Part I: It Is The Economy
Depreciation of the cedi has been once more in the news recently. And we have heard the usual accusations, counter-accusations and equalizations about relative performance or competence of the NPP and NDC governments. As an economist, I feel obliged to step in and help throw light on the subject. I deem this necessary because politicians and their associates who usually lead these debates often lack the requisite technical knowledge and their arguments tend to confuse the public. I do this in two articles. The first part, which is contained herein, will focus on the relevance of economic fundamentals to the depreciation, which seems to have dominated the current debate. The second article, which will follow this one, will discuss alternative currency regimes to the current flexible regime. I try my best to reduce the technicalities of the subject to the extent possible so as to make it understandable to the ‘average Ghanaian.’
The recent depreciation of the cedi is certainly not new news. We have been here numerous times before. In fact, those who are old enough will recognize that the cedi has been depreciating since its inception in 1965. When the cedi was adopted in 1965 to replace the Ghana pound, it was higher in value than the US dollar. The exchange rate then was 1.00 cedi=1.17 dollars. Over the years, the cedi continued on a downward slope. Let us jump all the way to 2007, when the cedi was redenominated. The Ghana cedi that was introduced was defined such that it was higher in value than the US dollar. The exchange rate then was US$1.00=GHc0.92 (orGHc1.00=US$1.09). Let us say the exchange rate is currently around US$1.00=GHc5.35 (or GHc1.00=US$0.19). Then my maths tells mean that since redenomination, the cedi has depreciated by about 83%. This is a huge depreciation in 11 ½ years, recognizing that, mathematically, the cedi will vanish should it depreciate by 100%!
Causes of Depreciation
The question to ask is: what explains the incessant depreciation of the cedi? First, let us start from some basics. The exchange rate between the cedi and the dollar at any time is determined by the balance of supply of dollars to Ghana and Ghana’s demand for dollars. Supply of dollars comes mainly from dollars received from exports of goods, use of Ghanaian services by foreigners, investment flows into Ghana, remittance inflows, loans and grants. On the other hand, demand for dollars comes mainly from payment of dollars for imports of goods, use of foreign services by Ghanaians, transfers of dividends and profits earned by foreigners investing in Ghana, interest and amortization of loans. However, outside these recognized channels for dollar supply and demand, there could be in and out movements of dollars through other channels. Flows through such unofficial channels are usually referred to as ‘capital flight.’ While they may not be captured in official transactions records, these flows also ultimately affect the exchange rate.
It is a fact that the aggregate supply of dollars to Ghana on an annual basis has, more often than not, lagged aggregate demand for dollars. And it is the gap that pushes up the exchange rate or causes depreciation. The gap varies from year to year, but, generally, the wider the gap the higher will be the depreciation. So, basically, you can say that the cedi has been depreciating all these years due to the persistence of the dollar supply-demand gap. It will be useful at this stage to drill down even further to determine what drives the dollar supply and demand. Here, two explanations are of relevance. These are the macroeconomic fundamentals and structural fundamentals explanations.
The macroeconomic fundamentals explanation relates the dollar supply and demand—and therefore the exchange rate—to macroeconomic indicators. These indicators include economic growth, inflation, fiscal deficit, external deficit and international reserves. Economic growth entails higher output, some of which will be exported and enable you earn more dollars. It has also been hypothesized that economic growth will give you more income some of which will be spent on imports and therefore increase demand for dollars. But it is believed that the overall effect of will economic growth be net receipt of dollars, which will support the cedi. Inflation has the effect of making Ghanaian prices higher relative to partner-country prices, making imports more attractive and thereby increasing demand for dollars and thereby weakening the cedi. Alternatively, inflation reduces the domestic purchasing power of the cedi, and in a world of open trade, the cedi will also be weak externally. The fiscal deficit and its financing inject more liquidity into the economy, which has the potential to increase dollar demand through the inflation channel or through import demand and which will eventually weaken the cedi. The external deficit has a direct link to the exchange rate because it implies excess dollar demand, which should weaken the cedi. International reserves accumulated from excess supply of dollars can be used to support future demand for dollars and therefore help strengthen the cedi. Having macroeconomic fundamentals point in the ‘positive’ direction or being strong implies high growth, low inflation, low fiscal deficit, low external deficit and high reserves. These will support the cedi. On the other hand, when the fundamentals point in the ‘negative direction or are ‘weak,’ then the cedi is also expected to weaken.
