Stabilizing the Leone: Can a Visionary Peg Work?

20 December 2007 at 21:42 | 770 views

By Christopher E.S. Warburton, Ph.D (Econ).

Protracted exchange rate overvaluation is the result of excessive absorption of consumer goods relative to exports; meaning that imports are in excess of exports for the wrong reasons. Therefore exchange rate misalignment is caused by trade deficits or surpluses.

The Sierra Leonean economy prior to the 1979 devaluation was agrarian, and the management of the agricultural sector was the primary responsibility of then government and the Sierra Leone Produce Marketing Board (SLPMB). The defalcation and money laundering which plagued that sector is common knowledge; just as the malfeasance and inefficiency that characterized its mismanagement.

To the extent that the economy was heavily dependent on agriculture, apart from the elusive income from mining, there is no rational economic principle that can convincingly explain why the income from agriculture was not reinvested in innovative ways to foster the development of the sector, including sustained linkages to import-substitution industries. Certainly, the country did not need a policy to zap the efforts of farmers by squandering their hard-earned income, or making it impossible for them to transport or transship their products to domestic and global markets (the effacement of the railway did just that, and the revenue from the effacement was looted). The shenanigans of policy making in the 1960s and 1970s indubitably imperiled the supply-side; a crucial engine of growth. If the supply-side was woefully deficient, the demand- side was ruinous.

The preference for importing ostentatious goods and implements of coercion (to pacify “audacious” citizens who asked embarrassing questions of god-like politicians) is baffling. The incremental benefit of imports (in the 1970s) to growth or development in the 1980s or even now, is negligible at best. The paucity of acquisition of investment goods reinforces the notion that the national debt was ill-conceived and counterproductive; the very basis for an overvalued Leone.

As I noted in my book, The Evolution of Crises and Underdevelopment in Africa, while 8% of GDP was spent on the military in 1989, per capita GDP declined by approximately 0.23 % in the 1980s, and 6.25% in the 1990s. Not surprisingly, economic performance in the 1980s mirrored the returns to disinvestment in the 1970s. Shockingly (perhaps), Sierra Leone was spending about 20% of its GDP to service its national debt in the 1970s. This is a staggering expenditure for a small open economy.

In the 1960s imports and exports as a percentage of gross domestic product (GDP) in Sierra Leone were hovering around 34% (somewhat balanced). In the 1970s imports constituted about 40% of GDP (ten percent more than exports). Imports constituted approximately 8% of GDP in the US for the same period of time. The lopsided trade, with negligible marginal benefit to investment, set the Leone on a downward spiral. The preconditions for the then IMF orthodoxy (known in intellectual circles as the “irreducible core”), were the direct result of a poisonous cocktail of domestic demand and supply macroeconomic policies that resulted in severe balance of payments problems. I have stated elsewhere why the IMF programs are sometimes problematic-the nature of the Articles of Agreement, the structure of domestic economies, foreign absorption, and corruption in high places. It cannot be presumed ex ante or ex post that ultra-constitutional measures must be taken to utilize IMF resources.

Exchange Rate by Fiat, or Market Performance and Fine-Tuning?

Pegging a currency requires more than a fiat. The sustainability of any exchange rate is contingent on economic conditions. These conditions include foreign absorption, which is unfortunately the key argument for devaluation, and availability of financial resources (otherwise known as reserves). Nations acquire reserves by generating income or borrowing; of course, acquisition is a better than borrowing. For the sake of brevity I will not discuss the process of the then IMF orthodoxy here. Suffice it to say that the basis of IMF intervention was mismanagement of the Sierra Leonean economy accompanied by systemic corruption. I wish to reiterate that any presumption that IMF resources must be used ex ante or ex post by extra-constitutional measures is flawed.

The remedial measure for stabilizing a “debauched” currency is not contingent on a visionary peg. Knowledgeable advocacy of the fixed exchange regime must be premised on the sustenance of the regime through an exchange rate-stabilization fund; not an impulsive choice. The adoption of a fixed exchange rate regime requires two mutually interdependent preconditions which do not necessarily preclude considerations of international economic law:

(i) Definition of the official or nominal value of a currency; and

(ii) Defense of the official or nominal value through a stabilization fund.

Trivialization of the second precondition by way of inadvertence or myopia is invariably a basis for accelerated “debauchery.”

The exchange-stabilization fund is set up to defend the official rate through purchases and sales of foreign currencies to ensure that the market exchange rate does not veer off the official exchange rate. This is a luxury that cash-starved, or resource-constrained Sierra Leone cannot afford right now. In simple terms, the monetary authorities of Sierra Leone must intervene in the foreign exchange market by buying Leones with foreign reserves or assets to defend the official rate (decrease the quantity of Leones) when an adverse shock or misalignment occurs that could not be corrected by reciprocal foreign absorption. In the luckiest of circumstances (if the Leone is undervalued) the monetary authorities will have to increase the quantity of Leones in the market rather than foreign assets.

The nation already has a hard time generating foreign reserves (which it cannot print anyway), and no amount of voodoo economics will enable it to contemporaneously defend such an ambitious proposition. Other remedial options, for example, interest rate and exchange control, are impractical for a small open economy with weak financial markets and a currency that is highly susceptible to speculative attack.

A glimmer of hope for an adoption of a fixed exchange rate regime rests on a peg of the Leone to a basket of currencies (not a single currency). A peg to a basket of currencies, special drawing right (SDR) for example, will minimize recurrent or sudden drastic interventions in the foreign exchange market as a result of wild price gyrations of a single currency. A broader issue is the extent to which trade with other nations of the world must be factored into consideration when selecting an exchange rate regime (not to mention the idea of regional integration or the current movement towards an optimum currency area).

Exchange rate stabilization is highly dependent on economic performance, the acquisition of foreign reserves, and prudent management of an exchange rate regime. Pegging a currency without adequate consideration of its defense is a basis for accelerated “debauchery”- a new “debauchery of currency.”