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Bifm Economic Review 2nd Quarter 2005 Economic Review Summary of Economic Developments Dr Keith Jefferis, Chairman of Bifm Investment Committee T he major economic event of the second quarter of 2005 was the devaluation of the Pula by 12 percent on May 29, and the introduction of a new mechanism for determining the Pula exchange rate. While catching most people by surprise, there were good reasons for the move, and in the long term it should be positive for the economy. In the short term, however, there will be negative consequences, including higher inflation, and economic confidence has undoubtedly taken a knock, which will take some time to recover. different countries and the trade weights used. Chart 1 shows the evolution of one of the possible REER measures in recent years, using trade weights that reflect (approximately) Botswana’s entire trade patterns, including diamonds1. It is clear that after being relatively stable, on average, through the 1990s, the REER appreciated sharply from mid-2002 onwards. If the relatively stable value of the REER during the 1990s is taken as an approximate equilibrium value, then by January 2004, the Pula was about 12% overvalued, in real terms. The devaluation of February 2004 reversed part of the real appreciation, but this was eroded by subsequent price and exchange rate movements, with the result that the Pula was again 12% overvalued by April 2005. The May 2005 devaluation takes the REER back close to its long-term value, although of course an important issue going forward will be the extent to which the competitiveness gains resulting from the devaluation can be sustained, given that inflation is likely to rise. While it is the devaluation that has received attention – understandably in terms of its short-term impact – the change in the exchange rate mechanism is more important than the devaluation in terms of long-term impact on the economy. By adopting a crawling band mechanism for the Pula, in which the Pula exchange rate will adjust in line with expected inflation differentials between Botswana and its major trading partners, the Government has indicated that it will not permit the real value of the Pula to deviate from a competitive, equilibrium value in future. This should, in principle, rule out any need for further devaluations. Furthermore, the adoption of a gradually widening band (between the Bank of Botswana’s buy and sell rates) will progressively allow market forces to determine the value of the Pula, hence introducing an element of floating into the exchange rate mechanism. This will, over time, enable monetary policy to become more effective in countering Botswana’s relatively high inflation as, until now, the fixed exchange rate has limited the effectiveness of monetary policy. The announcement of the crawling band mechanism gave few details about how it will work in practice. Hence we do not yet know key details, such as what the rate of crawl will be, and how it will be implemented – for instance, how frequently will the exchange rate against the basket be adjusted – daily, weekly, monthly, or at some other interval? On the basis of historical inflation continue... As the Ministry of Finance and Development Planning pointed out, the devaluation was prompted by concern about Botswana’s international competitiveness. Although there are no detailed official figures on measures of overall competitiveness, a useful starting point is the Real Effective Exchange Rate (REER). The real exchange rate adjusts the actual (nominal) exchange rate for differences in inflation between Botswana and its trading partners; a (relatively) higher inflation rate in Botswana, or an appreciating nominal exchange rate, will cause competitiveness to decline. The REER is simply the trade-weighted average of bilateral real exchange rates with Botswana’s major trading partners. Various different REER measures are possible, depending on the choice of price indices in 1. This REER measure uses weights of 50% SA rand and 50% SDR (IMF Special Drawing Right, which is itself a basket including US dollar (45%), euro (29%), yen (15%) and pound (11%)). These proportions are intended to reflect trade patterns, not pula currency basket weights. 2 differentials between Botswana and trading partners, a rate of crawl in the region of perhaps 2-3% a year might be expected. If so, the individual adjustments against the basket will be relatively small, and certainly too small for speculative activity based on predicting the crawl adjustments to be worthwhile. That is why, in most countries that have adopted crawling bands or pegs, the rate of crawl and frequency of adjustment is publicly disclosed. Nor do we know how quickly the band will be widened, and hence how quickly the fixed Pula peg will be loosened, although it will be obvious to market participants when this parameter is changed. Given the likely slow rate of crawl, and a slow widening of the band, the main influence on Pula exchange rates against other currencies in the short term will continue to be cross exchange rate movements of the currencies in the basket, especially the rand/US dollar rate. With the rand apparently on a depreciating trend against the dollar, the pula is likely to appreciate against the rand and depreciate against the dollar for the remainder of this year. In the long term, the devaluation should be of benefit to the economy, especially to exporting and import-competing sectors. The long-standing policy of export-led diversification is unlikely to be successful without a competitive exchange rate, and even those who have criticised the devaluation have generally failed to put forward alternative strategies for Botswana’s long term economic development or suggested how development can succeed with an overvalued exchange rate. Immediate benefits will be felt by the mining sector, government, manufacturing, tourism and other exportoriented services, which together account for around two-thirds of GDP. More generally, the devaluation and accompanying exchange rate policy changes signal a determination by government to make international competitiveness the overriding policy aim, in support of export-led growth. Short-term effects are more likely to be negative, however. Inflation will undoubtedly rise, although hopefully the effect will be small and fast, as it was following the February 2004 devaluation of 7.5%. Real incomes will fall, which will affect those sectors of the economy dependent upon consumer Economic Review spending, and there will no doubt be pressure from some quarters for wage rises. Also important is the impact on economic confidence in and about Botswana. In the long-term, the devaluation and the new exchange rate policy should help to boost confidence, as it will be supportive of growth. In the short-term, however, the impact on confidence has been extremely negative, for a variety of reasons: not only was the devaluation sudden and unexpected (as it had to be), it was also relatively large. Perhaps most damagingly for Botswana’s reputation amongst foreign