II.Exchange Rate Policy and De-Dollarization
Chapter 4. Pro-poor Exchange Rate Policy: A Poverty and Social Impact Analysis (PSIA)29
57. This chapter reviews exchange rate policy options that could minimize any adverse impact on the poor from an exogenous shock such as the elimination of the quota system in early 2005. As long as the build up of pressures on the balance of payments is modest relativ to the level of official reserves, maintaining a stable exchange rate could reduce potential adverse effect on the income of the poor.
A. Stylized Facts
58. Cambodia is a de-facto dollar economy. Most prices, except for some prices of nontradable goods and services in rural areas, are denominated in U.S. dollars, and up to 95 percent of total liquidity (including estimated cash in circulation) is in U.S. dollars. The domestic currency, the Cambodian riel (CR), is used mainly by the rural population as a medium of exchange, by the urban population as “coins” complementing US dollars in circulation, and by the government which spends more in riel than it collects.
59. As such, it is difficult to interpret the exchange rate as the relative value of currencies of two countries that would normally change in response to differentials in inflation and productivity growth, or changes in the terms of trade. But rather, the exchange rate reflects changes in demand for riel by a small fraction of the urban population who hold riel cash balances for transactions purpose. Although most of the poor in the rural area hold riel cash balances, they appear not to contribute much to exchange rate changes due to limited information and access to the foreign exchange market. The demand for riel is normally met by government spending through its extensive network of Treasury branches across the country. In 2002, for example, the government injected about CR 0.3 trillion riel (i.e., spending in riel net of collection in riel), of which about two third was retained as cash in circulation, matching the trend increase in riel demand in tandem with economic growth. The remaining amount was converted back to U.S. dollars by the private sector. Given the relative stability of growth of riel demand, barring any adverse sentiment, excessive cash injection of the government financed by bank borrowing is usually translated into a depreciation of the exchange rate, as the above chart shows, unless the National Bank of Cambodia (NBC) sells its foreign exchange, which it does not often do.
Changes in Net Claims on Government and Exchange Rate In billions of riel
60. The demand for riel is also sensitive to non-economic related news such as political developments. Any negative news that raises country risk will immediately lead to further dollarization, and in a much larger scale, to capital outflows. This was evidenced when total stock of foreign currency deposits dropped by 20 percent in a course of 1-2 weeks during the July 2003 elections. Moreover, bank owners withdrew their capital—which could not be withdrawn unless they liquidate the bank—in the form of bank loans to themselves. An increase in the currency risk, such as an increase in the exchange rate volatility, will prompt those holding riel to convert into U.S. dollars, as those who have access to the foreign exchange market are more concerned with retaining the value of their wealth in US$ terms. Only a small amount of excess supply/demand could affect a change in the exchange rate as the market is very shallow. In this regard, an NBER working paper reviewed about 85 countries that tried to de-dollarize,30 and found that only two of them managed to reduce the foreign currency deposit ratio significantly and keep it low for some time through reduced exchange rate volatility.31
61. The exchange rate closely affects inflation as measured by the official CPI, although data weaknesses hamper analysis. To illustrate this point, denote
Inflation and Exchange Rate Annual percent change
B. Pro-poor Exchange Rate Policy
62. An exogenous shock such as the elimination of the quota system in 2005 could worsen the trade deficit by about $120 million (about 20 percent of net international reserves). While the impact on banks is likely to be limited, for example, to a slower growth in U.S. dollar deposits,33 confidence could be shaken and further dollarization could occur and lead to capital outflows. To prevent this, the NBC could either allow the exchange rate to depreciate, or partially/fully defend the rate, which would not be difficult given the limited amount of foreign exchange reserves it might require. However, the implications of these policy options are more widespread.
Case 1. No foreign exchange market intervention: Suppose the NBC does not intervene and the exchange rate depreciates, say by 10 percent. The net impact on the fiscal position is estimated to be about 0.2 percent of GDP of additional revenue in domestic currency terms (see table below). The amount of additional fiscal revenue generated from the depreciation will not change much in the short run even if the government were to spend simply more in riel as, except for civil service wages and social transfers, government spending are largely tied to US$ prices.
|Domestic bank financing||−1.1||0.0||−1.1||0.0||−1.1|
Case 1a: Since the fiscal position should not be pro-cyclical, especially at a time when real GDP growth is declining, the government would need to raise civil service wages and social transfers at least to a level that would maintain a balanced recurrent budget. In the first instance, the result of this policy will be as follows: (i) the non-garment formal sector wealth (financial assets) and income will be unchanged; (ii) the financial wealth (which consists only of riel cash holding) of the rural poor will be reduced by 10 percent in U.S. dollar terms, and (iii) their income in U.S. dollar terms will be affected to the extent there is less than perfect pass through and some of their non-tradable goods and services are denominated in riel terms. To illustrate the point, define real income of the rural poor as
Case 1b: Alternatively, the government could allow the fiscal position to be pro-cyclical. In this case, civil service wages and social spending will decline, leading to an adjustment through contraction of aggregate demand. In this case, (iv) civil servants will be relatively poorer, and (v) the recipients of social spending will be adversely affected.
