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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
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