THE ECONOMIC IMPACT OF THE NOMINAL EXCHANGE RATE DEPRECIATION OF THE US DOLLAR

Transcription

1 THE ECONOMIC IMPACT OF THE NOMINAL EXCHANGE RATE DEPRECIATION OF THE US DOLLAR Tairi Rõõm The last decade has been characterised by a high volatility of the exchange rate of the US dollar against the Estonian kroon. In the years , the nominal FX-rate has ranged from kroons per dollar (1 May 1995) to kroons per dollar (1 July 2001). The maximum level of the exchange rate was 67.7% above the minimum level (see Figure 1) Figure 1. The monthly dynamics of the nominal exchange rate of the US dollar against the Estonian kroon between January 1994 July 2002 In the first half of the year 2002, a downward trend replaced the long-lasting upward trend of the dollar. Over the last six months, the exchange rate of the dollar has significantly fallen: in early July the dollar was 13% cheaper than in early February, ie the exchange rate fell between 1 February and 1 July from kroons per dollar to kroons. The lowest daily exchange rate of the dollar was registered on 19 July kroons. The last time the dollar was below that level was in November The depreciation of the dollar, taking place over the recent months, has been expected for quite a while already. Based on the log-term average euro/dollar FX-rate, the kroon (the euro) is still considered to be undervalued against the dollar. This is one of the reasons why analysts forecast a further decline in the exchange rate of the dollar. With this outlook in 31

2 No 1, 2002 view, this article analyses implications of the depreciation of the dollar on the Estonian economy. Advantages of the Depreciation of the Dollar The cost of dollar-denominated imported production inputs will fall and, consequently, the competitiveness of Estonian corporations is likely to improve. Table 1 displays the volume of exports and imports by main commodity groups and the key currencies in The data shows that dollar-denominated sales comprised a significant part in the imports of investment goods and other production inputs: the dollardenominated imports of machinery and equipment as well as metal and metal products formed up about a third (31.4%) of the total imports of these commodity groups. Therefore, it is likely that the depreciation of the dollar will enhance investments, which will involve a reduction of the production costs. As a result, the international competitiveness of Estonian companies is likely to improve. On the other hand, a rise in competitiveness will also depend on the extent the depreciated dollar will push production costs down for foreign companies that are competing with Estonian firms on export markets. Table 1. Estonia s exports and imports by key currencies in 2001 EUR and currencies pegged to the EUR exports imports USD and currencies pegged to the USD exports imports Other currencies exports imports Animal products 1, Vegetable products , Animal and vegetable fats and oils Prepared foodstuffs, beverages, spirits, tobacco , , Mineral products , , Products of chemical industry 1, , , , Plastics, rubber and articles thereof , Raw hides, skins, leather Wood and articles of wood 5, , Pulp, paper and articles thereof , Textiles and textile articles 4, , , , , Footwear, headgear Articles of stone, cement, ceramic products, glass , Precious metals and articles thereof Base metals and articles thereof 3, , , Machinery and equipment mechanical appliances, electrical 16, , , , , , Vehicles, aircrafts, vessels 1, , Optical, photographic, instruments measuring, checking , Arms and ammunition Miscellaneous manufactured articles 4, , Works of art and antiques Total 43, , , , , ,

