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Georgia’s Currency is Much More Than the GEL/USD Exchange Rate

It is easy to understand what it means for an economy to be weak or strong. We know that a strong economy is characterized by low unemployment and high growth rates. Other desirable traits are, for example, low levels of poverty and income inequality, when all citizens enjoy reasonable standards of living. 

Things are less clear when we think about our national currencies. 

When designating currencies as “weak” or “strong”, we usually think of the exchange rate against the dollar or the euro. Having a “weak” currency sounds like a bad thing, whereas a “strong” national currency may be taken a signal of economic potency. 

The reality is much more complicated. In most cases, the nominal exchange rate of the lari against the dollar tells us very little about how well the national currency is managed. To evaluate the National Bank’s performance in this domain we should rather be looking at how the value of national currency and domestic prices evolve over time. 

The National Bank’s goals in managing the currency are to prevent sharp fluctuations in exchange rates, and keep inflation at bay. Neither of these is an easy task. Here are some considerations that policymakers need to take into account.


WEAKER OR STRONGER?

There are two important prices that can be used to gauge the international competitiveness of a country’s exports. First, one can use the nominal effective exchange rate – the exchange rate against a basket of the main trading partner currencies. An alternative is the so-called real effective exchange rate, which relates the country’s price level to those in the main trading partner countries. The key is to strike the right balance. 

On the one hand, if a currency gets weaker over time this may boost the country’s international competitiveness by making its exports cheaper relative to other alternatives. On the other hand, if the currency gets weaker over time, this may signal underlying problems in the economy, which can be totally independent of monetary policy. 

This is especially true for small developing economies like Georgia, that are often subject to economic shocks beyond their control - such as the ups and downs in the levels of capital inflows, and fluctuations in the external demand for exports. A weaker currency also makes it harder for the country to afford key imports, for example food, medicine, or hi-tech products that the country cannot produce itself. Thus, devaluation can lead to an increase in the prices of imported goods, causing a spike in inflation. 

Getting domestic currency stronger over time can also be problematic. A strengthening of the currency can make imports cheaper, hurting domestic producers – a phenomenon known as the “Dutch disease.” On the one hand, this means that imported production inputs (such as machinery) are becoming cheaper. On the other, however, this also implies that domestic producer of similar goods are priced out of the market. Once the currency devalues, over-reliance on imported goods (including production inputs) can lead to a collapse in industrial output. 

The story of Argentina in the early 2000s provides a cautionary tale. The country strived to maintain a fixed exchange rate with the US dollar for nearly a decade before 2001. In 2001, when the global economy faltered following the burst of dot-com bubble, investors were no longer willing to lend to emerging markets, putting the peso under serious devaluation pressure. The peso’s devaluation meant that critical production inputs imported from abroad were no longer affordable. As a result, domestic production came to grinding halt, inflation shot up and unemployment skyrocketed within months. 

Thus, as one can see, striking the right balance with exchange rates can be tricky. Central banks are usually aware of the trade-offs involved. Thus, instead of trying to control the value of the national currency, central banks prefer to “target” inflation. Maintaining domestic price stability and letting exchange rate float relatively freely is considered a more desirable monetary policy goal for central banks.


REDUCING EXCHANGE RATE VOLATILITY AND THE “OVERPROTECTION” DANGER 

Even under the inflation targeting framework, minimizing sharp exchange rate fluctuations can be quite important for a small developing economy such as Georgia. If a country does not have a developed financial system and/or has a highly dollarized economy, sharp fluctuations in the currency value can strain private businesses, consumers and the country’s banking system overall. 

To avoid sharp movements in the currency value, central banks in developing countries usually keep an eye on exchange rate dynamics even when claiming that their domestic currency is freely floating. 

Yet, the central bank has to be very careful not to “overprotect” the currency. In particular, they should avoid creating unrealistic expectations as to the possibility of maintaining the exchange rate at a particular level. Otherwise, relying on the government’s implicit policy, private businesses and consumers will have weaker incentives to hedge against currency risks. 

Georgia is a good case in point. Prior to October 2013 and November 2014 devaluations, the exchange rate fairly stable, fluctuating around 1.65 GEL/USD. This stability may have affected the market’s expectations about the value of the lari, causing households and businesses to ignore the currency risk when deciding on which currency to borrow in.

 

EVOLUTION OF THE LARI 

The public concern and the politicians’ urge to do something about the GEL/USD exchange rate is understandable given the the high dollarization rate (over 60% of bank loans are denominated in USD). 

In recent months, the National Bank of Georgia came under political fire for its response to the sharp lari devaluation against the USD in November2014-April 2015. The public, lulled by many months of exchange rate stability, was not prepared for the devaluation, and was naturally looking for ways to return to the status quo. 

For economists, however, the sharp depreciation of Georgian Lari against the USD and other currencies was no surprise. As the Euro started sliding sharply against USD in June 2014, it was a matter of time before the Lari followed suit.  After all, the Euro is the currency of one of Georgia’s largest trading partners and foreign investors, the EU. The value of the lari is therefore more “in sync” with the value of the Euro than USD, despite the high rate of dollarization. 

