Appreciating the exchange rate to create prosperity

In the previous two ‘My Views,’ the following five popular fallacies of appreciating the exchange rate were discussed:

Fallacy One: A Government can fix the exchange rate at any level it wishes.

Fallacy Two: An appreciated exchange rate is a symbol of a country’s strength and prestige.

Fallacy Three: The appreciation of the exchange rate is a way for fighting inflation since the depreciation of the rate is the cause of inflation.

Fallacy Four: The appreciation of the exchange rate is a boon for the government budget since it reduces a government’s foreign debt servicing costs.

Fallacy Five: It is only exporters who hate an appreciation of the exchange rate.

In today’s ‘My View,’ the last fallacy that an exchange rate appreciation or an avoidance of a depreciation when there is pressure for a currency to depreciate will help a country to raise its per capita income in US Dollars and thereby elevate it to the status of a high income country is dealt with.

First to fundamentals

Per capita income is simply the average income which a citizen of a country would get if the total income is divided equally among all its citizens. This does not happen in reality and, in a given country depending on its income distribution, some people would get more income than others.

Yet, per capita income is a useful way to measure the level of economic development and prosperity of a nation. Accordingly, a country with a higher per capita income is considered, on average, richer than a country with a lower per capita income. Hence, the richness of a country is naturally considered a mirror of its enjoying a greater prosperity as well.

But, incomes of individual countries are calculated in their national currencies and to compare one country with another, it is necessary to present the per capita income figures of different countries in a common currency. The international convention has been to use the US Dollar as this common currency.

The conversion of income numbers to US Dollars

The conversion of the per capita income calculated in national currencies into US Dollars is done in three steps.

First, the total income of a country is calculated by measuring the market value of all the goods and services produced in that country during a given year. Since the market value includes increases or decreases in market prices, the total income so calculated has an element of price inflation as well. This means that if a country has a higher inflation, the market value of its income is also recorded at a higher level.

Second, the total market value of income is divided by the mid – year population, an average population figure for the whole year, to calculate the average income per head. Since it is the market value which is divided, the average per capita income includes an element of income increase due to inflation.

Third, the average per capita income so calculated is converted to US Dollars by dividing it by the average exchange rate which the national currency has against the US Dollar. It is generally believed that the per capita income so converted to US Dollars provides a meaningful indicator for comparison of per capita incomes of different countries, since they are all presented in the same common currency.

But comparison becomes misleading if wrong exchange rates are used

The underlying presumption of this procedure is that the exchange rate used for the conversion is one that reflects the true international value of a currency. A way to ensure that a currency reflects its true international value is to permit it to be determined by the market in response to the demand for and the supply of that currency.

The demand for a currency is made by foreigners who wish to buy visible goods (exports) and invisible services, make investments in a country and lend money to locals plus local migrant workers who send remittances to their families.

The supply of a currency is done by the local people who wish to buy goods (imports) and services produced by other countries and those who lend money to foreigners. The true international value of a currency is determined at the level when both the demand for and the supply of a currency become equal to each other. Economists call this the ‘equilibrium exchange rate’.

Both the demand and the supply forces take into account the inflation differential between the home country of the currency involved and its close trading partners. If the inflation is higher in the home country than its trading partners, the local goods become more expensive than the foreign goods. It leads to a decline in the demand and an increase in the supply bringing pressure for the exchange rate to depreciate. If the local inflation is lower, it would lead to the opposite result of appreciating the exchange rate.

Hence, the equilibrium exchange rate is a rate which has already taken the home country’s inflation into account. Accordingly, when the per capita income calculated in the local currency is converted in to the US Dollar by dividing it by the depreciated exchange rate, it removes the inflated impact which the local inflation has made on the per capita income.

But in actual practice, exchange rates are manipulated by the governments and not permitted to reach their equilibrium levels for political reasons. Economists call this ‘dirty floating’ because it is ‘a dirty act’ to use a powerful economic weapon for a non-economic purpose. As a result, the local currency becomes over-valued as against the foreign currencies.

Hence, as noted by the Hungarian-American economist Bela Balassa, the per capita incomes converted to US Dollars by using over-valued exchange rates tend to show a higher per capita income than what it should have been making it misleading and erroneous to compare with other countries. Thus, the over-valued per capita income fails as an indicator of welfare and prosperity of a nation.

A practical example

How does this happen? Suppose a country has 10 people and those 10 people produce 100 coconuts, the only commodity they produce in that country. If the market price of a coconut is, say one Rupee, then, the total market value of the income of those 10 people is Rs. 100. The per capita income of these 10 people, calculated in the local currency, is just Rs. 10.

Suppose that the exchange rate between the Rupee and the Dollar is that one Dollar is equal to one rupee. Then the per capita income converted to Dollars is also 10 Dollars.

Now suppose that in the next year, those 10 people produce 110 coconuts. In the language of economists, this country has a 10 per cent real economic growth. Suppose further that the government of this country liberally produces money to finance its expenditure programmes. As a result, suppose that the price of a coconut goes up from Rs. 1 to Rs. 2. The market value of the total production of coconuts is now Rs. 220. This increases the per capita income which includes the increase in the price as well from Rs. 10 to Rs. 22. If the Dollar-Rupee rate is maintained at the previous level of one Dollar for one Rupee despite the local inflation of 100 per cent, the per capita income will now rise from 10 Dollars to 22 Dollars.

But, since those 10 people have produced 10 coconuts more in the second year, their true prosperity has increased, on average, only by one coconut to 11 coconuts. At the previous year’s price level, this would have raised the per capita income only to Rs. 11 or in dollar terms, to 11 Dollars. But the Rupee had been prevented by the government from reaching its true value of two Rupees for one Dollar. As a result, the per capita income has now been inflated to 22 Dollars. This does not reflect a true enhancement of prosperity of the people of the country.

