Download Cape Verde Pre-Brief Presentation

EXCHANGE RATE REGIME IN THE
FACE OF CHALLENGES TO THE
CAPE VERDEAN ECONOMY
Patrick Imam
IMF
October 31st, 2008
The views expressed herein are those of the author and should not be
attributed to the IMF, its Executive Board, or its management.
EURORIZATION
WHAT WOULD BE ADVANTAGE
OF EURORIZATION?

Eurorization occurs when euro replaces
national currency as legal tender.

Countries that dollarized before 1999 did it for
political/historical factors (e.g. former colonial
relationship), not economic factors.

Experience of recent countries to dollarize
(Ecuador, El Salvador) is brief, and cannot
yet be judged.
Table 1: List of Dollarized Economies
Country
Andorra
Channel Islands
Greenland
Pitcairn Island
Saint Helena
Monaco
Tuvalu
San Marino
Guam
Puerto Rico
Samoa, American
Norfolk Island
Niue
Population
63,000
140,000
56,000
56
6,000
30,000
10,000
24,000
150,000
3.5m
60,000
2,000
2,000
Political Status
Independent
British dependencies
Danish self-governing region
British dependency
British colony
Independent
Independent
Independent
US territory
US Commonwealth
US territory
Australian external territory
New Zealand self-governing Territory
Panama
2.5m Independent
Nauru
8,000 Independent
Virgin Islands, US
100,000 US territory
Liechtenstein
31,000 Independent
Tokelau
1,600 New Zealand territory
Vatican City
1,000 Independent
Kiribati
80,000 Independent
Marshall Islands
60,000 Independent
Micronesia
120,000 Independent
Northern Mariana Islands
48,000 US Commonwealth
Palau
18,000 Independent
Cocos (Keeling) Islands
600 Australian external territory
Turks and Caicos Islands
14,000 British colony
Virgin Islands, British
17,000 British dependency
Cyprus, Northern
180,000 de facto independent
Ecuador
12.9m Independent
El Salvador
6.1m Independent
Timor-Leste
1.1m Independent
(1) Use 'balboa' for coins transactions, 'dollar' for notes transactions (1 balboa=US$1)
Source: Reinhard and Rogoff (2004) and CIA World Factbook
Currency Used
French France and Spanish Peseta
Pound sterling
Danish krone
New Zealand dollar and US dollar
Pound sterling
French France and Spanish Peseta
Australian dollar
Italian Lira
US dollar
US dollar
US dollar
Australian dollar
New Zealand dollar
US dollar (1)
Australian dollar
US dollar
Swiss France
New Zealand dollar
Italian Lira
Australian dollar
US dollar
US dollar
US dollar
US dollar
Australian dollar
US dollar
US dollar
Turkish Lira
US dollar
US dollar
US dollar
Introduction of Currency
1278 (since 1999 Euro)
1797
Before 1800
1800s
1834
1865 (since 1999 Euro)
1892
1897 (since 1999 Euro)
1898
1899
1899
Before 1900
1901
1904
1914
1917
1921
1926
1929 (since 1999 Euro)
1943
1944
1944
1944
1944
1955
1973
1973
1974
2000
2001
2002
BENEFITS OF EURORIZATION

Eliminates currency risk (which should lead to
lower inflation and interest rates).

Lowers transactions costs.

Strengthens fiscal discipline.

Basis for sound financial sector.
CHALLENGES OF EURORIZATION

Lack of an alternative adjustment mechanism to
asymmetric shocks: due to limited labor mobility, fiscal
transfer from EU.

Loss of ability to act as Lender of Last Resort.

Balassa-Samuelson effect – inflation differential with EU.

Cost of acquiring euro.

Loss of seignorage revenue.

