Thoughts on Kwacha’s over-valuation
GC Matchaya
I may not claim to have a lasting answer to this question however given the silence I will try to give my sketch of ideas on this as follows. The concerns about the Mw Kwacha being held at some fixed but high level surely spring from many angles but possibly the most useful one for most of us is the effect of such an exchange rate regime on the Malawi’s national accounts analysed in the context of a nation that has more on its table (projects etc requiring increased government spending) to deliver.
As appoint of departure therefore it might be important to recap the basic major components of the two major accounts that may be impacted by the exchange rate regime more directly and these are the current account here proxied by the trade balance (value of exports-value of imports) and the capital account proxied by the value of capital inflows into Malawi minus the value of capital outflows to other countries. Now remember again that under a market determined exchange rate, the sum of the capital account and that of the current account should be zero and remember that these accounts move in different direction such that if one is positive, the other should be negative. Further remember that under a fixed exchange rate, the condition above does not hold anymore but rather, the sum of the current account and the capital account need to equal a change in national reserves.
Chabwino, suppose the price of Mw kwacha in terms of US dollar or other currencies has risen over some period i.e. the kwacha has strengthened against the dollar or other currencies, or is deliberately held at a higher value than its real market value, then it is important to bear in mind the following:
Firstly, the volume of Mw exports may go down because, if our exporters maintain their prices in Mw kwacha terms, then the price in US dollar or other currencies rises, which could be expected to reduce demand for our exports such that the volume of exports falls. Even if our exporters cut Mw kwacha price to maintain US dollar or other currencies’ price (to remain competitive) the demand may then not be affected, but exporting could become less profitable, and exporters may reduce supply, so the volume of Malawi’s exports would still fall. But to calculate the impact on the balance of trade, we are typically interested in the VALUE and not just exports (i.e. price times volume is our interest). It turns out that we cannot predetermine the impact of this on value because the value of Mw exports depends partly on the extent to which exports go down in volume. For example, if the Mw kwacha price is unchanged, then the US dollar or other currency price rises, volume falls, then value of exports (revenue from exports) may rise or fall depending on how far volume falls (hence depends on elasticity of demand i.e. the extent to which exports change given a change in prices).
Secondly, the price of Mw imports would go down because if the other currencies price of imports remains unchanged, then the kwacha price would fall though it depends on the pricing policy of firms importing into Malawi. The volume of Malawi’s imports would go up because if the kwacha price falls then imports could be expected to increase from the basic consumer theory; well assuming all through that we are dealing with goods that are normal. Nonetheless, here again, the value of imports in the wake of the fall in price of imports and an increase in volume of imports depend on the extent to which the price falls and to which the imports increase. This is an issue dependent on the price elasticity of Malawi’s imports.
Given this simple analysis, it may already have become clear that the current account proxied by the trade balance would change in a manner that we cannot know in the absence of further information on the elasticities of exports and imports. The current account depends on the values of exports and imports which, as we just argued have an indeterminate change. Since I also stated a priori that the two accounts (capital and current) related negatively, we know that the change in the Capital account will depend on the change on the current account and hence we cannot tell what will happen to it before hand. The information we need to finally resoulve the question of the impact of an over-valuation on the balance of payments is about the elasticities. As a general approximation, a depreciation of the currency, would improve the trade balance and hence the current account of the sum of the easticieties in question exceeded one (they call this the Marshall-Lerner condition).
The other impact of the over-valued currency is somewhat positive and is on prices (general price level or inflation). The general price level in Malawi may go down because the change in import prices in Mw kwacha terms would either be zero or negative. If import prices in Mw kwacha fall, domestic firms are likely to have to follow suit and reduce their prices to remain competitive. Thus there could be a possible knock-on effect on prices charged by domestic firms and on remuneration (?), reducing the general price level in Bingu’s economy. Whether this is generally good, depends on how many jobs are lost as result of not being able to earn more revenue from trade etc (recap the negative relationship that sometimes ensues between inflation and unemployment-the short-run Phillips curve).
Earlier I mentioned issues on the government’s agenda and I flagged projects for development that need government spending to execute. I have all along and throughout chosen not to talk of aid and donations as possible moderators in the BOP equations. I will continue to do the same below as I make an assumption of increasing expenditure. So, suppose the DPP government, in the bid to fulfil its promises on development, and in the wake limited external assistance, continued to spend more under a fixed exchange rate, one can assume that national income and output go up, but then provided that the Marshall Lerner condition holds, the balance of trade goes down because as income rises, immediately the demand for imports rises so the balance of trade deteriorates (in the short run).
