Supporting the Policy Environment for Economic Development

Impact of exchange rate fluctuations on the economy of Mozambique

The Impact of Exchange Rate Fluctuations on Economic Development in Mozambique

The exchange rate is a central price in the economy of Mozambique. It is a key variable in establishing the domestic price level. It is the principal equilibrating variable in the country’s international trade and payments. And, ultimately, it is a major facilitating variable in determining the rate and pattern of economic growth. To underscore the importance of the exchange rate in the economy of Mozambique just ask any taxi driver in Maputo for the latest US dollar or Rand or Euro exchange rate and he can tell you right away. But ask him about other important prices, such as the latest bank interest rates or evolution of the consumer price index, and he will generally draw a blank. The taxi-driver’s intimate knowledge of exchange rates stems from the fact that foreign currency rates are ubiquitous to everyday life in Mozambique. Trade integration with global markets has risen fast over the last several decades, particularly in terms of imports, and foreign currency is widely used locally for consumer and business transactions (e.g., rent payments on apartments, buying consumer goods across the border, accounts payable in business), as well as for savings. This ever-present nature of foreign currency in daily life amplifies the importance of exchange rate fluctuations on the economy and captures the interest of policymakers.

The purpose of this study is to assess the impact of exchange rate shocks on the economy. The focus of attention will be on five transmission channels through which fluctuations in the exchange rate affect economic activity. The first is via domestic price determination. Changes in exchange rates generate changes in import and export prices. In the case of prices of imports, these shocks then reverberate through the pricing chain to consumer prices and producer costs. In the case of export prices, exchange rate shocks impact exporter margins and international sales. The second transmission channel is via trade flows. Exchange rate swings have expenditure-switching effects on trade volumes, as a country’s products and services become more or less expensive relative to foreign goods and services. This, in turn, leads to shifts in global demand away from or toward a country’s products. Third, changes in exchange rates impact firms’ profits in a number of ways. One way is via changes in competitiveness, which has an impact on export volumes and/or on sales of import substitutes on domestic markets. Another way is through changes in the price of a firm’s assets and liabilities, which impacts the company’s net worth. The fourth transmission channel is by way of changes in valuations. Exchange rate shocks can have valuation effects on the domestic currency value of foreign assets and liability holdings. These valuation changes produce wealth effects on consumers and on firms that influence aggregate spending and investment. Fifth, the cumulative impact of all these effects of exchange rate changes can have important consequences for economic growth.

The paper is organized to follow the order of the five transmission channels enumerated above. Section 1 reviews the history of exchange changes since 1994 when the government moved to a more liberal exchange rate regime. Section 2 looks at the impact of exchange rate movements on prices. Section 3 examines the effects of exchange rates on trade flows. Section 4 reviews the impact of the exchange rates on firm earnings. Section 5 assesses the effects of exchange rate swings on valuations of assets and liabilities. Section 6 looks at the exchange rate-growth link. Lastly, section 7 concludes with policy implications of the study.

Impact of the exchange rate on the economy

In late 2011, a SPEED-commissioned study confirmed that the real exchange rate in Mozambique has been appreciating since 1995. That study highlighted the key transmission mechanisms of the impact of exchange rate shifts, as well as possible economic impacts of a real appreciation.  In early November 2011, a SPEED Note  outlined the challenges of real appreciation of the metical as a developmental challenge in Mozambique. The Note stressed that an appreciating real exchange rate—as a result of enormous influx of foreign exchange from mineral resources revenues—will place great strains on the tradables sector, competitiveness and long-term economic development.  It advanced a few policy proposals to deal with currency appreciation, in particular, the establishment of a sovereign wealth fund. A second SPEED Note, also from November 2011, examined sovereign wealth funds in other countries as an instrument widely used to decelerate real appreciation, cope with constraints on domestic absorptive capacity, create space for structural changes and allow for inclusive development and poverty reduction.

SPEED embarked on a new study to investigate whether Dutch Disease and other signs of the resource curse already exist in Mozambique. This study will include policy recommendations and further work on sovereign wealth funds as a management instrument. This study is near completion. A workshop to present the draft report is scheduled for mid-August, while the final report should be published in September.

SPEED’s exchange rate work has helped place currency appreciation on the agenda as a major policy issue in Mozambique. This work is expected to deepen understanding across stakeholders about the dangers of real appreciation of the exchange rate.  Ultimately, if successful the work should spur policymakers to implement a sovereign wealth fund, augmented with a stabilization fund to protect against volatility in the commodities markets.

This work will form the foundation of a larger agenda SPEED plans to pursue around the impact of extractive industries on the Mozambican economy.  Specific next steps include presenting and discussing the findings and recommendations of the current study on the existence of Dutch Disease signals in the economy; and expanding outreach and discussion on sovereign wealth funds to cement the understanding that they represent a superior instrument to alternatives.  SPEED will also advance more specific proposals on sovereign and stability funds by analyzing the costs and benefits of various sovereign wealth and stabilization fund structures.  SPEED will also work with other international partners that are active in this field.

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