Despite the strong demand by the IMF and World Bank, the government of Prime Minister Abiy Ahmed resisted currency devaluation for years siting its economic impact mainly on the poor. However, chronic foreign currency shortages particularly in recent years forced him to reverse its long-standing policy of fixing the exchange rate in a bid to secure a reported loan of $10.7 billion from the International Monetary Fund (IMF) and World Bank. Under the new policy announced by the central bank, the value of the Ethiopian currency – the Birr – will be set by the market.
The IMF and World Bank has been calling for a series of reforms, including floating the currency, before it agrees to a bailout. The National Bank Governor, Mamo Mehretu, said the country was immediately introducing a competitive, market-based foreign exchange regime, in a major policy shift in half a century. The change allows commercial banks to buy and sell foreign currencies at negotiated prices. One of the reasons cited by the National Bank for the new policy was the flourishing of an “unanchored” parallel market, where, up until the policy change, the dollar was costing double the official rate. Importers were often forced to turn to the parallel market to purchase dollars because of a chronic shortage of foreign currency, meaning that some of the higher costs have already been priced in.
While the official Dollar-Birr exchange rate is taking an upward trend every day, the parallel exchange rate market mysteriously showed stability with no significant increase as it was anticipated by many. Following few days of the decision of the National Bank, the Dollar-Birr exchange rate surpassed the 100 Birr mark and the market, as it was expected, reacted by significant price hike on basic commodities. This situation alarmed Prime Minister Abiy to issue stern warning to Commercial Banks to evaluate and rethink their current practice. In a similar tone, Prime Minister Abiy also stated that he gave green light to the country’s law enforcement agencies to take legal measures against business men who are “sabotaging his reform drive” by illegally increase price and horde basic commodities to create artificial scarcity.
While notable economists argued the essence of “currency devaluation” with its inevitable impacts, Prime Minister Abiy in his usual “lecturing people” style counter argued by saying he is rather doing “Currency Unification than Currency Devaluation”. Taking note of this fact, the issue which needs proper analysis is what are the economic strategies of Currency Unification and Currency Devaluation.
In the complex world of international finance, currency devaluation and currency unification are two distinct yet interconnected strategies that countries employ to address various economic challenges. Understanding these concepts and their implications can shed light on their impact on national economies and global markets.
Anatoli Colicev of University of Liverpool stated that Currency Devaluation refers to the deliberate reduction in the value of a country’s currency relative to other currencies. This is typically achieved through governmental or central bank policies and is often employed to boost a country’s economic competitiveness. Here’s a closer look at why and how this strategy is used. There are several reasons for Currency Devaluation.
According to Anatoli Colicev, countries devalue their currency to boosting exports. By lowering the value of its currency, a country makes its exports cheaper and more attractive to foreign buyers. This can lead to an increase in export volumes, potentially improving the trade balance. Country’s devalue their currency in a bid to reduce their trade deficits. For countries experiencing large trade deficits, devaluation can help narrow the gap by making imports more expensive and exports cheaper. Countries are also devaluing their currency to stimulate their domestic economy: A weaker currency can encourage consumers to buy domestically-produced goods instead of imported ones, thereby stimulating local industries.
By devaluing their currencies, countries will face risks and challenges in which inflation is the prime one. Joep Konings, Dean of the Graduate School of Business at Nazarbayev University noted that Currency Devaluation can lead to higher prices for imported goods, contributing to inflation. This can erode purchasing power and potentially lead to cost-of-living increases. According to Richard Cooper of Princeton University, countries with significant amounts of foreign-denominated debt may find that devaluation increases the cost of repaying these obligations, leading to potential financial strain. Currency devaluation also affect the investor confidence. Frequent or severe devaluations can undermine investor confidence, potentially leading to capital flight and reduced foreign investment.
On the other hand,Currency Unification involves the merging of multiple currencies into a single, unified currency system. This strategy is often pursued to streamline economic activities and enhance regional stability. Here’s an overview of why countries might choose to unify their currencies and the challenges they face.
Pierre-Richard Agenor, an IMF Economist stated that economic Integration is one of the motivations for Currency Unification. Currency unification can facilitate easier trade and investment among countries by eliminating exchange rate uncertainties and transaction costs. The Euro, adopted by many European Union countries, is a prime example of this approach. Enhanced Stability is the other motivation for Currency Unification. According to Pierre-Richard Agenor, a single currency can help stabilize economies by anchoring them to a common monetary policy, which can be particularly beneficial for countries with historically volatile currencies. Increased Market Efficiency will also motivate Currency Unification. Unified currency systems can enhance market efficiency by reducing the complexities of currency exchange, thereby promoting greater economic cooperation and integration.
Here, it is imperative to analyze the challenges of Currency Unification. One of the challenges is “Loss of Monetary Autonomy”. Robert Flood, Senior Economist of IMF noted that countries adopting a common currency relinquish control over their individual monetary policies, which can be problematic if their economic conditions diverge significantly from the unified monetary policy. “Economic Disparities” is the other challenge of Currency Unification. Economic disparities among member countries can create tensions, as a single currency may not equally benefit all participating nations. This can lead to imbalances and potential economic strain on less stable economies. The other challenge of Currency Unification is “Transition Costs”. The process of unifying currencies involves substantial administrative and logistical costs, including the redesign of financial systems and the management of the transition period.
Regarding the interconnections and implications, Currency Devaluation and Unification, while seemingly opposite strategies, can sometimes intersect. For instance, countries considering unification may devalue their currencies as part of a preparatory strategy to align their economies before adopting a common currency. Conversely, the process of unification can affect the relative value of currencies within the unified system.
In summary, currency devaluation and unification represent critical economic strategies with distinct purposes and implications. Devaluation can provide short-term economic relief and competitive advantages but comes with risks such as inflation and loss of investor confidence. Currency unification, on the other hand, aims at long-term economic stability and efficiency but involves significant trade-offs and challenges, including the loss of individual monetary control and economic disparities among member states. Understanding these strategies helps policymakers, investors, and analysts navigate the complexities of global economics and make informed decisions in a dynamic financial landscape.
