated the currency in 1993. He said that between 1987 and 1998, the value of the T&T dollar to the US dollar moved from $3.6 to $6.3—which from my calculation is a 75 per cent decline.
This is not to make the point that the flotation alone was responsible for the moderation of prices in T&T as the country experienced significant trade liberalisation as well as fiscal adjustments in that period (such as the simplification and reduction in the income tax system and the introduction of the Value Added Tax system). It is only to make the point that, in certain circumstances, spiralling inflation is not a necessary consequence of depreciation.
