The decision of the new government to unify the exchange rate had the almost immediate result of a depreciation of the price of the Argentine peso.

As expected, the measure had repercussions in the media and social networks, proliferating opinion articles on the matter, both in favor of and against the measure.

Our article arises in response to two major flaws that were presented in the majority of these notes and opinions, which - we consider - threaten a plural understanding of the economy by the population.

The first is that a large amount of the material presents the devaluation as an event dependent entirely on a political decision, without any mention of the market forces that can force variations in the exchange rate; even against the will of the rulers.

The second is the especially common tendency among Argentines to highlight only the advantages or disadvantages of the economic policy decision, depending on the path in which the author of the journalistic article is located.

This time we will focus on answering 10 questions to understand what variables and facts impact the determination of the exchange rate and, consequently, what effects should be expected from a devaluation. We will try to shed light on the issue in a simple way, seeking that our readers can improve their opinion, weighing the costs and benefits of the measure from a technical point of view, which - we hope - serves as a complement to the subjective or ideological assessments of Every citizen.

On the one hand, it will be seen that the path that the exchange rate follows in an economy depends on the - let's call them - invisible forces of the capitalist system and that, although there are many mechanisms to counteract them, it is not always easy to go against them.

Secondly, it will be clear that, like almost all economic policy actions, the consequences can hardly be classified in their entirety as “positive” or “negative.”

Whether the result is a high or low exchange rate, an interventionist policy is exercised, or price determination is left to the market, devalued through a shock or gradually; All of these measures generate winners and losers, in addition to having positive and negative consequences in the short and long term.

The final assessment of economic policy will depend on the assessment that each person makes personally about the importance of each economic sector, or the short term versus the long term. We believe that to form a responsible opinion it is crucial to be aware of each of the consequences.

1-What are the nominal exchange rate and the real exchange rate?

El exchange rate itself indicates the price of a currency measured in the local currency, that is, the rate at which both currencies are exchanged.

The most common thing is to measure the exchange rate bilaterally against the US dollar, given that this has the peculiarity of being considered an international exchange currency. Thus, a higher exchange rate implies that you will have to pay more pesos to get a dollar.

However, and contrary to common sense, this type of exchange is not the most relevant when determining economic policy. First of all, because the value of the dollar varies with respect to other currencies.

For example, in the last year most countries strongly depreciated their currencies against the dollar. Being tied to the value of the North American currency in this context implies that the Argentine peso gains value with respect to -for example- the Brazilian real.

Strictly speaking, when there are free floating or managed floating exchange regimes (like ours), the correct term to indicate that the local currency has lost value against a currency is “depreciation”. However, the force of use and custom ended up imposing the term “devaluation.”

A very important concept that is not taken into account when talking about nominal exchange rate, that is, the price that appears daily in the news and that practically every adult Argentine knows; is that it does not determine the competitiveness of the economy. The relevant index for national production is what is known as real exchange rate.

To easily differentiate them, it can be said that the nominal exchange rate shows the price of the foreign currency expressed in the local currency, while the real exchange rate serves to compare the prices of a basket of goods produced in our country with respect to the rest of the country. world. The formula is simple to understand:

• e = real exchange rate
• E = nominal exchange rate
• CPI = local price index
• CPI = price index of the rest of the world

In other words, the real exchange rate is what tells us whether local products are cheap or expensive compared to the rest of the world. In this way, when the real exchange rate falls, it means that local products become more expensive compared to those from the rest of the world, therefore it will be more difficult to compete with other countries.

The usual consequence is a reduction in exports and an increase in imports. The opposite occurs when the real exchange rate rises.

The real exchange rate basically depends on three variables. The first is the nominal exchange rate. The second is local inflation and the third is inflation in the rest of the world.

For the real exchange rate to remain stable, that is, for the economy to neither lose nor gain competitiveness, the depreciation of the currency must be equivalent to the difference between local inflation and the rest of the world.

To give a simple example, if the depreciation of the Argentine peso is 15% per year, but inflation is 20 percentage points higher than that of the rest of the world, it means that the economy is losing competitiveness. Even though the Argentine peso is worth less and less against the dollar, the dollar prices of local goods are increasingly higher.

In this way, we arrive at the first conclusion: If an economy has a very high inflation rate, it is also likely to have a high currency depreciation rate, in order to avoid a relative increase in the cost of the goods it produces. In other words, not only does currency devaluation generate inflation, but inflation also generates devaluations.

To give an example in terms of the formula we saw previously: if the local price index [CPI] increases by 20%, the nominal exchange rate [E] must increase (depreciate) another 20%, in order not to affect the level of the real exchange rate [e]. It should be noted that in this example, we assume that the Rest of the World Price Index [CPI] remains constant.