The structural explanation of dollar supply and demand relates to the economy’s production and demand structures. On the one hand, as explained above, the supply of dollars to Ghana depends to a large extent on the country’s capacity to produce export goods and the nature of those goods in terms of the values that they command on international markets. Here, we note that Ghana has continued to export largely primary commodities—cocoa, gold, oil, timber—which have low value-added and command low prices on international markets. As such, the country’s capacity to earn foreign exchange remains constrained. This has the effect of putting constant pressure on the exchange rate. On the other hand, the country is heavily dependent on imports of consumer, intermediate and capital goods as it lacks adequate domestic production capacity for these goods. The excessive demand for imports also has the effect of putting the exchange rate under constant pressure. Mr. Kenneth Thompson of Dalex FinanceLtd has a simple and poignant way of putting this one way traffic regarding imports versus exports that I find interesting and relevant here. He says that about seventy-five of the containers that bring imports to Ghana go back empty with only twenty-five percent of them carrying export goods. The volume of importer traffic going to China and Dubai these days is a clear sign of the volume of dollar demand and highlights the pressure it puts on the exchange rate. Ironically, it is these same traders who are most vocal in complaining about the cedi depreciation when they are a big part of the problem.
The macroeconomic indicators and structural factors, which determine dollar supply and demand—and eventually the exchange rate—constitute what are broadly referred to as the economy’s fundamentals. In November 2013, as a Senior Economist at the Institute of Economic Affairs (IEA), Ghana, I wrote a paper at a time when the cedi had come under substantial pressure titled: The Answer to the Cedi’s Weakness is to Address the Economy’s Fundamentals. In the paper, I discussed the effects of both macroeconomic and structural fundamentals. Appearing on CitiTv in January 2019 as a member of a two-man panel to discuss the economy, I was asked by the host, Ben Avle, whether I still stood by the argument I made in the paper, which he had researched. My answer was: “absolutely yes.” The Vice President is also quoted extensively as having said a couple of years back something to the effect that if the fundamentals of the economy are bad, the cedi or exchange rate will expose you. So the Vice President and I seem to be speaking the same language, i.e. the exchange rate is determined predominantly by the fundamentals of the economy. However, unfortunately, public discussion of this topic seems to have focused almost exclusively on the macroeconomic fundamentals to the exclusion of the structural fundamentals. The macroeconomic fundamentals alone cannot assure lasting exchange rate stability. The structural fundamentals should be right as well.
Through improved economic management, underpinned by strengthened fiscal discipline, the Government has managed to turn around almost all the bad macroeconomic indicators that it inherited in January 2017. Growth has increased; inflation has declined to single digit; the fiscal deficit has declined; the external deficit has narrowed; and international reserves have improved. Thus, the macroeconomic fundamentals have improved. This has supported the exchange rate, with less rapid depreciation. But is this enough to ensure lasting exchange rate stability? Certainly not. The cedi has come under pressure yet again in recent weeks. And what this should remind us is that the underlying structural export-production and import-demand weaknesses persist and will affect the exchange rate from time to time and unless they are permanently addressed.
To even complicate matters, it has to be said here that while the exchange rate is predominantly determined by the ‘fundamentals of the economy,’ other non-fundamental influences may be also at play from time to time. These other factors include: ‘shock factors’ such as commodity price slump, adverse foreign policy action (such as a hike in US interest rates that sucks dollars from emerging markets), adverse domestic political development (that may precipitate forex outflows), and Hajj pilgrimage (that may cause a temporary spike in forex demand) as well as ‘non-shock factors’ such as dollarisation of payments for goods and services (durable consumer goods, rents, hotel services, airline services, etc),speculation (that may involve betting on the cedi or demanding dollars to hedge against future depreciation) and underground financial flows.