The capital account will then need to go up because the current account would worsen due to the deterioration of the balance of trade. Of course the immediate effect of a worsening current account could be a fall in reserves, but as we know possibly, there is limit to how far reserves can be run down, therefore at some point the capital account would have to increase to balance out the fall in the current account. The capital account, if it may improve, short term interest rates would need to go up because an increase in capital inflows must be encouraged. Increasing domestic interest rates to encourage the purchase of financial assets and attract more foreign investment would be desirable, though this is not solid to lean on given that our financial markets are in the egg and that FDI flows in like milk from an ailing cow!!
In other words, given an overvalued exchange rate, and the need to increase government expenditure to meet development needs of the people, one can expect increasing current account deficits, which leads to some combination of declining reserves, increased capital account inflows and higher interest rates. The decline in reserves is limited by the stock of reserves available. The increase in capital account inflows can be sustained provided foreigners are prepared to lend. However, continued borrowing from anywhere increases outstanding stock of debt and of interest payments to overseas, which may not be desirable in the long run as essentially we would be strangling future generations with ngongole.
In Practice
Following the discussion above and the assumptions made, one can note the following crucial issues: whether the over –valued kwacha would indeed lead to a deterioration of the Current account depends on the elasticities of imports and exports. So, are the elasticities of agro-products such as tobacco, coffee, tea, sugar, uranium very high such that an increase in prices will lead to a massive drop in our exports (?), may be NO, in which case it’s possible that over valuation may not even negatively affect the trade balance. Even if it did, could such a small deterioration be of real importance to the fiscal stance of the nation? Maybe No, unless the effect is so much so that donor aid is not enough to compensate for the negative change in the trade balance (at present Malawi enjoys more donor aid due to prudent macro-economic management by the incumbent government). Of course an over-valuation could be deflationary, which is advantageous as well. There are basically several other issues to consider, let us stop here for now, but stay tuned!
Eh tu
I may not claim to have a lasting answer to this question however given the silence I will try to give my sketch of ideas on this as follows. The concerns about the Mw Kwacha being held at some fixed but high level surely spring from many angles but possibly the most useful one for most of us is the effect of such an exchange rate regime on the Malawi’s national accounts analysed in the context of a nation that has more on its table (projects etc requiring increased government spending) to deliver.
As appoint of departure therefore it might be important to recap the basic major components of the two major accounts that may be impacted by the exchange rate regime more directly and these are the current account here proxied by the trade balance (value of exports-value of imports) and the capital account proxied by the value of capital inflows into Malawi minus the value of capital outflows to other countries. Now remember again that under a market determined exchange rate, the sum of the capital account and that of the current account should be zero and remember that these accounts move in different direction such that if one is positive, the other should be negative. Further remember that under a fixed exchange rate, the condition above does not hold anymore but rather, the sum of the current account and the capital account need to equal a change in national reserves.
Chabwino, suppose the price of Mw kwacha in terms of US dollar or other currencies has risen over some period i.e. the kwacha has strengthened against the dollar or other currencies, or is deliberately held at a higher value than its real market value, then it is important to bear in mind the following:
Firstly, the volume of Mw exports may go down because, if our exporters maintain their prices in Mw kwacha terms, then the price in US dollar or other currencies rises, which could be expected to reduce demand for our exports such that the volume of exports falls. Even if our exporters cut Mw kwacha price to maintain US dollar or other currencies’ price (to remain competitive) the demand may then not be affected, but exporting could become less profitable, and exporters may reduce supply, so the volume of Malawi’s exports would still fall. But to calculate the impact on the balance of trade, we are typically interested in the VALUE and not just exports (i.e. price times volume is our interest). It turns out that we cannot predetermine the impact of this on value because the value of Mw exports depends partly on the extent to which exports go down in volume. For example, if the Mw kwacha price is unchanged, then the US dollar or other currency price rises, volume falls, then value of exports (revenue from exports) may rise or fall depending on how far volume falls (hence depends on elasticity of demand i.e. the extent to which exports change given a change in prices).
Secondly, the price of Mw imports would go down because if the other currencies price of imports remains unchanged, then the kwacha price would fall though it depends on the pricing policy of firms importing into Malawi. The volume of Malawi’s imports would go up because if the kwacha price falls then imports could be expected to increase from the basic consumer theory; well assuming all through that we are dealing with goods that are normal. Nonetheless, here again, the value of imports in the wake of the fall in price of imports and an increase in volume of imports depend on the extent to which the price falls and to which the imports increase. This is an issue dependent on the price elasticity of Malawi’s imports.
