The value of a currency, measured in terms of other currencies, has consequences for the real economy. A more expensive lari, for example, makes it more profitable to import goods into Georgia. The importer has to pay the foreign goods with foreign currency, and when the lari is more valuable, less lari are needed to pay for them. Driven by competition, importing companies will forward some of this cost reduction to the consumers and charge lower prices for imported goods.
At the same time, an appreciation of the lari puts a burden on exporters. A bottle of good Georgian wine has production costs of, say, 6 lari, and a foreigner who wants to buy that bottle now has to spend more of their own currency in order to cover those production costs (of course, the final price must also include transportation costs and a markup for the producer).
In reverse, a cheaper lari creates difficulties for importers and helps exporters.
Given the relevance of the exchange rate for the real economy, it is an important question whether and how a central bank should try to influence the exchange rate of its currency. Specifically, should the National Bank of Georgia (NBG) try to fight the recent lari depreciation?
FIXED, FREE, AND MANAGED
The NBG can influence the exchange rate of the lari by selling lari or selling foreign currency. By the law of supply and demand, the first measure leads to a devaluation of the lari, while the second will cause an appreciation. However, there is an important asymmetry here. While the NBG can sell virtually unlimited amounts of lari (it is the privilege of the NBG to create lari), it can only sell as much foreign currency as it holds in stock.
There are three positions a central bank can adopt. One possibility is to completely refrain from any interventions that are aimed at influencing the exchange rate. This is called the free float policy. Another possibility is to let market forces rule but only within certain boundaries. The central bank sets a target zone for the exchange rate and only intervenes when the exchange rate threatens to move out of the target zone. This is called a managed float, and this is the policy adopted by the NBG. Finally, a central bank can also subscribe to a fixed exchange rate regime, which means that it commits to exchange its currency at a constant rate.
What are the advantages and disadvantages of the three approaches?
The fixed exchange rate regime has the clear advantage that it removes uncertainty. Foreign investors will be more inclined to convert their currency if they think that they can reconvert it at any time without making losses due to a devaluation that happened in the meantime. This effect, however, only takes effect if a central bank credibly claims that it will maintain the fixed exchange rate. This credibility is not always given, as it happened often in history that central banks were forced to abandon a fixed exchange rate regime.
Fixed exchange rate regimes are always at risk of inviting currency speculation. This relates to the fact that, as mentioned above, while a central bank can easily reduce the value of its currency, its potential to increase its value are limited by the amount of foreign currency it holds. When, for example, the Mexican Peso was pegged to the US dollar in 1994, speculators all over the world borrowed Peso from Mexican banks, brought it to the Mexican central bank and converted it into dollar at the fixed exchange rate. At one point, the central bank ran out of dollars and could not sustain the fixed exchange rate anymore. As a result, the peso crashed, and the speculators only needed a small fraction of the converted dollars to pay back their peso debts.
A freely floating exchange rate does not allow for speculation, and it automatically stabilizes the trade balance. When a country imports more than it exports, this exerts pressure on its currency to devaluate, which, by the mechanism we described above, will strengthen exports and make imports more expensive. This mechanism pushes the trade balance always towards equalization.
Another advantage of a floating exchange regime is the so-called monetary independence. Maintaining a fixed exchange rate puts tight restrictions on what the central bank can do. For example, a reduction of the interest rate could cause people to sell domestic currency, leading to difficulties for the central bank to sustain the fixed exchange rate. When the country is not obliged to maintain a certain exchange rate, the central bank can freely use its monetary instruments, in particular the interest rate, for fostering whatever economic goals there are.
Finally, if the exchange rate is freely floating, there is no need to accrue large amounts of foreign currency. These are only needed for interventions, which, by definition, do not occur in a free float system.
The managed float, adopted by the National Bank of Georgia, combines the “best of all worlds”. Through interventions, the exchange rate is not as volatile as it would otherwise be. Uncertainty is reduced. There is not a huge potential to speculate against the lari, and the NBG retains a lot of monetary independence. Moreover, the amount of foreign currency the NBG has to keep in store is limited.
SHOULD THE NBG ACT NOW?
Ignoring short-run fluctuations, the value of the lari vis-à-vis the dollar has been going downwards since the beginning of November 2013 (see the chart). This pressure to devaluate not only hit the lari, but also the currencies of many other emerging economies around the world. The South African rand started to lose value at approximately the same time as the lari, and the Turkish lira was captured by this trend around mid-December.
The downward movement of the lari does not necessarily cause problems in itself. As was explained above, if the lari devaluates, Georgian products gain competitiveness on foreign markets. Also the increase in import prices is not something one has to be overly concerned about. It fosters “import substitution”, i.e. the replacement of imported goods by domestically produced Georgian goods. Due to the downward trend of the lari, we will soon find more Georgian products in the shelves of the supermarkets, in particular things that the Georgian economy can do well (e.g. foodstuff).
The devaluation is arguably just a symptom of another development, namely the large-scale withdrawal of capital that was invested in emerging economies. As long as interest rates were at unprecedented low levels in Europe and the USA, investors were incentivized to bring their capital to countries like Georgia, convert it to lari, and deposit it on a high interest rate lari account. The huge interest rate difference compensated for the risk associated with the investment in an upcoming country like Georgia.
As the policy of “quantitative easing” in the US seems to come to an end, there are expectations that interest rates in the USA will return to more normal levels. In anticipation of this, people reconvert their lari into dollars and withdraw them from Georgia. In the preceding week, the central banks of Turkey and India reacted to this very development by sharply increasing interest rates, providing an incentive to not pull capital out of their countries.
In our opinion, however, if the NBG would do the same, it would be a rather ambivalent measure, as it likely fails to resolve the shortage of capital in the Georgian economy. It may even aggravate the problem. While higher interest rates would counter the capital movements “out of the lari”, they would arguably not help Georgian companies to get loans for acceptable interest rates, as the interest rates faced by local firms are correlated to the interest rate set by the central bank.
The NBG has already two times sold 40 million dollar to catch the USD/GEL exchange rate at 1.7762. This was probably a prudent measure for slowing down the depreciation and for preventing excesses and herding behavior. From now on, however, it may be better to refrain from further interventions and let the economy move into a new equilibrium.