2-How is the exchange rate of an economy determined?

The first thing to consider is that the nominal exchange rate is a price and that therefore is determined in the same way as all prices in the economy: redundantly, by supply and demand.

Of course, in this case supply and demand are very particular, but the mechanism by which the exchange rate is determined is very similar to that of the price of any good.

If there are more people who want to buy dollars than those who want to sell, the price of the dollar rises. Otherwise, if there are more people who want to sell than people who want to buy, the price of the dollar falls.

What must be analyzed then is how many people want to exchange their pesos for dollars and how many dollars enter the economy to be converted into pesos.

Who sells dollars?

1. Exporters, who sell their products abroad, obtain dollars and enter them into the local economy.
2. Foreign investors who buy assets in pesos locally. This includes everything from the purchase of a local company to a loan in dollars obtained by the government or any private individual, including sales of dollars for pesos that are carried out through home banking.
3. Foreign tourists.

Who buys dollars? Since it cannot be any other way, in this case the relationship is reversed. Dollars are bought by importers who need to pay for the merchandise they bring from abroad and by people who buy foreign assets, whether dollars themselves, stocks or bonds. Also tourists who travel abroad.

What is important to understand is that left to its own devices, the exchange rate will automatically vary to balance these forces, until the amount of dollars you want to sell is exactly the same as the amount you want to buy. Suppose, for example, that there is excess demand for dollars in the economy.

In that case, the price of the dollar, the exchange rate, will rise. As a result, many people will decide to buy fewer dollars, either because they consider it too expensive or simply because the same amount of pesos equals fewer dollars.

The effect operates above all in the medium term, in the same direction for exporters and importers: a depreciation of the currency makes foreign products more expensive, reduces imports and boosts exports.

The exchange rate that the market sets on its own is usually called equilibrium exchange rate. That is to say, this does not always coincide with the exchange rate with which the economy is actually operating. It is like a kind of attractor point, a place towards which it converges.

In this way we arrive at our second conclusion: Market forces always seek to balance the supply and demand of currencies, bringing the exchange rate to its equilibrium level. Consequently, bypassing these mechanisms and setting an exchange rate other than the same one, although feasible, is not always easy.

Next, we will examine what happens when you seek to modify this price.

3-Can a government set levels other than the equilibrium exchange rate? As?

Yes, the exchange rate with which the economy operates is not always the equilibrium one. The government can set different levels at that level through two generic mechanisms, quite easy to understand.

The first is by intervening directly in the supply and demand of currencies. This measure is usually carried out by almost all Central Banks in the world, especially to avoid excessive volatilities in the exchange rate. The correlate of this intervention is the variation in international reserves.

If the Central Bank wants prevent the exchange rate from increasing, what you should do is go out and sell currencies at the target price. That is, cover the difference in dollars that the agents of the economy seek to acquire at the current price, and cannot due to lack of supply.

As a corollary, there will be a reduction in the international reserves of the Central Bank (now in the hands of the public), as well as a fall in the amount of money circulating in the economy (since it is purchased by the Central Bank).

On the contrary, if the Central Bank wants to prevent the currency from appreciating, what it must do is buy dollars, thus increasing its international reserves, but also the issuance.

This is the main role played by international reserves of the Central Bank. They allow said entity to intervene in the exchange market and avoid sudden depreciations. Likewise, it should be clear that, contrary to what many people think, perhaps due to the history of convertibility in the 90s; The equilibrium exchange rate of an economy cannot be calculated simply as the ratio between the amount of dollars held by the Central Bank and the existing pesos.

Even without international reserves, the exchange rate can depreciate if supply and demand determine it. In other words, not having reserves does not imply that the exchange rate must rise, but it does imply that market forces will make it rise, and the Central Bank will not be able to do absolutely anything to prevent it.

An even more disturbing thought: the amount of money in the economy is always greater than what is printed on paper because of what is known as the bank multiplier.

Thus, even if the bills are equivalent to the amount of dollars held by the largest banking entity, it is possible that it will not be able to withstand a run against the peso. This explains why even with the convertibility law, currency depreciation ended up being inevitable.

But the second mechanism that the government has to avoid variations in the exchange rate remains to be described. It is simply the foreign trade restrictions, and the entry and exit of capital.

If the government wants to avoid a currency devaluation, it can reduce the demand for foreign currency by applying taxes or prohibitions on both imports and capital outflows.

This is what has been sought in recent years through the application of the DJAI, restrictions on the transfer of dividends abroad, or simply the exchange rate.

Otherwise, if what you want to avoid is a exchange rate appreciation, the most common elements are restrictions on the transfer of capital and the application of export duties.