3 Many import goods will become cheaper, bringing along an increase in the purchasing power of consumers. The depreciation of the dollar reduces importers costs, which should lower prices for final consumers. Table 1 shows that besides investment goods, dollar-denominated imports considerably exceeded exports in three main commodity groups: mineral products (primarily petrol and other fuels), household appliances and textile products. A decline in the fuel prices as a result of dollar depreciation, remains questionable as in the markets of different fuels suppliers in general have a monopolistic position in Estionia. Unlike companies, which are operating in the competitive environment, monopolies lack a stimulus to cut prices when their expenditures on production inputs decline. Judging by the history of the pricing policies of petrol station chains in Estonia, we can assume that hidden cartel agreements exist in the retail petrol market. The retail gas supplier in Estonia (Eesti Gaas) is in fact a monopoly. Also, many municipal heating companies have acquired a monopolistic position on the market. Due to the lack of competition, the depreciation of the dollar has not brought along a significant price fall in the retail markets of petrol and other fuels. At the same time, the oil price increase in the world market has substantially contained the impact of the depreciating dollar. In the retail markets of household appliances and textile products, companies operate in a competitive environment; therefore, it is most likely that the depreciation of the dollar will push the prices of these goods down. The average duration of the supply contracts between importers and distributors is the primary factor to determine how rapidly the decrease in the exchange rate will be reflected in the price level. Inflation will slow down and lower price pressure will have a favourable impact on the interest rates. The decrease in the prices of import goods due to the declining exchange rate of the dollar will hinder inflation both in Estonia and in Europe. This will increase the probability that the eurozone interest rates will remain low in the future as well. Consequently, the fall in the dollar FX-rate should also curb interest rates in Estonia. The continuously low interest rate level will encourage investments and boost economic growth. However, this positive impact could be inhibited due to the risk that such an economic growth is not sustainable. Low interest rates encourage domestic demand and if it is not accompanied by equal growth in external demand, the scenario of 1997 could reoccur: current account deficit could widen and economy overheat, which will be followed by a sharp economic contraction. The sustainability of Estonia s economic growth will also depend on whether the coimpact of slower inflation rate and depreciation of the dollar will cause the real effective exchange rate of the kroon (REER) go up or down. In the short term, the REER will increase if the dollar depreciates, whereas in the long term a rise in the effective exchange rate of the kroon will bring along a decline in the inflation rate pushing also the REER down. It has been found that in Estonia an increase in the nominal effective exchange rate (NEER) is followed by a decrease in the inflation rate with a four-month lag 1. 1 VAR-analysis yields that a one-percentage-point growth in the NEER of the kroon will make the inflation rate shrink by percentage points after four months. 33

4 No 1, 2002 The favourable impact of the depreciation of the kroon on foreign investments is ambiguous. If financial markets assume that the depreciation trend of the dollar continues, it is possible that investors will relocate their assets to European (including Estonian) capital markets. In the long term, the reallocation of foreign investments will be determined on whether the decline in the exchange rate of the dollar improves European growth outlooks compared to the United States. The decline in the exchange rate will push the relative value of the European assets upward and inhibit interest rate expectations, which should improve the growth outlook in Europe. On the other hand, the appreciation of the euro will simultaneously also curb the competitiveness of the euro area companies, which accompanied by shrinking export demand could deteriorate the economic growth outlook. In the short term, foreign capital is likely to move to European bond markets due to exchange rate changes. Rapidly falling equity markets make investors look for less risky investment opportunities and based on the assumption that the dollar will continue depreciating, the yield on European bonds exceeds that of the US. As the bond market in Estonia is very small, the movement of foreign capital to the European bond markets will not affect us directly. The impact of the appreciation of the kroon on FDI in Estonia is most likely insignificant, as the share of investments from the US and other countries settling in dollars has been modest. Disadvantages of the Depreciation of the Dollar The depreciation of the dollar will shrink Estonia s export demand. Figure 2 displays the nominal effective exchange rate of the Estonian kroon against the currencies of our major trading partners. Since February this year, the NEER has increased by 4%, ceteris paribus restraining export demand. Considering the industrial countries that are Estonia s major trading partners, the aggregate impact of the depreciation of the dollar on the NEER is close to zero. Changes in the exchange rate of the dollar have no direct impact on Estonia s exports to developed countries, whereas in the long term the depreciation of the dollar may have a more significant implication on the Western-oriented exports through a shift in the euro area s import demand. Which way the import demand will change depends on whether the favourable impact of the dollar s depreciation on the euro area s domestic demand can outweigh the deterioration in the competitiveness of the European corporations. The impact of dollar depreciation on Eastern- and Southern-oriented export demand can be evaluated through the change in the NEER against the currencies of the transition economies. Figure 2 shows that the nominal exchange rate of the kroon has increased against the currencies of Latvia, Lithuania and Russia in proportion to the drop against the dollar: since the beginning of 2002, the nominal effective exchange rate of the Estonian kroon against the currencies of transition economies has increased by about 13%. 34