To sum up briefly, the incessant cedi depreciation is the result of the influences of: a) volatilities in macroeconomic fundamentals; b) persistence of weak structural fundamentals; and c) non-fundamental factors.
Remedies for Depreciation
Remedies for the incessant cedi depreciation can be inferred from the factors identified above to be responsible for it.
First, it is important to ensure that the macroeconomic fundamentals are well-aligned. This requires,in the main, strong fiscal discipline. The Government has initiated commendable steps to this end, including passage of a Fiscal Responsibility Law that includes a budget deficit ceiling and formation of a Fiscal Policy Advisory Council. As the country approaches the end of the IMF program and the 2020 election looms large,it important to internalize fiscal responsibility and policy credibility that will create confidence in the investor community and support the exchange rate through both forex supply and demand channels.It is also important to intensify efforts to address the underlying structural weaknesses in export production and import-demand to support a strong cedi. In particular, there is a need for reinforced policies to diversify and add value to our exports while developing the domestic industrial base to reduce import dependence. Unless the economy is seriously transformed as suggested, the cedi will continue to depreciate even if the macroeconomic fundamentals improve.As to the non-fundamental factors, such as shocks, there is very little that one can do about them. Factors like speculation and dollarization, however, may even be symptoms of the wrong fundamentals and therefore may ease as the latter improve.
I must say here that the public anger that is usually vented on Bank of Ghana when the cedi shows marked depreciation is misplaced and unjustified. The Bank of Ghana Act mandates the Bank to “promote by monetary measures the stabilization of the value of the currency within and outside Ghana.”The Bank is to “promote stabilization” of the currency. This is not the same asking itto “stabilize the currency.” And in any case, the Bank has very limited instruments at its disposal to carry out this stabilization promotion mandate. These are essentially the Policy Rate and international reserves. The Policy Rate has multiple targets, including price stability and economic growth, and, therefore, it cannot be devoted exclusively to the exchange rate. The reserves in Bank of Ghana’s custody are usually limited as they reflect the country’s overall forex supply and demand balance. Therefore, the reserves can be deployed in the foreign exchange market only to a limited extent. Indeed, Bank of Ghana’s interventions in the forex market, beyond helping to support the usual demand for foreign exchange, will normally aim to counter temporary shocks that may not be related to economic fundamentals. The Bank does not have the capacityand it will even be counterproductive for it to resist exchange rate movements driven by economic fundamentals.
As explained in detail above, the exchange rate is determined by a whole range of fundamental and non-fundamental factors, which are not under Bank of Ghana’s control.Therefore, the next time we encounter a deprecation episode, we should cast our minds to the following possible reasons: a) misalignment of the macroeconomic fundamentals; b)structural weaknesses in the economy; and c) any temporary shocks. Unless we address: a) and b) in particular on a durable basis, the cedi will continue to depreciate. Bank of Ghana may intervene from time to time to counter depreciation that is caused by temporary factors and unrelated to the fundamentals of the economy. In so doing, it may be able to stabilize the exchange rate for a while but the weak fundamentals will eventually kick in
I have to say here that almost all developing countries with similar challenging fundamentals are prone to perennial depreciation of their currencies. These countries continually face forex supply-demand gaps that constantly put pressure on their currencies. And Ghana is not an exception. In fact, if you look across small and open countries with flexible exchange rates, you realize that Ghana has even been doing better than many of them. This is not to take away the fact that we need to do better and the way to do that is to fix the economy’s fundamentals on a durable basis. Ultimately, it is the economy—stupid!
As I gave notice above, I will come up with a follow-up paper, which will look at alternative currency arrangements and whether any of them could be the answer to the perennial cedi depreciation that is happening under Ghana’s flexible exchange rate regime.
Author: Dr. J. K. Kwakye,
4th March, 2019