An important clarification On the last point: the application of export duties used with the purpose of avoiding an appreciation of the currency, loses a lot of effectiveness if the government spends the resources it collects with that tax, given that in this way the dollars also end up being converted into pesos. .

It is for this reason that this type of policy is usually accompanied by the creation of investment funds abroad or debt relief policies.

4-Can these levels be maintained forever?

No. Or at least, it's difficult.

What happens if we insist on avoiding a devaluation, that is, keeping the exchange rate below equilibrium? If that were the case, the Central Bank would be continually losing reserves.

In other words, the amount of international reserves held by the entity limits the duration of the low nominal exchange rate policy.

Faced with this dilemma, it is common for some governments to resort to loans abroad to increase reserves, but if there are no changes in the productive (or financial) structure that modify the equilibrium level of the exchange rate (for example: an increase in exports) these Actions represent only a temporary solution.

However, this type of loans -sometimes- end up being effective, because the signal of a Central Bank with a higher level of reserves can discourage financial speculation, given that expectations of depreciation are reduced, and therefore demand falls. of assets nominated in foreign currency awaiting devaluation.

On the other hand, maintaining the exchange rate above its equilibrium level is easier in the medium term, but it is still difficult to do it forever. In this case, the central bank must acquire foreign currency and deliver pesos in exchange. The correlate is an increase in the amount of money circulating in the economy.

Generally, this causes an increase in the price level, thereby reducing the real exchange rate. Thus, the adjustment ends up being carried out not through a devaluation, but through higher inflation.

The causes of inflation and the relationship between the amount of money in circulation and the price level is a topic that requires an even greater discussion than that of the determination of the exchange rate. Opinions on the subject range from those who believe that the relationship between prices and currency is practically direct, to those who deny that any causality exists.

The most accepted opinion is that - in most cases - a significant increase in the monetary base (understood as an exogenous shock) would cause an increase in prices.

This does not imply that there are no cases in which an increase in the money supply can be absorbed by variations in the rate of circulation of money or the product, nor that any price variation is explained exclusively by changes in the monetary base.

However, it is a much slower process, and it can be delayed even more if the Central Bank compensates for this increase in the monetary base by reducing the amount of money in the economy through some other means, for example, by selling bills.

In this case, the disadvantage is that this type of asset implies the payment of an additional amount in interest, so the Central Bank could incur a deficit.

5-What advantages and disadvantages does the high exchange rate have? Who wins and who loses?

The advantage of a high exchange rate is that it makes the economy more competitive in prices. In this way, national production is favored, given that producers of tradable goods (those that can be exported and imported) have more possibilities of selling their production abroad.

On more than one occasion a government has used a high exchange rate to promote the growth of national industry.

The disadvantage is that it harms the employees, at least in the short term, because the salary in dollars is kept artificially low. In other words, the competitiveness gained is fundamentally based on paying lower wages.

Among the different productive sectors, those who benefit the most are those who can export their production. Becoming more competitive allows them to increase their production, but even if they don't, the possibility of earning foreign currency income at artificially low costs improves the profitability of their business.

In fact, the most competitive sectors of the economy obtain extraordinary profits from maintaining this policy.

On the other hand, those sectors that only sell their production in the domestic market are harmed, because the lower level of wages leads to lower consumption. In this way, producers of (non-tradable) services are among the most affected.

6-What advantages and disadvantages does the low exchange rate have? Who wins and who loses?

Contrary to what happened with the high exchange rate, an artificially low exchange rate reduces the price competitiveness of the economy, harming the producers of tradable goods, who suffer a decrease in their profitability and, sometimes, even have to reduce its production.

On the other hand, wage earners improve their purchasing power, especially for goods that are not produced locally. In this way, many governments tend to fall in love with the idea of ​​a low exchange rate, since it favors a better standard of living for the population, which also translates into better electoral results.

As mentioned above (but in the opposite sense), producers of non-tradable goods benefit from this increase in the purchasing power of the population.

Another reason to keep the exchange rate low or, rather, to avoid devaluations; is the possibility of using it as anti-inflationary anchor.

In high inflation economies, a devaluation could encourage this problem, so it is normal for governments to decide to let the exchange rate appreciate rather than run the risk of prices skyrocketing. Of course, this is a temporary solution.

One point in particular deserves more detailed discussion here. On many occasions, industrial producers are against devaluations, even when their production is technically exportable.

This occurs when the goods made by these sectors are sold mainly in the domestic market, so the negative impact that the devaluation has on real wages (due to the increase in the prices of imported products) translates into lower demand.

In this way, a devaluation can be strongly contractionary (in fact it usually is in the short term), since it harms not only service producers but also the industry.

