By Hinsley Njila for The Chia Report
Recent persistent and unchallenged rumors about the imminent devaluation of the CFA Franc have left many who do business and/or hold long cash positions in Central and West Africa unsettled about the potential consequences to their interests. In the November 22nd issue of the Frontier Telegraph, Dr. Gary Busch alleges that the agreement to devalue the currency has already been reached by the Africans and the French. Furthermore, he alleges that Alassane Ouattara has been dispatched to make the rounds to all 14 CFA zone member countries to help them prepare for this eventual change.
We cannot independently verify the allegations by Mr. Busch, but it is prudent for us to analyze the situation in support of the interests that we protect in the region. In this article, I will offer a few explanations to the untrained economist as to the how and why a currency gets devaluated. I will talk about how central banks fix exchange rates, and with Cameroon being my focus, I will relate some of the lessons of devaluations in Mexico in 1995 and Thailand in 1997 to enhance my advice to the central government.
How and why does currency devaluation occur?
Devaluation is the reduction in the value of a currency toward goods and services, or with respect to the value of other currencies with which the currency can be exchanged. Stated in other words, devaluation occurs when the central bank raises the domestic currency price of foreign currency.
Whenever there is the perception that devaluation is imminent, this may lead to speculators ditching local currency for foreign reserves, in turn increasing pressure on the issuing country to actually devalue. Without perfect information, speculators will often continue buying foreign reserves, which ultimately lead to balance of payment issues. This phenomenon is what happened in Mexico in 1994 as Paul Krugman and Maurice Obstfeld wrote in ‘International Economic’ (2000) where the real exchange rate ultimately became equal to the nominal exchange rate and the currency fell very rapidly.
Devaluation can help do three main things
- Allow governments to fight domestic unemployment despite the lack of effective monetary policy.
- Resulting improvement in the current account, something that the government may find desirable.
- Lastly, to affect the reserves of the central banks if they are running low.
Currency would also be devalued in an environment where inflation rises quite rapidly because a Central bank in cahoots with a government is printing money to cover government expenses rather than borrowing.
How Central Banks Fix Exchange Rates
No analysis of the problems of West and Central Africa would be complete without taking into account the implications of fixed exchange rates. The CFA has been pegged to the French Francs since 1948, and during its history it has been devalued once in 1994 – CFA50 to CFA100=FF1. The responsibility of converting CFA to Euros has always been guaranteed by the French Treasury without any monetary policy implications for the Bank of France and ECB. Although BCEAO and BEAC maintain an overdraft facility with the Bank of France, their withdrawal limits were set in 1973.
Each CFA central bank must keep at least 65 per cent of its foreign assets in its operations account with the French Treasury; provide for foreign exchange cover of at least 20 per cent for sight liabilities; and impose a cap on credit extended to each member country equivalent to 20 per cent of that country's public revenue in the preceding year. Since 1999, the CFA/Euro exchange rate was fixed at CFA665.957 = EURO1.
Central banks succeed in holding exchange rates fixed only if financial transactions ensure that asset markets remain in equilibrium when exchange rate is at its fixed level. The process through which asset market equilibrium is maintained is often illustrated by the model of simultaneous foreign exchange and money equilibrium. Krugman and Obstfeld have a theoretical illustration of the Money Market Equilibrium under a Fixed Exchange Rate environment. They stipulate that to hold domestic rate at R*, the central bank’s foreign exchange intervention must adjust the money supply so that R* equates aggregate real domestic money demand and the real money supply: Ms/P = L(R*,Y). When exchange rates are fixed to a value say E0, market participants always expect it to remain fixed through the intervention of central banks.
Lessons from Thailand and Mexico
In their detailed analysis of the emerging market crisis that started with Thailand’s devaluation in 1997, Krugman and Obstfeld came up with very clear, easy to understand lessons learned. Of all the lessons they pointed out, we identified 3 that are most relatable to the situation in Cameroon, and we address those below:
1) The central importance of banking
I am a little concerned that if this rumor is left unaddressed, speculators at some point may trigger a bank run. If this should happen, one can conceivably see a scenario where in the short run the government may be conflicted between restricting the money supply to support the currency and the need to print large quantities of money to support bank runs. This will lead to many banks collapsing in Cameroon, causing extreme disruption to the economy by cutting off credit channels, even for profitable companies.
2) Choosing the right exchange rate regime
I do not get a sense by running inflation models for Cameroon since 1960 that the country has stabilized inflation. I fear that pegging on future exchange rates without this may not alleviate inflation expectations. This may lead to real appreciations and current account deficits that expose them to speculative attack. Much of the financial sector and corporations may suddenly find themselves insolvent.
3) The proper sequence of reform measures
Cameroon’s economy has been going through a series of distortions for quite a while now. I am a little concerned that ignoring the principle of second best, whereby when an economy suffers from multiple distortions, the removal of a few may make matters worse, not better. Additionally, I do not know that there are proper safeguards and supervision in place for financial institutions in Cameroon to cope with such distortions. At a time when growth is still fragile post 2008, foreign capital which is already at historically low levels, may flee with an economic slowdown leaving domestic banks insolvent. BEAC should insist that Cameroon delay opening their Capital account until it is sure that the country’s financial sector can handle the potential distortions.
Such an unexpected devaluation of the CFA will lower the foreign currency value of the government of Cameroon’s domestic currency liabilities to the private sector. The initial reserve gain by BEAC will be financed by a surprise tax on the holders of government bonds and money.
Paul Krugman & Maurice Obstfeld ‘International Economics (2000)’ Theory and Policy
The CFA Franc: new peg for a common currency http://www.un.org/ecosocdev/geninfo/afrec/subjindx/124euro3.htm