Hence, governments can inflate the per capita income numbers in Dollar terms by not allowing the exchange rate to reach its true value as per the inflation rate differential between the home country and its trading partners. But it is just a statistical number and not a mirror of the prosperity enjoyed by people.

This possibility has led some people to believe that a country could raise its per capita income in Dollar terms just by appreciating the currency or by preventing it to depreciate even when there are mounting pressures for the currency to do so.

A case in practice: The former Soviet Union

The former Soviet Union for more than six decades maintained an over-valued Ruble partly to show the rest of the world that its economy was stronger than those in the Western countries and partly to prove that its planning method is free from wild and damaging economic fluctuations. Accordingly, the Dollar-Ruble rate had been fixed at one Ruble is equal to 1.80 US Dollars or one Dollar is equal to 56 Soviet kopeks, slightly higher than a half of a Ruble.

There were chronic and acute shortages of consumer goods in the Soviet Union from around 1940s bringing upward pressure for domestic prices to increase. However, such pressures were not permitted to show themselves up in the market by the introduction of a stringent price control system. Thus, the open inflation became hidden and manifested itself in long queues for distributing consumer goods on the one hand and a thriving black market for these goods on the other.

This was further complicated by the introduction of a similarly stringent system of import and exchange controls. In this manner, the Soviet Union was able to keep the pressure for its Ruble to fall in the market under suppression.

The Soviet Union, together with its other satellite states in Eastern Europe, did not calculate the total output of the nation the way it is calculated by other members of the UN system. Though it followed the principles of the System of National Accounting or SNA issued by the United Nations, its coverage was much narrower than the GDP calculated by the other countries.

Accordingly, the Soviet Union calculated a Net Material Product or NMP which excluded what it considered non-productive services, but included the depreciation component of the fixed assets used for the production of the material product. These non-productive services included the health, education, housing, public utilities, communication, banking, government and banking services, etc.

Hence, to convert the Soviet NMP to the traditional Gross Domestic Product or GDP compiled by other countries, it was necessary to add those services and the depreciation component to the Soviet NMP. This provided the total output in the Soviet Union on a comparable basis in Rubles. This output was converted to US Dollars by multiplying it by the over-valued Ruble-Dollar rate at $ 1.80 per Ruble.

The per capita income so calculated in US Dollars for the Soviet Union resulted in a phenomenally high number making it a member of the rich world. For instance, its GDP in 1989 amounted to $ 2,500 billion yielding a per capita income of $ 8,700.

But after the Soviet Union got disintegrated in 1991, the sins committed by the Soviet rulers by artificially maintaining a higher exchange rate visited upon the Ruble of the new Republic of Russia. The Ruble fell in the open market from 56 kopeks a Dollar to 100 Rubles in early 1992, 3929 Rubles in late 1994, 5100 Rubles in 1995 and 5600 Rubles in 1996. This led the Central Bank of Russia to re-denominate the Ruble in 1998.

Accordingly, for every 1,000 old Rubles, one new Ruble was issued and the exchange rate between the Ruble and the Dollar was set at a depreciated rate of 6.20 Rubles per Dollar. As of today, this rate has further depreciated to 30 Rubles a Dollar. Had the old Rubles been in circulation, this means that the Ruble-Dollar exchange rate has depreciated to 30,000 Rubles per Dollar.

Along with the fall in the Ruble, the per capita income of Russia too fell to a drastically low level. Using the new exchange rate, in 1992, the World Bank recalculated the per capita income of the Soviet Union for 1990. This number was simply $ 2,870, only a third of the previous per capita income.

Hence, a country can show a high number for its per capita income in Dollars by artificially appreciating the exchange rate or preventing it from depreciating despite the pressure for depreciation arising from high domestic inflation. But, it does not show an improvement in prosperity of its people. As experienced by the Soviet Union, it is just a number to mislead the rest of the world. Since it is like a castle made of paper, it would collapse in no time if the exchange rate succumbs to the growing market pressures.

Sri Lanka’s doubling of per capita income

Sri Lanka’s Central Bank in a Box Article in its Annual Report 2010 (p 31) has shown how Sri Lanka would double its per capita income from $ 2,794 in 2011 to $ 4,190 in 2014. To work out these numbers, the bank has assumed that the per capita income would rise during this period by a nominal rate of 14.5% year after year.

Since the per capita income is calculated by dividing the total income by the mid year population, the total income has to rise faster than this rate allowing for the population growth rate as well. When an annual population growth of 1% is allowed, this means that Sri Lanka’s GDP should rise by 15.5% on average during this period. Since the average real growth during this period is about 8% per annum, the nominal growth of 15.5% includes an average annual inflation rate of 7.5% per annum.

Despite this inflation rate and its adverse impact on the Real Effective Exchange Rate in the form an appreciation of the Rupee in real terms, it appears that the Bank has assumed without disclosing it explicitly that the current Rupee-Dollar rate will remain unchanged over this whole period to yield the per capita income numbers reported in the Box Article.

Per capita income is not just a statistical artefact but a representation of the prosperity of the people. The real prosperity of the people rises not by a nominal increase in income, but by its real increase as shown in our coconut producing country example above.

Hence, to double the real prosperity of people within the next four year period, Sri Lanka should maintain an annual real economic growth of 19% on average, 18% real growth plus 1% population growth, if one uses the ‘rule of thumb’ derived from the compound growth formula in mathematics. This high growth rate is clearly outside Sri Lanka’s available resource base.

(W.A. Wijewardena can be reached at [email protected].)