‘Don’t lose faith in flexible exchange rate regime’
In the past few months, the kwacha has rapidly lost value against major foreign currencies. Our Senior News Analyst DUMBANI MZALE sought the views of the World Bank country manager LAURA KULLENBERG on this occurrence.
Q
:In simple terms, how should Malawians understand this fall in the value of their currency?
A
:I think we need to take a realistic view on the depreciation of the kwacha against the dollar, considering the various factors that drive movements in floating exchange rates. So, in simple term, let us start by considering the difference in annual inflation between the US [which is close to zero], and Malawi [which is currently at 23 percent]. So, just in basic purchasing power terms—meaning for relative prices to remain the same in the two currencies—then we can expect the kwacha to depreciate by around 23 percent each year. So, as long as inflation in Malawi remains substantially higher than in the United States, then we can expect the kwacha to continue to lose value against the dollar. This is just a simple economic fact.
Q
:But why now? How would you explain the timing of this recent depreciation even before the end of the tobacco selling season?
A
:This is due to a number of factors. Firstly, Malawi naturally has a seasonal pattern of supply and demand for foreign exchange which has an effect on the upwards and downwards movement of the exchange rate. The largest sector of export earnings is still tobacco, with inflows coming in during the auction sales season of between March to September. Then, there is an increase in import requirements around October to December, when key agricultural inputs such as fertiliser need to be imported.
In addition, this year has seen a poor agricultural crop which is likely to affect a number of economic variables, including gross domestic product (GDP) growth, inflation and export earnings from cash crops. This drop in production appears to have had an impact on business confidence. Confidence was already weak due to uncertainty about government policy and the challenges that government is experiencing in reducing the budget deficit. So, with weak private sector confidence, it is perhaps unsurprising that a number of shocks have had the effect of undermining market confidence in the kwacha.
Q
:What can Malawi do in the short-term to tame the kwacha?
A
:The most important need is for government to reduce the size of its fiscal deficits and to maintain a tight monetary policy until inflation can be brought down to a lower level. High inflation does all sorts of damage to Malawi, including eroding the purchasing power of all Malawians and discouraging savings—especially the poor, so there are many reasons why we would want to see lower inflation. In addition, it is important to put the recent kwacha depreciation into the broader context. Given current uncertainties in the global economy, including weaker investor confidence in the prospects of emerging markets, particularly China, we have seen exchange rate depreciation across a number of developing countries against the dollar. For example, the South African rand—one of Malawi’s most important trading partners— has also weakened, so the relative depreciation of the kwacha against the rand is much less compared to the dollar.
Q
:You have mention inflation several times. What makes it so bad in Malawi?
A
:Yes, inflation is a key problem. Inflation in Malawi has returned to an upward trajectory and remains well above regional comparators. In Malawi, food accounts for a larger share in the inflation basket, about 50 percent nationally, and much higher in rural areas. The weather shocks on agricultural production in the 2014/15 season have contributed to this upward movement. However, the core underlying factors are related to government’s continued large fiscal deficits and borrowing requirements. Plus of course when the exchange rate depreciates, this raises the cost of imported goods, further increasing inflationary pressures.
Q
:Is there a long-term solution to minimise this exchange rate volatility?
A
:In the long run, the challenge will be to improve Malawi’s competitiveness so that the country can generate additional sources of export earnings. This means improving economic infrastructure, in particular, power, water and transport services, building human capital through education and skills training and simplifying Malawi’s often complex and burdensome regulatory environment for business.
In the short-term, the basic macroeconomic imbalances that have caused so much difficulty in Malawi need to be addressed [on fiscal deficits, inflation etc.]. In addition, it is important not to lose faith in the flexible exchange rate regime. It is important to look beyond the exchange rate to the underlying issues that are causing the kwacha to depreciate.
Q
:In view of the rate at which the Kwacha is falling, would it be advisable for government to fix the exchange rate as a way of containing the problem?
A
:A few years ago, government tried to fix the exchange rate. We saw what damage can occur. If we try to fix the exchange rate without dealing with the fundamental problems that keep pushing up prices, particularly the size of the budget deficit and government’s large domestic borrowing requirement, then all those inflationary pressures keep on building up without any outlet. The risk would be a return to shortages of essential imported goods such as fuel, doing real damage to the economy.
Q
:Any final word?
A
:These issues of inflation and currency volatility are of close interest to us at the World Bank. We are currently finalising our Malawi Economic Monitor publication—the second one for 2015, in which we provide more analysis on these issues surrounding economic developments in Malawi. We will publish this second edition in October and it will be available online on the World Bank Malawi website.
