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Exchange Rate Appreciation in Armenia: Inevitable Trap or an Outcome of Bad Policies?

[March 19, 2007]

PART I

The events surrounding a rather dramatic appreciation of Armenia's currency, the dram, within the past 18 months or so have sparked a debate and stirred a lot of emotions in Armenia. Numbers have been quoted on both sides without providing much insight for non-economists to understand what those numbers could imply for the incentives of economic agents today or for Armenia's economy in the future. Within the scope of this article I will attempt to do just that. I will try to shed some light on why I think the policies accompanying the appreciation of the dram—with all its economic implications—were grossly inadequate to address the underlying causes of this appreciation. Without jeopardizing the strength of the overall argument and in order to appeal to a wider (non-technical) audience, I will refrain from referring to any statistics, since they are widely available through the Armenian and international sources—the economic intuition and some basic facts should serve us well enough here. We will look at the underlying theoretical arguments as well as discuss the peculiarities of Armenia's case in detail. Prior to arriving at our conclusions, we will also review the policy options available to the authorities—2 years ago when things were beginning to turn sour and even now—and test their performance against what I consider a logical course of action under the circumstances.

Facts and Basic Economic Theory

Let me start by listing all the facts and theoretical predictions that would be helpful in understanding the problem we have before us.

(1) Armenia receives a large (approximately one-fifth of its GDP—no more numbers, I promise!) and persistent amount of remittances each year. This is in addition to Foreign Direct Investment that the economy attracts as well as the official loans and assistance (mostly from the World Bank but also from G7 governments) which the budget receives.

(2) Capital inflows—especially ones of this magnitude—result in appreciation of the nominal exchange rate (defined as the amount of drams paid in the open market for one unit of foreign currency), since more foreign currency chases a fixed amount of domestic currency. If the prices of goods sold domestically do not adjust to reflect this change in the nominal exchange rate, the real exchange rate (defined as the amount of goods dram can buy domestically or the purchasing power of dram) too is bound to appreciate.

(3) The real exchange rate appreciation reduces external competitiveness and hurts the export-oriented companies by typically reducing the amount they sell abroad. It also makes imports cheaper and, therefore, leads to a bigger flow of imports. The combination of fewer exports and more imports leads to larger trade deficits.

(4) If deemed necessary, and under the right circumstances, monetary, fiscal, as well as structural policy measures can be used to prevent the exchange rate from appreciation and mitigate impact of appreciation on the trade balance and domestic economy (i.e., growth).

Bases for Evaluation

Before we turn to the question of appropriateness of the policy response under these circumstances, let me offer you some criteria to judge the need for any policy intervention. Indeed, one would have to answer the following sets of questions before we even get to the issue of policy response:

(1) Is the net benefit to the economy from an exchange rate appreciation positive or negative? It may well be that the policymakers could see things differently and decide not to intervene thinking that the net impact of the economy from appreciation is positive.

(2) If the net effect of the appreciation is negative, under which circumstances would it be reasonable for the authorities to intervene and try to reverse the appreciation and mitigate its negative consequences? After all, it may well be that while the overall impact is negative, interfering with the outcome may not be optimal, or the tools available to policymakers would not be effective in addressing the situation.

The first question is relatively straightforward to answer. Most macroeconomists would agree that the benefits of the real exchange rate appreciation are few and far between. Most notably, they would include a lower price for imported goods measured in terms of domestic currency. This would typically result in more money in the pockets of domestic consumers (if they choose to continue buying the same amount of imported goods, because they are cheaper now) or more imported goods being consumed (as consumers substitute the more expensive domestically produced goods for the less expensive imported goods), or both. The overall price of the basket of goods and services consumed by individuals and firms in Armenia would go down in all cases. This would only happen, however, if domestic prices are allowed to adjust, that is, if the importers are willing to pass a share of the additional profit they are making on to domestic consumers by selling their goods at a lower price, consistent with a more appreciated exchange rate. Competition, however, is a necessary precondition for this to happen, as importers with monopoly power would not do this voluntarily but would rather continue charging the consumers the old prices in drams that prevailed before the appreciation.

However, if the domestic prices are not allowed to adjust because of the structural problems in the economy (e.g., monopoly power of importers, or “sticky” administrative prices for goods that have high import content, etc.), the appreciation will have no benefit for the domestic consumers and will be equivalent to a transfer (of wealth) from exporters to importers, with potentially serious and long-lasting repercussions for the economy. We will demonstrate this below.