investors was the fact that the devaluation came only two days before the maturity of the P750m BW001 government bond, in which foreign investors had significant holdings. Their returns from investing in Botswana were, therefore, much reduced and, while it could be argued that the interest rate on the bond was high precisely to compensate for risk, including that of devaluation, the timing was interpreted – wrongly – as being deliberately malicious. Recovering from a damaged international reputation and rebuilding confidence will undoubtedly be a slow process. However, the devaluation is unlikely to have any negative impact on Botswana’s international credit rating. Both Moody’s and Standard & Poors have been concerned about the slow pace of diversification and the government’s fiscal problems, and the devaluation will help to address both of these issues. And while the magnitude of the devaluation was large by the standard of previous Botswana devaluations (7.5% in 2004, and typically 5% or less during the 1980s and early 1990s), it needs to be kept in international perspective, noting that floating exchange rate currencies can often move by much greater amounts – the rand/dollar and euro/dollar rates being prime examples. Even on a trade weighted basis, the rand depreciated by 6% between April and June this year. The prospect of greater nominal and real exchange rate stability for the pula going forward should provide some compensation for the shock of the devaluation. Inflation and Interest Rates Inflation has been generally falling since January, when it reached 8.0%, although showing a disappointing increase from 6.2% in April to 6.3% in May, prior to the devaluation. The May increase resulted mainly from a hefty rise in the cost of new vehicles, and resulted in inflation remaining just above the top edge of the Bank of Botswana’s 3%6% inflation objective range for 2005. Prior to the devaluation, inflation was expected to continue falling through the year, and there was a good chance that it would soon have been with the BoB’s desired range. The devaluation has changed the inflation picture entirely, however, even though predicting the inflationary impact of the devaluation is difficult. Following the February 2004 devaluation of 7.5%, there were a few months of relatively large monthly price increases, but by July these had tailed off and the overall impact on prices is estimated at 2%-3%. Assuming a similar pattern this time around, with the devaluation having a relatively small and fast pass-through to prices, inflation can be expected to rise continue... 3 by some 4%-5%. Therefore, a rise in inflation to 10%-11% is likely over the next 2-3 months, where (due to the annual nature of the inflation calculations) it will remain at least until the end of the first quarter of 2006 (see Chart 2). As yet there have been no indications as to the likely monetary policy response to the devaluation; the Bank of Botswana’s midterm review of the Monetary Policy Statement, likely to be released in late August, will provide important information in this regard. At the very least, it is likely that the monetary policy easing that had been anticipated in the light of falling inflation earlier in the year will be put on hold until the inflationary impact of the devaluation has worked itself out. Monetary Conditions Index The combined impact of monetary and exchange rate conditions on the economy can be assessed by way of a Monetary Economic Review Conditions Index (MCI), which is calculated as a weighted average of the real effective exchange rate (REER) and the real interest rate (RIR). As Chart 3 shows, there has been a steady rise (tightening) in the MCI recent years, due to both an appreciating REER and rising real interest rates2. A high or rising MCI will tend to constrain aggregate demand and economic growth, and will also restrict inflationary pressures. A lower MCI will tend to be supportive of growth, but may be inflationary if excessive aggregate demand pressures are stimulated. As the chart shows, the devaluation has reduced the MCI considerably, leading to an easing of monetary conditions, which should boost growth prospects. Domestic Economic Conditions There is considerable evidence to suggest that domestic conditions remain weak, although some indication that the slowing trend may have bottomed out. As Chart 4 shows, our indicator of domestic economic conditions has been in negative (weak) territory since early 2004, having started its downward trend in mid-2003. It reached a low point at the end of 2004, but has since improved slightly, although overall economic conditions remain very weak3. The economic downturn is not particularly surprising, although it is encouraging that it appears to have bottomed out. As noted above, monetary and exchange rate conditions have been steadily tightening over a long period – at least prior to the May devaluation. Fiscal conditions have also been tight, with the slowdown in government spending in the 2004/05 and 2005/06 fiscal years and lack of a public sector salary adjustment in 2005. This has had a negative impact on certain economic sectors – especially construction and the retail/wholesale trade sector. The latter will be squeezed further by higher costs and the contraction in real incomes resulting from the devaluation. In the short-term it is likely that domestic demand conditions will remain weak. While troubling for some activities, this is, however, a supportive environment for the devaluation – weak domestic demand makes it less likely that there will be a large or long-lasting inflationary impact, and hence more likely that the objectives of the devaluation will be achieved. 2. The weights used in the MCI calculation are 2/3 for the RIR and 1/3 for the REER where, following convention, the REER enters as percentage change, and the RIR as the percentage point change, from the chosen base period. While the weights should, in principle, be derived from an empirical analysis of the impact of interest rates and the exchange rate on economic growth, the coefficients chosen here are consistent with those estimated for other small open economies. The absolute value of the MCI has no economic significance; what is important is movements over time, and the value at a particular point in time relative to the chosen base period. 3. The index presented here represents a first attempt to produce an indicator of domestic economic conditions in Botswana. Such an initiative is constrained by the lack of good quality, timely economic data – broad-based indicators such as GDP, for instance, are only produced with a relatively long lag. The indicator here combines two data series that meet the requirements of quality and timeliness – the annual growth rates of bank credit to private businesses and of non-mining electricity consumption – and which are reasonably representative Bifm Botswana Limited Asset Management. Property Management. Private Equity. Corporate Advisory Services. Private Bag BR 185, Broadhurst, Botswana Tel: +(267) 395 1564. Fax: +(267) 390 0358. Website: www.bifm.co.bw