However, something that is not usually discussed is that for this to occur the economy must have a somewhat unbalanced productive structure.

Let's do the exercise of thinking about a scenario of free competition: although the devaluation would reduce domestic demand, the industry could benefit from less competition from imported products (which become more expensive) or from the possibility of starting to export.

Thus, after the initial negative shock, given that you cannot start exporting from one day to the next, the final net effect can be positive for the sector.

But this would not be the case if the industry depends on import restrictions. This occurs because they already eliminate foreign competition, so there is not much to gain from a depreciation of the currency.

The possibility of exporting would also not be available, because industries that require protection to sell domestically are usually very far from being able to compete in international markets.

Botton line, the industry is initially harmed by a currency devaluation, but the impact in the medium term depends on the level of protection: industries that survive thanks to restrictions on competition are harmed in the long term, while the others can improve their situation thanks to greater competitiveness.

7-Does this mean that the exchange rate set by the market is always the best option?

Not again. As can already be deduced from the article, there are no absolute answers in economics, nor permanent measures: everything depends on the context or, even more so, on each particular situation.

 

To illustrate, we will name here some particular cases in which it may be quite convenient to intervene in the fixing of the exchange rate. Which does not exclude that there may be other situations in which this is also desirable, we will only name the most common ones here.

1- Capital markets present a lot of volatility: that is, the entry and exit of financial flows that seek to arbitrage prices to capture short-term profits. In that case, it is logical to expect temporary intervention to stabilize the exchange rate and smooth out variations.

2- The capital markets take the exchange rate to a level that is not (and will not be) consistent with the productive and export development of the country: it may happen that a constant inflow or outflow of capital takes the exchange rate to an equilibrium in which the trade balance is strongly in deficit, for example.

The above can lead to a problem, since an exchange rate is being set that is too low for the survival of local activities, even when the supply and demand of foreign currency is in balance. This generally occurs when a lot of foreign currency is earned through privatization, loans or speculative investments, which then do not end up translating into an improvement in the productivity of the economy.

3- The economic structure is unbalanced and they want to develop a sector that is not competitive at the current exchange rate. This generally occurs in countries rich in natural resources.

The export of these resources generates a large income of foreign currency and reduces the exchange rate, making it more difficult for the rest of the industries to compete internationally.

If there is any reason why you want to develop these other industries, one possibility is to differentiate the exchange rate into two, which can be done by setting a double exchange rate or through specific taxes on the exploitation of natural resources (such as case of export duties).

The latter is the phenomenon known as dutch disease. It should be noted that the mere fact of the existence of abundant natural resources has led to interventions of this style, justified by this theory.

However, to justify a differentiated exchange rate, it is also necessary to explain why we want to develop these other types of activities, instead of letting the economy run its course and specializing in the exploitation of natural resources.

There is generally consensus on combating the Dutch disease when the appreciation is temporary (for example, the price of the good being exported takes on unusually high values), but justifying this type of policy as a measure for development is a little more difficult.

4- The economy is too in debt. If the country is too indebted in foreign currency, a devaluation could lead to payment chains breaking, generating bankruptcies and crises.

Maintaining the appreciated exchange rate forever is far from solving this problem, but if you can get out of that situation in the not-too-distant future, it seems sensible to avoid an unnecessary crisis.

8-How has the real exchange rate evolved in Argentina in recent decades?

Sometimes a picture is worth a thousand words. In the following graph, you can see how the real exchange rate increased after the devaluation of 2002, but it appreciated again due to the effect of inflation and the devaluation of Brazil starting in 2008.

A quick look at the graph reveals two interesting questions regarding our history. The first is that the real exchange rate of our economy as of December 2015 is at levels similar to those registered in the last period of convertibility.

Second, and something that has already been pointed out in previous articles, the level of the real exchange rate that functioned as one of the pillars of the model - simply - of the previous administration, was high.

9-Why have different types of exchange emerged in recent years?

To avoid a depreciation of the currency, the management of the outgoing national government implemented controls on the purchase of foreign currency. The reality is that many agents still wanted to acquire foreign currency at a price higher than that set by the Central Bank, which led to the creation of a parallel market or black currency market. 

Among the different measures that were adopted, is the much discussed exchange rate trap.

10-What prices are expected to show an increase after unification?

In the event of a devaluation, the prices that change the most are those of commodities, that is, those whose price is fixed in dollars in the international market. That is why grains, milk, meat, oil and minerals show sharp increases.

In Argentina, the result is that the prices of products that are produced internally, such as some foods, increase even more rapidly than goods with a high imported component, something that is not fully understood by the common population.

Taking out commodities, those products that have a greater imported component will show a greater price variation. Services, being non-tradable, would show the smallest increase.