Sunday 19 December 2004

Safeguarding the Lira`s Reputation

The Sunday Times of Malta 

 
Economists Prof Lino Briguglio and Gordon Cordina (The Sunday Times 12th December 2004 ` Some common sense about the exchange rate and competitiveness) give us a text book lecture on why the exchange rate policy should not be considered as part of a cure package to address our economic ills.

Regretfully they seem detached from economic reality as being experienced in the real economy, particularly in the productive sector that has to compete and win globally.

Briguglio and Cordina argue that the Central Bank would be breaking its promise if it endorses a devaluation of the lira. They argue that the ultimate aim of the rate of exchange policy should be to maintain currency stability. I totally agree with this but question whether stability should be kept in the nominal rate of exchange or in the real rate of exchange.

The Central Bank adamantly keeps the nominal rate of exchange pegged and seems unconcerned that our real rate of exchange has overvalued itself by 11% (until July 2004) over its 1995 base and is likely to continue spiralling upwards as our inflation exceeds that of competitor countries.

So whilst I fully agree that we should never have brought ourselves to the point where we require a devaluation of the lira to regain competitiveness, the fact is that we are in a state where the lira is seriously misaligned against its real value because the Central Bank broke its promise to keep domestic inflation rate at a competitive level. And it did so in betrayal of its autonomous charter as its reduced interest rates to levels not justified by the huge fiscal deficit in order to make it easy government to borrow and delay the discipline to address the unsustainable fiscal imbalances.

I cannot therefore agree with Briguglio and Cordina`s appeal to leave the exchange rate policy in the hands of independent and capable central bankers. Experience shows that their claims for such attributes is at best doubtful.

Temporary exchange rate misalignments could normally be addressed by adopting anti-inflationary measures in order to gain an inflation advantage over competitors and regain competitiveness without the need to change the nominal rate of exchange computation. With international inflation at very low levels it is impossible to adopt this approach for three reasons. Firstly because if we go below the low inflation levels of our competitors we practically enter Japanese style deflation which is hardly an auspicious way to regain competitiveness.` Secondly because the misalignment is too big to address by attempting reversal of inflation differentials and it would take an inordinately long time to regain competitiveness without adjusting the nominal rate. And lastly there is nothing to suggest we can effectively regain an inflation advantage as the priority to address the fiscal deficit will generate impulses of price increases as subsidies get removed ( e.g kerosene measures in the last budget whose effect still have to show up in the retail price index).

When we have the sort of double percentage digit misalignment between the nominal rate and the real rate of exchange it is foolish and economically suicidal to continue denying the need to use the exchange rate policy as part of a package to regain competitiveness. Argentina`s experience in defending a fixed currency board between the peso and the US Dollar is a recent reminder of such failed policies.` Britain`s experience in ERM I which had to be aborted in 1992 is a more distant but equally suitable lesson from the past.

Cordina and Briguglio argue that devaluation benefits would be lost because wages would rise in response to cost of living impulses generated by the devaluation itself. These are unproven assertions.` Whilst such assumptions would hold if our economy were growing at a fast rate we have an economy which has not grown at all these last four years and which is running well below capacity.` The competitive gains generated by the devaluation would, I contend, in the large part be preserved as the economy has first to make use of its idle spare capacity before transmitting price increases down the line to the final consumer.

To a large extent the preservation of the competitive benefits flowing from a devaluation would largely depend on government taking other complimentary measures. Particularly as a major employer of a large unproductive sector, the government should lead by example and ensure that it does not give in to pressures to grant compensatory wage increases. Such stance could hopefully address part of the imbalances which exist between employment in the public sector, where the least productive are most protected, and the private sector where the most productive are the least protected. The excess protection of public sector employment should reflect itself in lower real wages, stimulating the shift of human resources to the private sector as the increased competitiveness of the latter gained through the devaluation stimulates demand for new employment.

Finally Briguglio and Cordina are kidding us when they state that our foreign reserves offer 109% coverage of foreign reserves for every Lm1 the Central Bank issued in the economy. The reserves are meant to service not just the balance sheet of the Central Bank but that of the entire banking sector.` The adequacy of the reserves should therefore be judged in comparison to the broad money supply as it is such money supply that has `the freedom to demand changeover from Lm to foreign currency. The percentage coverage here is low and falling and doubtfully sufficient to organise a smooth changeover to the Euro during the ERM II period.

Whilst I agree that exchange rate policy on its own would not produce a lasting solution I am afraid that in the situation we have been led into, without proper use of rate of exchange policy, any package that may be agreed would be missing an indispensable component for achieving real lasting solution.

On the other hand I can understand that those who want just cosmetics, holding their safe ground whilst blaming others for doing the same, are inclined to continue preaching from the mountain top that the nominal exchange rate is untouchable.

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