Given this simple analysis, it may already have become clear that the current account proxied by the trade balance would change in a manner that we cannot know in the absence of further information on the elasticities of exports and imports. The current account depends on the values of exports and imports which, as we just argued have an indeterminate change. Since I also stated a priori that the two accounts (capital and current) related negatively, we know that the change in the Capital account will depend on the change on the current account and hence we cannot tell what will happen to it before hand. The information we need to finally resoulve the question of the impact of an over-valuation on the balance of payments is about the elasticities. As a general approximation, a depreciation of the currency, would improve the trade balance and hence the current account of the sum of the easticieties in question exceeded one (they call this the Marshall-Lerner condition).
The other impact of the over-valued currency is somewhat positive and is on prices (general price level or inflation). The general price level in Malawi may go down because the change in import prices in Mw kwacha terms would either be zero or negative. If import prices in Mw kwacha fall, domestic firms are likely to have to follow suit and reduce their prices to remain competitive. Thus there could be a possible knock-on effect on prices charged by domestic firms and on remuneration (?), reducing the general price level in Bingu’s economy. Whether this is generally good, depends on how many jobs are lost as result of not being able to earn more revenue from trade etc (recap the negative relationship that sometimes ensues between inflation and unemployment-the short-run Phillips curve).
Earlier I mentioned issues on the government’s agenda and I flagged projects for development that need government spending to execute. I have all along and throughout chosen not to talk of aid and donations as possible moderators in the BOP equations. I will continue to do the same below as I make an assumption of increasing expenditure. So, suppose the DPP government, in the bid to fulfil its promises on development, and in the wake limited external assistance, continued to spend more under a fixed exchange rate, one can assume that national income and output go up, but then provided that the Marshall Lerner condition holds, the balance of trade goes down because as income rises, immediately the demand for imports rises so the balance of trade deteriorates (in the short run).
The capital account will then need to go up because the current account would worsen due to the deterioration of the balance of trade. Of course the immediate effect of a worsening current account could be a fall in reserves, but as we know possibly, there is limit to how far reserves can be run down, therefore at some point the capital account would have to increase to balance out the fall in the current account. The capital account, if it may improve, short term interest rates would need to go up because an increase in capital inflows must be encouraged. Increasing domestic interest rates to encourage the purchase of financial assets and attract more foreign investment would be desirable, though this is not solid to lean on given that our financial markets are in the egg and that FDI flows in like milk from an ailing cow!!
In other words, given an overvalued exchange rate, and the need to increase government expenditure to meet development needs of the people, one can expect increasing current account deficits, which leads to some combination of declining reserves, increased capital account inflows and higher interest rates. The decline in reserves is limited by the stock of reserves available. The increase in capital account inflows can be sustained provided foreigners are prepared to lend. However, continued borrowing from anywhere increases outstanding stock of debt and of interest payments to overseas, which may not be desirable in the long run as essentially we would be strangling future generations with ngongole.
In Practice
Following the discussion above and the assumptions made, one can note the following crucial issues: whether the over –valued kwacha would indeed lead to a deterioration of the Current account depends on the elasticities of imports and exports. So, are the elasticities of agro-products such as tobacco, coffee, tea, sugar, uranium very high such that an increase in prices will lead to a massive drop in our exports (?), may be NO, in which case it’s possible that over valuation may not even negatively affect the trade balance. Even if it did, could such a small deterioration be of real importance to the fiscal stance of the nation? Maybe No, unless the effect is so much so that donor aid is not enough to compensate for the negative change in the trade balance (at present Malawi enjoys more donor aid due to prudent macro-economic management by the incumbent government). Of course an over-valuation could be deflationary, which is advantageous as well. There are basically several other issues to consider, let us stop here for now, but stay tuned!
Eh tu
Very interesting observations. I think our imports and exports defy a devalution (though havent gone thr literature) but my quick look at our trade numbers confirms the reasoning.
ReplyDeleteSound macroeconomic stability that we have enjoyed seems key to me and the above averahe election we just had (by African standards) is value adding...but i reckon huge reforms in the financial sector including exchange controls plus mistrust bwetween businesses and government are part of this equation. I have no answer but i am following this with interest..sometimes our economy has defied economic logic
I agree with you. It is really because it is a very tiny economy, which is oon the receiving end, yet its activities have no effect on the world market. for example a devaluation to stimulate which exports NOW and to what extent should we devalue? The answers on elasticities of our imports and exports become important. Again if we consider that Malawi fails to even exhaust the quota of its allorted trade shares on the sugar and perhaps the tobacco markets, you wonder whether an exchange rate depreciation helps in any way. Yet we know that if the kwacha depreciates, the impact on imports will be instant, and Malawians will hurt greatly because we are generally an importing nation.
ReplyDeleteI will possibly post more views as soon as I get hold of more basic stats soon. cheers