5 15% NEER average against the currencies of developed countries against the currencies of transition economies 10% 5% 0% -5% -10% -15% Figure 2. The nominal effective exchange rate of the Estonian kroon against the currencies of Estonia s major trading partners between The economic conditions of the companies exporting to Eastern markets and/or competing with the imports from the Eastern markets will deteriorate. This could cause an increase in unemployment. These companies, which export their products for dollars and quote major costs (wages, production input) in kroons will suffer economic difficulties upon the depreciation of the dollar, unless they have hedged the exchange rate risk in foreign exchange markets. The likelihood that companies are exposed to such a risk is high: studies reveal that, as a rule, Estonian firms do not hedge their foreign exchange positions 1. The depreciation of the dollar can reduce the turnover of companies that export their products to CIS countries (Russia, the Ukraine) as, on the average, the consumers of goods exported to these countries are more price- sensitive and corporate profit margins are low. The adverse impact of the exchange rate change is probably the largest in the sector exporting fish and seafood products to the eastern markets. The depreciation of the dollar will also deteriorate the market position of the companies that sell their products in Estonia and compete with imports from Russia, Latvia, Lithuania and other transition economies (eg sweets and other foodstuffs, pharmaceuticals, etc). The external balance of the Estonian economy could deteriorate in the medium term, whereas the trade balance could exhibit a short-term improvement. The depreciation of the dollar will raise the nominal exchange rate of the kroon. In the long term, a rise in the exchange rate will widen the current account deficit, provided that the Marshall-Lerner criterion will apply. In the short term (before the depreciation of the dollar will affect trading volumes), the effect would be opposite: current account deficit would shrink as the appreciation of the kroon will improve Estonia s terms of trade. 2 The NEER of the Estonian kroon has been calculated against the currencies of six industrial countries (the USA, Finland, Sweden, Denmark, the Netherlands and Germany) and three transition economies (Latvia, Lithuania and Russia). 3 According to an EMOR survey in spring 2002, less than 10% of the companies with more than 20 workers hedge the foreign exchange risk. 35

6 No 1, 2002 In the international trade theory, the controversial impact of the falling exchange rate on the external balance, with an initial deterioration of the current account deficit followed by a recovery, is known as the J-curve effect (see Figure 3). A rise in the exchange rate will cause a so-called reverse J-curve effect. In the short term, both the value of exports and imports denominated in kroons will shrink but as dollar-denominated imports exceed exports more than twofold, the price effect will bring about the decrease in the value of imports, which exceeds that of exports. In the long term, the change in the relative prices of exports and imports brings along a change in the quantity of imported and exported goods the volume of exports will go down and that of imports up. Whether and how fast the current account deficit will start deteriorating will depend on the average duration of supply contracts and the elasticities of import and export demand, ie on whether the Marshall-Lerner criterion is satisfied. As a rule, the criterion is met if the coefficients of the import and export demand elasticities sum up to greater than unity 4. As Estonia is a price taker in export markets, theoretically, our export demand is perfectly elastic (the elasticity coefficient is infinite). However, price elasticity of import demand is difficult to estimate. Elasticity coefficient for fuels is small; the demand for other product groups (home appliances and textile goods) imported for dollars can be quite elastic. In conclusion, we can assume that the sum of import and export demand is elastic and it is quite probable that the external balance will deteriorate in the medium term as a result of a rise in the nominal exchange rate of the kroon. Current account Surplus 0 Time Deficit Figure 3. Impact of exchange rate decrease on trade balance: the J-curve effect The external balance could deteriorate, since the drop in the exchange rate of the dollar will help to preserve the low level of interest rates. The inflow of cheap loan 4 The Marshall-Lerner criterion stating that the price elasticities of export and import demands must sum to greater than unity applies to a situation where initially (prior to a change in the exchange rate) trade of goods is balanced. As in Estonia, the initial balance does not exist (imports exceed exports), the Marshall-Lerner criterion should be modified in order to analyse our situation. Considering the initial size of the trade deficit quoted in dollars in Estonia, the modified Marshall-Lerner criterion states that the price elasticities of import and export demands must sum to at least

7 money and financing of domestic-demand-oriented loan products (real estate and consumption loans) could result in deterioration of the current account deficit. The above table shows that dollar-based exports in Estonia fall several times below dollar-based imports. Thus, positive implications arising from depreciating imports should exceed negative implications arising from appreciating exports. However, this logic remains conditional. If the negative implications of the depreciation of the dollar are disproportionately high in one sector (eg export of fish products) and will increase unemployment in these sectors, whereas positive implications are dispersed, the overall impact of the depreciation of the dollar can still be negative. 37