Professor Seid Hassan’s Essay on the Devaluation of the Birr
I am submitting this short note to point to some technical errors in Professor Hassan’s most recent contribution reminding us once again that given the structure of the Ethiopian economy, devaluing the Ethiopian birr is more likely to aggravate the already high level of inflation and result in other adverse disequilibria than improve the competitiveness of Ethiopia’s exports. I should state at the outset that I have no quarrel with the essence of his conclusions regarding the likely consequences of an announced discrete devaluation for the country’s trade balance and for the stability of domestic prices. I am an admirer of Professor Hassan’s commitment for the wellbeing of our people and our native land. However, given the high regard the public accords his observations on the economy of Ethiopia, I believe it is important for any errors to be corrected.
Professor Hassan’s piece contains technical errors which misinform the reader on the nature and mechanics of currency devaluation and depreciation. According to Professor Hassan, the World Bank recommends that the birr be devalued by 10%. Many people, including some professional economists, have a fit trying to explain what a 10% devaluation means exactly. Almost everyone gets the sense that it implies the currency (the birr in this case) will lose 10% of its value. But the problem arises when you ask whether that that means: (a) it take 10% more birr to buy the same amount of foreign currency or (b) you get 10% less foreign currency for the same amount of birr. And these two notions describe two very different outcomes.
The exchange rate of a country’s currency is best stated as the amount of foreign currency which could be bought with one unit of the domestic currency. For Ethiopia, the exchange rate of the birr in terms of the US$ is expressed as the amount of US cents which be bought with one birr. If the birr is devalued, each birr fetches fewer US cents. As such the rate of devaluation is correctly stated as the reduction in the amount of US cents which could be exchanged for one birr after devaluation expressed as a percent of the number of cents which were traded for one birr before the devaluation.
Let us take a very simple illustration. Suppose the exchange rate yesterday was Birr10/US$1 and today the rate changes to be Birr20/US$1. If you apply Hassan’s illustration, this will look like a 100% devaluation. But in fact, in order to determine the magnitude of the devaluation implied by this example, you would need to first restate the exchange rate as US cents per birr rather than birr per US$. Stated in this way, the exchange rate yesterday was US$0.10/Birr1 (ten US cents per one birr) and the exchange rate today is US$0.05/Birr1 (five US cents per one birr). You can now calculate the devaluation of the birr or its loss of value as the percentage reduction in the US cent you could buy with one birr: (US$0.10-US$0.05)/US$0.10, which equals to 50%.
The error in Hassan’s approach means that he miscalculated what he called the stealth devaluation of the birr between the last official devaluation and today to be 21% instead of 17.3%. Many media outlets similarly misreported the magnitude of the devaluation which the nation orchestrated in 2010 to be about 16% when in reality it was well over 20%.
Hassan agrees with the World Bank that the birr is currently overvalued and I suspect they are both right. After all, overall prices have been rising at or near double digit rates per year since the last devaluation while the exchange rate has been has been depreciating by an average of about 4% per year during that time. However, Professor Hassan makes another significant mistake when he attributed the current overvaluation of the birr to the “influx of remittances and foreign aid”.
By definition, overvaluation implies that the official exchange rate of a currency is higher than what can be justified by the demand for and supply of foreign currency in that country. It is true that in recent years, the flow of remittances through official channels has increased dramatically, as has the flow of foreign capital from loans and grants. These developments have substantially increased the inflow (supply) of foreign currency to Ethiopia. It so happens that for reasons that need not be argued here, the demand for foreign currency has increased at an even faster pace over the last several years resulting in an imbalance in the flow of foreign currency into and out of Ethiopia and creating a downward pressure on the exchange rate of the birr. Had it not been for the hefty increase in remittances and foreign aid, the noted imbalance in currency flows would have been even wider. Consequently, except if the authorities allowed the birr to depreciate at an even faster pace, the overvaluation of the birr would have been much worse without the hefty increases in remittances and foreign aid. These developments in remittances and foreign aid did in fact significantly mitigate the degree of overvaluation the birr in the face of sustained inflationary pressures. Professor Hassan wrongly states that such developments contributed to the overvaluation of the birr.
I trust that the authorities have not forgotten the lesson of the devaluation of 2010. It triggered a very painful cycle of inflation which brought the forward momentum in the economy almost to a halt. Instead, the authorities should persist on their course of controlled depreciation of no more than one or two percent per month while keeping their eyes squarely focused on domestic prices, job creation and economic growth. Exchange rate manipulation can serve as powerful economic tool only those countries where manufactures constitute a large segment of the country’s exportable. Of course this is the stated medium term aspiration of the Ethiopian authorities. Until we get there, its best for the country to pursue other avenues for increasing the value and volume of the non-manufactured exports.
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