Additional (if only rather artificial) benefits of the exchange rate appreciation include possible de-dollarization of the domestic economy (because persistent appreciation pushes people to keep more of their savings in domestic currency instead of foreign currency) and ease of servicing the government's foreign currency-denominated debt (because it takes the government less domestic currency to pay for a $1 of foreign debt). These are rather unimportant bi-products of the appreciation outcome, however, particularly in Armenia's case (where the Central Bank has a reasonable grasp on the conduct of the monetary policy and where the government's foreign debt level is low by any measure), and would be dropped from the discussion.

On the contrary, the cost of the exchange rate appreciation for the economy could be sizable and long-lasting. The most important component of it comes from the loss of profit margins and competitiveness that the appreciation results for exporters, that is, anyone who wishes to sell domestically-produced goods and services to foreign nationals (abroad or in Armenia). While the exact cost to the society as a whole—both producers and consumers (who actually work for those producers/exporters to earn their salaries)—is difficult to predict, this cost is likely to be sizable, and in a country with Armenia's level of financial sector development, also potentially irreversible. A producer that receives a significant portion of its revenues from the sale to foreigners and buys most of its inputs (i.e., raw materials and labor) from Armenia will see its profits shrink, because he is earning less in drams for selling his goods but continues paying the same amount of drams for its inputs. Beyond a point, the producer will start making losses. Let me demonstrate this with an example. A producer that earns 1,000 dram from selling his goods to foreigners (in exchange for foreign currency) and pays 800 drams in wages and raw materials (thus making 25 percent return on his investment), would see his profits turning negative if he is faced with a 30 percent appreciation: his revenues will now be 700 dram, while he will be forced to still pay 800 for his inputs. If this producer wishes to cut his losses, his response to the appreciation would be to either cut the level of production (to cut his total losses) or to switch to imported inputs of production to the extent possible, assuming that the prices of the imported raw materials are allowed to adjust and the imports are now cheaper. (In case you wonder, the exporter CANNOT charge higher prices for his goods sold abroad, because the prices of those goods are determined by the foreign market and are therefore outside of his control—he only takes those prices as given). If, however, the prices of imported goods were not allowed to drop at home with the exchange rate (as it is likely to be in Armenia because of the monopolized structure of the import distribution networks), the only choice he has is to cut the level of production. This would necessarily involve laying off some workers engaged in production. And while it is true that the laid off workers could have the benefit of access to cheaper imported goods they may no longer have the income to buy those goods. Not an easy situation to be in, is it? At the aggregate (i.e., macroeconomic level) this, of course, would translate into lower total output produced domestically and lower (or negative) GDP growth (depending where the growth would have been before the appreciation).

Critics would argue that the producers always have another option—they could invest in new technologies which could make them more efficient and help them “weather this shock.” However, investment is costly and few would argue that the best time to undertake investment is when your profit margins are taking (shall we say) a nosedive! Hence, while investing in new technologies remains a theoretical possibility, in reality—where producers are cash-constrained and access to credit is limited because of financial sector imperfections—this will remain only a wishful thinking.

Critics would also argue that the dram has been undervalued and the appreciation was inevitable. It may well have been undervalued, even though in general this is a very difficult call to make for the most sophisticated of the economists, since it requires good data and serious econometric analysis, which I have not seen yet compiled for Armenia. It is difficult for me to imagine the dram to be undervalued just by looking at Armenia's trade balance—Armenia's large and persistent trade deficit would suggest the opposite, and would be indicative of future pressures on the dram to depreciate (and NOT appreciate) to equilibrate the flow of goods in and out of the country and bring the trade balance to zero. To rephrase this, in circumstances where the demand for foreign exchange (i.e., imports) exceeds the supply of foreign currency (i.e., exports), the value of foreign currency relative to domestic currency would go up (and NOT down). In any case, even if the dram was undervalued (because there are arguably other factors at play in addition to the pressures from the trade account), this adjustment (to bring the exchange rate to a level consistent with the purchasing price parity) did not have to happen so suddenly and be a result of misguided policies even if the latter are a direct result of another, an independent, factor such as strong flow of remittances. In an economy like Armenia's (given its level of development), the appreciation would have come inevitably but gradually as a result of improvements in productivity and efficiency, a phenomenon called Balassa-Samuelson effect in economics.

to be continued

Njdeh Melkonian

Njdeh Melkonian is an economist based in Indiana, United States, who specializes in economic and developmental issues, including those facing the economies of transition.