Most developed nations are capable of using their own currency to pay for exports, thus having a better chance of managing its debt in foreign currencies. This is not true of developing nations according to Frances Coppola, which makes them financially vulnerable.
In my last post, I said that the fact that a government can buy anything that is for sale in its own currency is not sufficient to confer monetary sovereignty. A country which is dependent on essential imports, such as foodstuffs and oil, for which it must pay in dollars is not monetarily sovereign. Some people disputed this on the grounds that such a country could earn the dollars it needs through exports. So I thought I would write a post discussing how realistic this is in practice.
Strictly speaking, the only country in the world that can always pay for everything it needs in its own currency is the United States. However, most developed countries that issue their own currencies have deep and liquid FX markets that enable them to exchange their currencies freely for other currencies; many also have swap lines with the Federal Reserve. Eurozone countries don’t issue their own currencies, but the bloc as a whole issues the world’s second reserve currency. It is not going to run out of the means to buy imports.
In practice, therefore, developed countries can generally use their own currencies to pay for imports. But this is not true of developing countries – and most countries in the world are developing countries. In my view, a definition of monetary sovereignty that does not work for most countries in the world is not much use.
A developing country with poor creditworthiness and a thinly-traded currency is unlikely to be able to pay for imports in its own currency. It must obtain what used to be known as “hard currency,” usually dollars. A country that must obtain FX to buy essential imports is effectively using the currency of another country even if it issues its own currency with a floating exchange rate. The government may be able to buy everything that is for sale in its own currency, but it is not able to buy everything the country needs. It is dependent on external sources for hard currency.
There are essentially three ways of obtaining hard currency: earning it through exports, buying it on FX markets, or borrowing it. None of these fully protect the country from FX crisis. A negative terms-of-trade shock, such as happened to commodity exporters in 2014-15, can quickly wipe out net export earnings, turning a current account surplus to a deficit and forcing the country to borrow FX. Exchange rate collapse (which may be associated with a terms-of-trade shock) can make buying FX on international markets to pay for imports all but impossible. And borrowing in foreign currencies quickly becomes unsustainable if the exchange rate drops. Floating exchange rates do not confer monetary sovereignty, even for a developing country that issues its own currency, if the country is dependent on imports for essentials such as basic foodstuffs. This is true even if the country normally runs a current account surplus.
Those who say that developing countries can always pay for essential imports with money earned from exports are really saying that developing countries should never under any circumstances run current account deficits. Where imports are concerned, the country must “live within its means.” It can spend only what it earns from exports, and no more. These governments really are like households.
Since the Asian crisis of 1997-8, many developing countries – particularly those with dominant extractive industries – have done exactly this. They have opted to run persistent current account surpluses, building up FX reserves to protect themselves from “sudden stops” and enable them to support their exchange rates. In theory, these countries earn all the FX they need to pay for imports. They do not need to borrow FX.
And yet many still have FX debt, particularly in the private sector. As I noted in my previous post, a developing country with high private sector FX debt is vulnerable to exchange rate collapse. Servicing debts in ever-more expensive foreign currencies is damaging for indebted corporations, and the rising cost in domestic currency of obtaining dollars seriously hinders trade and business development. This applies whether or not the country has sufficient FX reserves to support businesses that need dollars, and whether or not the government can obtain more FX by exchanging its own currency. The rising cost of dollars as the exchange rate falls is itself enough to push the economy into recession.
But if the current account is in surplus and there are ample FX reserves, why does the private sector, and sometimes the public sector too, have FX debt? There are two reasons.
The first is cash flow. Businesses may overall have an FX surplus, as indeed the country might. But cash doesn’t always arrive when you want it to, and suppliers have to be paid. So corporations can be forced to borrow FX to pay essential bills in advance of the necessary FX funds arriving. In theory, a currency-issuing government should not have to borrow FX – it should simply be able to exchange its own currency. But if the currency is thinly traded, selling it can cause the exchange rate to fall precipitously, especially if the government is printing the currency it is selling. Because of the adverse effect of sharp exchange rate falls on domestic inflation and indebted private sector actors, many governments prefer to borrow FX to cover short-term shortfalls.
The second, and more significant, is investment. Consider a company that is buying plant to establish a new business in, say, Morocco. It is likely to have to pay for that plant in dollars. It could borrow dirhams and exchange them for dollars, but as this would most likely have to come from a local bank rather than from the cheaper international capital markets, it could pay very high interest on the loan. Furthermore, if it is planning to manufacture goods for export in dollars, borrowing in dirham would create a currency mismatch on its balance sheet which would expose it to exchange rate fluctuations. For these reasons, many companies prefer to issue dollar debt rather than borrow in local currencies. But this means that they have FX debt on their balance sheets even if the cost of their imports in dollars is lower than their export earnings in dollars.