Case 2: Foreign exchange market intervention: If the NBC intervenes to maintain a stable exchange rate, international reserves will decline. At least in the first instance, however, it will not lead to any of the above results noted in (ii) through (v).
Under both cases, the secondary impact will be lower GDP growth, hence reduced income, mainly in the urban areas. The rural area will be affected to the extent that there is less transfer from urban workers’ income to their families.
63. While exchange rate flexibility should be maintained in order to absorb exogenous shocks, careful consideration will need to be given to the redistributive effects of the exchange rate policy. This is particularly so in cases where the potential impact of a shock on the exchange rate and on international reserves is not expected to be large, and where an adjustment of the exchange rate will not have significant impact in helping to absorb a change in the structure of the economy.
Inflation in trading partners in U.S. dollar terms have moved broadly in tandem with domestic prices (in riel), except during the Asian crisis period (Figure 1).35 During 1997–98, although the weighted average of trading partners’ inflation in their respective currencies rose to 7-8 percent, in U.S. dollar terms, inflation declined to below 30 percent due to the large devaluations of the exchange rates against the U.S. dollar. Once trading partner inflation is converted into riel, the large difference during the Asian crisis is sharply reduced (Figure 2), although the initial sharp depreciation in the late 1997 (especially of the Thai baht) and the sharp appreciation in 1998 is clearly evident in the remaining gaps during this period.
Inflation: Cambodia and Trading Partner Countries
The overall pass-through from exchange rate changes to domestic prices in a dollarized economy needs to take into account the ‘accounting’ effect of exchange rate movements into domestic price (expressed in CR). This is illustrated from the formulation of the domestic CPI (expressed in CR) as shown in the main text, namely:
- If β = 1: we have full (accounting) pass through
- If β = 0: pass-through is ε.
- If there were no non-tradable goods, there would be full pass-through as well.
The actual pass through could be different from this ‘accounting’ effect due to price movements arising from policy responses of the central bank to exchange rate movements, unrelated but concomitant domestic demand and supply shocks, and from decisions by producers not to increase the prices of goods (and take a cut in profit-margin instead) in response to higher cost of imported inputs.36
Estimating pass through
A structural VAR model is used to estimate the extent of pass-through, using monthly data from January 1996 through December 2003. Owing to data constraints, only a trivariate VAR is considered, recognizing that there could be external factors other than the exchange rate that could affect the domestic price level. The inflation rate (in US dollar) of trading partner countries is considered a suitable candidate that might affect domestic inflation. A real variable, such as the output gap, is left out due to lack of data.37
Granger causality tests show that both exchange rate depreciation ê and partner inflation π* Granger-cause (that is, the lags of these variables help forecast) the domestic inflation rate π; however, inflation does not Granger-cause ê and π*. The variables ê and π * do not Granger-cause each other.
To retrieve the structural shocks to each variable, short-run restrictions are imposed—shocks to ê and π have no contemporaneous effect on π*, and shocks to π have no contemporaneous effect on ê. These restrictions have the same effect as that of ordering the variables as π*, ê, and π.38 The lag-length of 2 was chosen using the SIC criterion, although the results are robust to inclusion of higher lags.
Following a one-standard deviation shock (increase) to exchange rate depreciation, domestic inflation goes up—with a maximum effect at 4 months. The associated pass through39 from exchange rate depreciation to domestic inflation is 18 percent on impact, around 41 percent by the end of the first year, and 51 percent at the end of two years following the shock. The negative effect of partner country inflation shocks on domestic inflation appears to be heavily influenced by the strong negative relationship—arising from common shocks to regional exchange rates against the U.S. dollar—observed in some periods during and in the aftermath of the Asian crisis.
Pass Through of Exchange Rate and Partner Inflation
To assess whether the large shocks in the Asian crisis are producing this result, the VAR was re-run using a sub-period January 1999 to December 2003. The results now show that the induced response of inflation due to partner inflation shocks is positive, mostly after 5-9 months. However, the impulse response due to exchange rate shocks are now negative, but not significantly different from zero. The results may reflect the importance of domestic shocks as well as partner country inflation in explaining inflation movements during exchange rate stability.