© 2020, Farok J. Contractor, Rutgers Business School
In many dozens of emerging nations, perhaps as many as sixty of them, the government interferes in the foreign exchange market to prevent, or delay, the devaluation of its currency.
Featured Image Credit: ngcoin.com
A recent article from the Financial Times (FT) about Argentina’s peso is yet another illustration of government meddling. It is illuminating, but also sad, because it seems “history is repeating itself”—not only in Argentina, but across the emerging world. The Argentine government has been allowing only a “…depreciation in the peso of about 2 to 3 percent a month,” which is still slower than its inflation rate of 53.4 percent in 2019 (and likely higher now), thus resulting in overvaluation of the peso.
The Effects of Overvaluation of a Currency
- With currency overvaluation, exports are hurt because at the official exchange rate the dollar earnings of exporters convert into fewer dollars than they should (compared with the purchasing power parity [PPP] exchange rate that would prevail if the government did not meddle).
- Import demand is unnaturally high because at the official exchange rate imports look artificially cheap.
- For a while, the country can meet the excess import demand by drawing down previously accumulated dollar reserves from its central bank and supplying dollars through the banking system to prospective importers.
- But if dollar reserves are almost exhausted, then the government can ask for a loan of dollars from the IMF or try to float a dollar-denominated loan in, say, the New York bond market. (But such a temporary fix can go only so far because the time comes when nobody wants to loan any more dollars to the country, fearing it may just default on its loan obligation. )
- Sooner or later, because the country does not earn enough hard currency from its reduced exports, there will simply not be enough dollars (hard currency) to meet the import demand, and then the government has to do something to slow down imports. Hence…
- A rationing system is instituted so that at the bank only privileged, high-priority importers get dollars at the favorable official exchange rate, while other low-priority requesters are denied any allocation of dollars (hard currency) at the bank. The companies and individuals who are denied may, if they are rich enough or desperate enough for an import, look to unofficial means to obtain dollars. Hence…
- An unofficial market in dollars emerges (the FT article says that the unofficial or parallel market exchange rate—in pesos per dollar—is more than double the official rate).
Source: Perez, S. (2020). Argentina, running low on dollars, faces fresh economic turmoil. Wall Street Journal, October 15.
- Finally (by November 2020, the FT predicts), the situation becomes untenable because hard currency export earnings fall so low that the dollars the country earns do not even cover absolute necessities, such as medicines, energy, components, or finished products to keep the economy going. That leads to…
- A sharp devaluation, which the government wished to avoid, but ultimately could not prevent.
This post raises some questions, which I may address in a future post:
- If such bad effects occur from a policy of overvaluing the currency, why then do so many countries do it?
- Why do the IMF and lenders in the bond market keep loaning money to countries like Argentina, especially when they know that Argentina has defaulted on its repayment obligations seven times in the past?
 Mander, B. (2020). Argentina on ‘collision course’ towards currency devaluation. Financial Times, October 13.
 Argentina has defaulted on its international debt obligations at least seven times.
 Also see my 2019 posts:
- Advantages and Drawbacks of Undervalued Versus Overvalued Currencies
- Is the Indian Rupee Undervalued or Overvalued? What Purchasing Power Parity Theory Tells Us
- Trump Administration Labels China a “Currency Manipulator”: What’s behind the accusation, and who’s right?