The fundamentals of the Ghanaian cedi
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The depreciation of the
Ghanaian Cedi has now become a perennial crisis. Overtime, we have come to the
realization that the depreciation of the currency is structural and not
necessarily due any form of mismanagement of the economy by the government in power.
This mainly because this trend of annual depreciation is historical and
successive governments have failed to stall its occurrence.
Ghana’s current vice president, Dr. Bawumia, in
a series of public lectures, highlighted the discrepancy between the exchange
rate and inflation. Figure 1 below provides anecdotal evidence of the
continuous discrepancy between inflation and exchange rate overtime in Ghana.
Discrepancy between inflation and exchange
rate
The theoretical underpinning of the relationship
between inflation and exchange rates is the relative purchasing power parity
(PPP). Through PPP, the appreciation or depreciation of the exchange rate
should be equalled to inflation rate differentials. However, empirical evidence
has shown that this is far from the reality. For instance, the Big Mac Index
built by the Economist newspaper tests this theory using price of McDonald’s
Big Mac burger. The burger is used because it is a well-known and globally
uniformed consumer product. The index shows that the PPP theory is not
empirically feasible, especially in the short-run as the index shows a
discrepancy between the market and PPP implied exchange rates.
The discrepancy between the exchange rate and
inflation is due to the irrationality of certain assumptions under which the
PPP theory was formulated. First, the assumption of zero transaction cost in
the goods markets is not realistic. This assumption means that trade is
frictionless and that there are no transportation and tariff costs when goods
cross borders. Second, the assumption that all goods are tradable. Most
tangible goods have both the tradable and non-tradable components. The
intractability of these assumptions makes it difficult to assume that a simple
relationship between inflation and exchange rate exists. This is relevant today
in Ghana as we still witnessing a drifting apart of inflation and exchange
rates, especially from 2016. However, a myriad of empirical evidence has shown
that the PPP theory holds in the long-run as price level and exchange rate
drift together along a common trend.
Fundamental causes of depreciation
The depreciation or appreciation of the Ghana
Cedi is fundamentally determined by the supply and demand for US dollars (USD)
in Ghana. The supply of USD is mainly from foreign reserves which is dependent
on the amount of foreign exchange we receive from exports and foreign aid. With
Ghana now classified as a lower middle-income country, the foreign aid
component would continuously dwindle. Demand for USD also comes mainly from our
insatiable demand for foreign goods in Ghana. Increased foreign consumption
leads to an increase in demand for USD, thereby mounting incessant pressure on
the Cedi.
Another major cause of the depreciation is the
dollarization of the Ghanaian economy, where goods and services are being
priced illegally in USD. This is mostly done by foreign companies operating in
Ghana (international airlines, hotels, etc.) When you are buying KLM ticket in
Denmark, the prices of the tickets are quoted in Danish Kroner, not Euro or
USD. Even the government of Ghana is culpable when it comes to pricing in USD.
For instance, the container import charges such as port dues and stevedoring
charges are all priced in USD at our ports. Even in situations where goods and
services are quoted in local currency, the Cedi equivalents are quoted using
higher exchange rates. As a result, customers will prefer to pay in USD instead
of the Cedi equivalents that are pegged at arbitrarily determined exchange
rates.
The depreciation of the Cedi can be a blessing
in disguise as it could make our exports cheaper and Ghanaian exports more
competitive internationally. However, there is a condition (the Marshall Lerner
Condition) which stipulates that devaluation will improve the devaluing nation’s
trade balance if the sum of the devaluing nation’s demand elasticity for
imports plus the foreign nation’s demand elasticity for exports is greater than
one. This potential benefit associated with depreciation is undermined because
the Ghanaian economy is import-dependent.
The way forward
A short-term solution to stall the free fall of
the Ghanaian Cedi is a clamp down on the dollarization of the economy. Foreign
or local companies must not be allowed to price their goods and services in USD
in Ghana. In addition, individuals without foreign sources of income should not
be allowed to save in foreign currencies. The subtle practice of pricing in
local currency but pegged to some arbitrarily exchange rate should be
discouraged. If the government is able to discourage such negative practices,
the demand for USD in Ghana will decrease and thus bring some stability to the
economy.
Concerns about the exchange rate is not only
limited to the devaluation, but also the persistent volatility or continuous
fluctuation in the exchange rate. I am certain most importers would prefer an
exchange rate of say GHC20=USD 1 to GH6=USD 1, if the higher rate will have a
lower volatility. For the purpose of planning, importers or business owners
would prefer a higher exchange rate with lower volatility to a lower exchange
rate with higher volatility. Higher volatility creates uncertainty about
international transactions.
The management of the economy should not be
limited to the current government. Government must embrace a holistic approach
by bringing all stakeholders to the drawing board to think through and devise
short and long-term solutions to tackle this economic canker. This is important
because the time for long-term solutions will surpass the political term of any
government. In addition, we should intensify the political independence of the
central bank and stop politicizing some of these state institutions, only then
can we hold the technocrats responsible and not politicians. It is the sole
responsibility of the Bank of Ghana to ensure the stability of our local
currency.
Source: ghanaweb.com