A number of commentators argue that Greece cannot succeed in its fiscal consolidation because it cannot devalue. The argument is that a fiscal consolidation has a negative effect on domestic demand and the only hope for a country implementing a severe fiscal tightening such as an IMF programme is to devalue to boost its exports and generate growth. Although this argument has undoubtedly some truth in it, we would like to challenge it as the reality is actually much more complex than that. A devaluation is not always the panacea that some think it is.
First, an historical reminder: the Greek IMF plan is supposed to be unique in that it is for a country that cannot devalue. This is actually wrong. Recent examples exist of IMF countries with no ability to devalue. Latvia could not devalue either because a large part of the private liabilities were in foreign currencies, so a devaluation would have created a wave of defaults. Senegal, at the end of the 1990s, is another example, being part of the Franc CFA, a devaluation was not possible.
Trade Balance Effect
The main economic argument is that a devaluation makes exports cheaper and boosts competitiveness. This is undoubtedly true and indeed one should expect an increase in exports after a devaluation. However Jon Anderson in a recent note (Bad rules of Thumb #16 – Devaluation solves a lot of problem, 1 September 2011) uses many emerging economy examples to shows that devaluations are not always followed by an improvement in growth.
To quote Jon “The bottom line is that there is relatively little evidence to suggest that a devaluation works in terms of consistently promoting exports growth or trade adjustment in emerging countries¨. Same for growth, “keep in mind that the evidence in favour of devaluation is a lot less compelling than many people think”. Chart 1 shows the argument neatly. It compares growth in the five years before and after a devaluation. As one can see, there is no clear growth acceleration after a country lets its currency depreciate. If anything, the opposite seems true; growth tends to be lower after the devaluation.
To understand why, forget the economic argument for a second. Let’s look at the accounting argument in the case of Greece. The total value of Greek imports last year was EUR67.7bn while the total value of exports was EUR48.2bn, hence a trade deficit of EUR19.5bn. Now imagine Greece re-introduces its own currency and devalues it, just for the sake of the argument let’s assume a 50% devaluation as in our break-up piece (see Euro breakup – the consequences 6 September, 2011). The value of exports will not change; that is the plan: you do not change the price of exports in the national currency, so they are 50% cheaper from the point of view of the country that imports Greek goods. So exports remain at 48.2bn in the new money. But the value of imports jumps by 50%, so it jumps to 101.6bn. This means that the trade deficit is not 19.5bn anymore but 53.4bn in local currency. Congratulations: you have increased the trade deficit by 174%.
Chart 1: Devaluations Are Not Compelling for Growth
Obviously, the above accounting argument is too simplistic because it does not take into account the economic part of the story. Imports, because they are so expensive, would be reduced and exports, because they are so competitive, will increase. But the point is the following: the elasticity of exports and imports to price is key, especially in the case of Greece, where the accounting argument would generate a massive deficit first. For the devaluation argument to be valid, one needs to assume that exports and imports will react in size to the FX move, but also react very quickly. Why do we need a quick reaction? Well, simply because the EUR19.5bn deficit last year was 8.5% of GDP, the FX effect, without export/import adjustment would push the deficit to 23.2% of GDP – a level not sustainable for long.
Let’s push the argument further, imagine that by leaving the euro and devaluating, Greece is cut off from the financial markets. This is a typical feature of defaults; collateral damage is indeed that trade financing evaporates. Then it would not be possible to finance the trade deficit. Then the trade deficit would have to go down to zero, i.e., imports would have to be reduced to the level of exports. Remember that imports are now worth 101.6bn in the new Greek money, while exports are worth 48.2bn. Congratulations: you have just reduced your imports by 53%.
Is that a far-fetched scenario? Yes and no. Greece would need “hard currency” to pay its imports, one of the main repercussions of a default and devaluation in a country is that trade financing is made very difficult if not impossible at least for some time. Some countries have been in this situation and have been forced to prioritise imports of food and energy, for instance. So it is not an impossible scenario.
Another way to see the above-mentioned argument is that domestic inflation would surge. Why is that? Simply because import prices jump by the amount of the devaluation. Greece’s imports as a share of GDP are about 20%. Let’s once again forget about economics and move purely to accounting. The maths is very simple: a 50% devaluation would increase the price of 20% of GDP. Congratulations: you have increased inflation by 10%!
The economic mechanisms will make the adjustment more complex. Part of the devaluation would be absorbed by the corporate margins and not all the price increase would be passed to the consumer, at least not immediately. Hence the 10% is to be seen as a maximum. But inflation would accelerate and wages would almost certainly rise. This means that a country with a large devaluation runs the risk of initiating a wage-inflation spiral that could force more devaluation, hence more imported inflation. The key assumption here is the degree of reaction of wages to inflation. If wages do not react (i.e., real wages slide deep into negative territory), the inflation spiral does not materialise and the decline of real wage delivers the competitiveness improvement needed.
We would underline, however, that commentators arguing that a devaluation is “painless” are wrong. A devaluation is efficient at boosting competitiveness if and only if real wages are eroded, i.e., if the purchasing power of workers is reduced.
One further consequence of a devaluation, which partly results from the above discussion on inflation, is the impact on borrowing cost. One stylised fact in the literature on emerging market borrowing is that emerging market countries issue long-dated debt in foreign “hard” currencies, and short-term debt in domestic and foreign currency. But until recently, very little long-term debt was issued in local currency. Why is that? One problem for the country that borrows is to provide to the lender a credible commitment. If the country that issues debt has the ability to take action that hurts the creditor after the debt is issued, the creditor will ask for a risk premium. One typical example is inflation: after issuing a debt in its national currency, a government might inflate away its debt. If a country cannot credibly commit to low inflation, a foreign creditor will be ready to lend in domestic currency only short term, not long term. Long-term borrowing will be in hard currency, which will protect the creditor from the inflation risk.
This results in extra borrowing costs for the country. Any depreciation of the currency makes debt repayment in foreign currency more expensive. De facto, the government becomes long domestic currency (via its tax receipts) and short hard currency (the debt repayments).
Who is “Super Solvent”?
It also increases the risk of what economists call “debt run”. A “debt run” is a situation analogous to a bank run, but in this case the victim is the borrower. Because of lack of confidence, lenders refuse to lend and refuse to roll over the debt, even with a borrower who is fundamentally solvent. If the market closes, the borrower can be forced to default. This is one instance of “self-fulfilling” attack.
Why is a country which devalues its currency more prone to this effect? Because such a country is very likely, as explained above, to run a significant proportion of its debt in foreign currency. Hence the country has to be “solvent”, but for the market to be fully confident, the country has to be solvent also in the case of a currency crisis. If this is the case, a debt run is unlikely to happen. In economic parlance, the country has to be “super solvent”, i.e., able to repay its debt in hard currencies even in the case of a devaluation. This dramatically constrains the borrowing capacity of a country (not such a bad idea after all), while having a sizeable impact on the risk premium embedded in the sovereign curve.