Political costs – loss of national symbol.
SEIGNORAGE LOSS FOR CPV

Loss of seignorage revenue estimated at
0.5 - 1 percent of GDP per annum


“Stock Cost”
future seignorage earning
Table 2: Present Value Loss of Seignorage Revenue (as a share of GDP)
Growth rate
(%)
0%
1%
2%
3%
1%
25.0
33.5
50.0
100.0
Inflation rate (%)
2%
3%
30.0
34.5
39.5
46.0
59.5
69.0
119.0
138.5
4%
39.0
52.5
78.5
157.0
Assume: real interet rate r = 4% and currency-to-GDP ratio of c = 10%
ESTIMATED SEIGNORAGE LOSS:
ACCESSION COUNTRIES
Table 3B :Seignorage Gains for CEECs
Country
Population %
of EU-25
GDP % EU25
Capital share
in EU-25
Cash
Gains
as % of GDP
% EU-25
(euro bn)
as % of GDP
Bulgaria
1.70
0.16
0.93
4.81
0.16
0.13
0.89
Czech Republic
2.12
0.69
1.40
4.81
0.72
0.12
0.18
Estonia
0.30
0.07
0.18
4.81
0.07
0.02
0.31
Hungary
2.06
0.65
1.36
4.81
0.68
0.11
0.19
Latvia
0.50
0.10
0.30
4.81
0.10
0.03
0.37
Lithuania
0.76
0.14
0.45
4.81
0.15
0.05
0.39
Poland
7.98
1.99
4.99
4.81
2.09
0.49
0.27
Romania
4.63
0.46
2.54
4.81
0.48
0.35
0.83
Slovak Republic
1.12
0.24
0.68
4.81
0.25
0.07
0.32
Slovenia
0.41
0.23
0.32
4.81
0.24
0.01
0.07
CEEC-10
21.58
4.73
13.15
4.81
4.94
1.38
0.38
Source: Daniel Gros (2004) "Profiting from the Euro? Seignorage Gains from Euro Area Accession" Journal of Common Market
Studies, Vol. 42, pp.795-813
• Unlike these EU countries, Cape Verde will forgo
seignorage revenue.
ILLUSTRATIVE EXERCISE: FISCAL
IMPACT OF LOSS OF SEIGNORAGE
Chart 1: Debt with and without access to seignorage revenue, 2008-2028
Debt/GDP ratio
Debt/GDP ratio
70
30
Public Debt without access to seignorage
(left scale)
60
25
50
20
40
15
Public Debt with access to seignorage
(left scale)
30
10
20
Domestic Borrowing requirement
(right scale)
10
5
0
0
2008
2010
2012
2014
2016
2018
2020
2022
2024
2026
Source: IMF Staff estimates
• For higher growth rate to compensate for seignorage revenue loss,
need permanent increase in growth rate of 3 percentage points.
ARGUMENT OFTEN HEARD FOR WHY
SEIGNORAGE LOSS NOT IMPORTANT

“Eurorization will raise the level of Foreign
Direct Investment, which will spur growth,
and raise tax revenues that will make up for
the seignorage losses.”

While eurorization is likely to lead to a one-off
temporary increase in growth (similar to a
technology improvement), it is unlikely to
have a permanent effect.
GROWTH EFFECT OF EURORIZATION
TEMPORARY, NOT PERMANENT
Growth
rate
Permanent growth
increase
Temporary growth
increase
Introduction of Euro
Time
ECONOMIC TRADE-OFF FROM
EURORIZATION

Benefit



Lower interest rates (matters for hyper-inflation
countries like Ecuador, but not likely to be high in
Cape Verde)
Higher growth rate (one-off effect, not a
permanent increase)
Cost

Loss of seignorage revenue (likely to be high
when exchange rate credible and economy highly
monetized)
POSSIBLE SOLUTION TO LOSS OF
SEIGNORAGE REVENUE

Donors could consider providing Cape Verde an
annual grant (to offset seignorage losses) akin to
the check Bulgaria and Romania and other EU
accession countries will get from the EU.

While a currency board could minimize the loss in
seignorage revenues and strengthen credibility
further (reducing risk premium), overall, it does not
provide huge benefits relative to the current peg
system.
OPERATIONAL ASPECTS OF
EURORIZATION

Create flexible economy: wages, prices, budget must adjust quickly
to avoid employment swings.

Need larger fiscal buffer as CPV more volatile (Finland).

Financial reform to make system more robust.

Adopt euro at an appropriate exchange rate parity (Germany vs.
Spain).

Risk of large capital inflows as no currency risk (Slovenia).

Deal with practical problems of coins (Ecuador).

Address possible disenchantment with perception that euro leads
to higher prices (Belgium).
TENTATIVE CONCLUSIONS

No compelling case to change current exchange rate
regime (peg). Because its not clear from theory and
practice whether gains from eurorization outweigh
losses for CPV.



adopting euro would be virtually irrevocable.
seignorage losses would require substantial fiscal
tightening for CPV.
In the event the authorities want to proceed, a
recommendation would be to start with a currency
board, as a transitional arrangement, to an eventual
adoption of the euro as a legal tender. An alternative
move would be to seek compensation from donors
before proceeding with eurorization.
Thank You