EMD: The challenges of inflexible exchange rates
External vulnerabilities have declined in recent history for many emerging market (EM) economies, as many of them have given up currency pegs and allowed the exchange rate to be the primary tool for macroeconomic adjustment. This has made many countries less vulnerable to terms of trade and other external shocks.
But what about other, small EM countries that have retained their pegs? To answer this question, we visited three countries in the Caribbean region that have been hit by external shocks and have (or have had) inflexible exchange rates: Suriname, Trinidad, and Barbados.
Many believe that countries in the Caribbean have limited capacity to increase goods and services exports by devaluing the currency because they have limited productive capacity and rely heavily on imported goods.
Small economies often have limited resources to curb speculative interest, and may rely on moral suasion and regulations to curtail demand for foreign exchange. Stability in the peg is critical to managing inflation expectations, and to maintaining a healthy banking system. When Suriname abruptly floated its exchange rate last year, the banks and borrowers were unprepared, resulting in an increase in non-performing loans. All other things being equal, we would prefer that countries with fixed exchange rates have higher foreign reserves than countries with floating exchange rates.
Prudent fiscal policy is even more important for countries with fixed exchange rates. Unfortunately, as is frequently the case in many developing countries (and some developed economies), prudent fiscal policy can be a quite unpopular medicine to swallow. Strong political leadership is often required to curb expenses and raise revenues. The three countries we visited have large fiscal deficits, raising questions about their ability to service their external debt.
The countries we visited have limited productive capacity, and rely on trade in order to import essential goods. Suriname’s primary export is gold, Trinidad’s is oil and gas, and Barbados’s is tourism and financial services. If their ability to earn foreign exchange declines by a change in the price of the good or service where they have a comparative advantage, their ability to earn foreign exchange and service their debt could be severely impaired.
We have seen a material decline in credit fundamentals in each of these economies as a result of lower foreign exchange earnings. Given the narrow sources of foreign exchange earnings in their economies, the state plays an unusually large role in the transfer of wealth between haves and have nots. During good times, public sector employment tends to become bloated and cash transfers rise. This becomes fiscally unsustainable when times are bad and it can become hard to find political willingness to fire unnecessary workers.
Being a small open economy has its pros and cons.
Small open economies frequently have shallow domestic markets and may not have deep pools of capital. This can cause them to be reliant on foreign capital to fund deficits. One or two small/medium sized projects can have a huge impact on the real economy, especially if their economies are undiversified.
This cuts both ways: foreign capital outflows or changing external conditions can have material adverse effects on the real economy but if one of these countries were to experience severe economic hardship, it would not take a lot of capital to get the real economy going again. In the case of Suriname, the economy was severely hurt by the shutdown of the Suralco alumina plant. New activity from the Meriam Gold Mine in 2017 has made the outlook for the economy much brighter.
If push comes to shove, none of the countries we visited are too big to be bailed out. Three to four large foreign investment firms or Wall Street banks could certainly raise enough money to make a huge impact on a small Caribbean economy.
Many countries in the Caribbean were hit hard following the financial crisis in 2008. Trade is important for their economies and a loss of foreign exchange earnings has had a large impact. If a country wants to run a fixed exchange rate regime, it needs a high degree of fiscal discipline and fiscal flexibility. The politics of public sector employment have arguably resulted in a slower- than-optimal fiscal adjustment. However, we think the worst is behind for Suriname, Trinidad and Barbados and their future looks slightly brighter than it did a few years ago.
Jared Lou is portfolio manager, EMD Hard Currency, at NN Investment Partners