There are a few other reasons, mostly outside of Georgia’s control, for the lari to lose in value against other currencies. In particular, the price of commodities (such as copper) exported by Georgia have come down in recent month. Likewise, Georgia has been negatively affected by weaker demand in its traditional export markets (such as Russia, Azerbaijan and Ukraine). The economic slowdown in Russia and Greece has also affected the dollar value of remittances Georgia received from these countries. 

In this environment, trying to keep the GEL/USD exchange rate at the 2013-2014 level would have been a futile exercise, eroding foreign currency reserves and failing to “save” the lari exchange rate. The National Bank of Georgia’s policy of non-intervention was therefore both smart and justified. 

Using this bigger picture framework, the lari’s performance over the past few years can be viewed in a more positive way. Georgia was able to maintain inflation at an acceptable level, within the National Bank’s target range.

Given all the external pressures, Georgia was fortunate to avoid the fate of some of its immediate neighbors, such as Russia, which have seen their currencies tumble, bringing about inflationary pressurs and prompting sharp increases in lending interest rates. The fact that Georgia managed to avoid high domestic inflation, maintained acceptable levels of international reserves, and avoided speculative pressures on the currency market, speaks to the soundness of NBG monetary policy decisions so far. 

The key to improving the standing of the Georgian lari in the future lies with Georgia’s economic performance. The latter depends on the country’s success in attracting foreign direct investment, diversifying its non-commodity export base, improving labor productivity, as well as accumulating physical and human capital. 

In the meantime, the Georgian public would be well advised to end its obsession with the lari exchange rate and pay more attention to the bigger picture.

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Comments

 
Guest - JanFidrmuc on Tuesday, 15 September 2015 18:32

Good article. I wonder if dollarization (or euroization) might be the way forward, either by completely replacing the lari in circulation with dollars or euros, or via the currency board route. The former has been adopted by Monte Negro and Kosovo and has worked well there. The latter proved very successful in the three Baltic countries, all of which have graduated to full eurozone membership in the meantime.

In the context of a small open economy such as Georgia's, it's not clear whether the advantages of having a separate currency really outweigh the costs due to exchange-rate uncertainty, distortions, and conversion costs.

Good article. I wonder if dollarization (or euroization) might be the way forward, either by completely replacing the lari in circulation with dollars or euros, or via the currency board route. The former has been adopted by Monte Negro and Kosovo and has worked well there. The latter proved very successful in the three Baltic countries, all of which have graduated to full eurozone membership in the meantime. In the context of a small open economy such as Georgia's, it's not clear whether the advantages of having a separate currency really outweigh the costs due to exchange-rate uncertainty, distortions, and conversion costs.
Guest - Yasya on Tuesday, 15 September 2015 22:37

As far as currency is concerned I am of the opinion that adopting either USD or Euro may not have clear advantages for Georgia. The country is balancing its economic exposure between both Europe and Asia, through trade and remittances. And it is not sufficiently well integrated with either part of the continent. For example, remittances are about 8% of GDP, and nearly 45% of those are from Russia. Also, Azerbaijan and Tukrey, and now, increasingly, China are big trade destinations.
Plus, so far Georgia didn't have big problems with hyperinflation or chronic inflation to justify the trouble of moving towards the Euro or the dollar.

As far as currency is concerned I am of the opinion that adopting either USD or Euro may not have clear advantages for Georgia. The country is balancing its economic exposure between both Europe and Asia, through trade and remittances. And it is not sufficiently well integrated with either part of the continent. For example, remittances are about 8% of GDP, and nearly 45% of those are from Russia. Also, Azerbaijan and Tukrey, and now, increasingly, China are big trade destinations. Plus, so far Georgia didn't have big problems with hyperinflation or chronic inflation to justify the trouble of moving towards the Euro or the dollar.
Guest - Chase on Wednesday, 16 September 2015 14:57

I agree with Yasya that it wouldn't be the most advantageous. To add to the argument, I interviewed Matthias Matthijs of Johns Hopkins University a few months ago on the Euro crisis, and he made the excellent point that Georgia's sovereignty over currency matters much more than short and medium term shocks. Georgia's inflation and sovereign debt are at very healthy levels, because Georgia can still control the Lari supply to hit its target indicators. You can find the interview here.

http://www.iset-pi.ge/index.php/en/publications/iset-economist-blog2/entry/greece-and-the-eurozone-crisis

I agree with Yasya that it wouldn't be the most advantageous. To add to the argument, I interviewed Matthias Matthijs of Johns Hopkins University a few months ago on the Euro crisis, and he made the excellent point that Georgia's sovereignty over currency matters much more than short and medium term shocks. Georgia's inflation and sovereign debt are at very healthy levels, because Georgia can still control the Lari supply to hit its target indicators. You can find the interview here. http://www.iset-pi.ge/index.php/en/publications/iset-economist-blog2/entry/greece-and-the-eurozone-crisis
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