The same is also true of the government. And this brings me to the core weakness in the argument that developing countries can always earn the FX they need through exports.
Consider a country which does not produce enough basic foodstuffs to feed its population. It may have poor quality land and water shortages; it may have seriously underdeveloped agricultural production; it may be overpopulated. Whatever the reason, in the short term it must buy the food it needs to feed its population. And because international foodstuffs are invoiced in dollars, it must pay for this in dollars. If its export sector is also undeveloped, it will lack sufficient FX to buy the food its population needs.
The obvious long-term solution is for the country to increase its agricultural production so that it can feed all its people. Alternatively, if developing agriculture is problematic, for example due to persistent flooding, the country needs to increase production for export so it can earn the FX to buy the imports to feed its people. Both of these approaches require investment, and investment requires dollars. Additionally, production takes time to develop – and in the meantime, people must be fed. So the country must in the short-term borrow FX to pay for imports, and it must also borrow FX to invest for the future. If it does neither, then its people will starve both in the short term and the longer term. FX debt is thus inevitable in a country that has an insufficiently developed supply side.
A few people suggested that a job guarantee would help to develop the supply side. This is true, but supply side improvement takes time, and in the meantime people must eat. The story of the Irish famine delivers a cautionary tale about relying on job guarantees to relieve hunger. Starving people aren’t productive. They need to eat first, then work. Paying them a job guarantee wage when the country is not earning sufficient dollars to import the food they need to eat is pointless and cruel.
Keeping the current account in balance or surplus by restricting imports and favouring exports is extraordinarily difficult to achieve, especially for a country with weak institutions and widespread corruption. To understand why, we need to think through what forcibly keeping the current account in balance or surplus entails.
- Imports must be controlled so that the country can never find itself with an FX gap that must be funded. High import tariffs can help the country to restrict non-essential imports. But if FX earnings from exports fall, even essential imports may have to be cut, regardless of the impact on the population.
- Following from this, exchange rate movements cannot be allowed to wipe out terms of trade advantage. Many developing countries, particularly commodity exporters, fix or manage their exchange rates to prevent them rising.
- The country must make sure that FX earnings from exports do not leave the country except in payment for imports. This means strict capital controls, including complete prohibition of profits repatriation by foreign industries, and limiting or banning FX and bullion holdings by the private sector.
- FX borrowing by government must be outlawed completely, and FX borrowing by the private sector must be restricted so that it can only be used for investment. If corporations and households are allowed to borrow in foreign currency to fund consumption spending, the current account will go into deficit.
Keeping the current account in balance or surplus at all times means deliberately suppressing domestic demand, to prevent imports from rising. In a country which depends on imports for essential foodstuffs, this could mean the poorest being constantly at risk of starvation. Additionally, since all resources would be directed to export production and supply-side development, the better-off might struggle to save. And there would be unemployment, since in an FX-dependent economy, full employment is limited by the ability of the import-export sector to generate net earnings. Creating jobs that do not increase export production, and do not substitute domestic production for imports, simply causes inflation.
There needs to be fiscal restriction too. Developing countries with real resource shortfalls that force them to import essentials must develop strong supply sides in preference to boosting domestic demand. The last thing such a country needs is deficit spending in its own currency that boosts domestic demand beyond what its own supply side can satisfy, sucking in imports which must be paid for externally with dollars even if they are sold domestically for local currency. Hey presto, before you know it, you have rising FX debt and a falling market exchange rate, the essential ingredients for an FX crisis.
This has played out time and time again in places like Latin America. Own-currency fiscal stimulus creates a short-term economic boom driven by rising consumption spending, which sucks in imports, creating a FX gap which must be funded with FX borrowing. As FX borrowing rises, investors get nervous and start selling both the FX debt and the currency, causing interest rates to rise and the exchange rate to fall. Servicing the FX debt starts to become more expensive as the domestic currency exchange rate falls. Eventually, the country either runs out of FX reserves or is effectively shut out of FX markets by prohibitively high interest rates on FX debt. When this happens, either the country defaults or it ends up in an IMF programme.
But the social costs of keeping the current account in balance or surplus are high. Consequently, there is always a risk that a populist government, encouraged by reading economic theory that prioritizes deficit-funded social programmes over externally-funded supply-side development, will abandon these restrictions and embark on a fiscal stimulus programme that quickly draws in imports funded by high FX borrowing. Because of this, economic theories designed for rich developed countries are positively dangerous to FX-dependent developing countries.
And if you don’t believe me, read Rudiger Dornbusch, and weep for the countries – and they are many – that repeat the same mistakes again and again.