Monetary and fiscal policy vs. foreign exchange rate

The US dollar has strengthened significantly against the Albanian Lek as well as the currencies of many industrialized countries and emerging markets in the period of mid-2022. This overvaluation of the dollar is seen in the current conditions of rising inflation as a major challenge for the economy of Albania.

In the recent past (a few seasons ago), a strong dollar was not considered a worrisome problem, as it is today. Whereas, in the conditions in which the economy, inflation and public debt are at their abnormal levels, this approach of the dollar to the Lek is a problem, although not to the extent that the approach of the Euro to the market has.

A major reason is the fact of exposure of external debt in dollars (11.2% of total debt).

However, today the problem is not only debt service, but the moment when a strong dollar fuels inflationary pressures and makes it more difficult to service the debt expressed in dollars.

A strong US dollar/euro[1]

it has already made debt servicing more difficult. This is a particular problem for the Albanian government and companies, because most of their borrowing is in Euros and a little less in dollars.

The external borrowing of the Albanian economy for the Euro has increased by 12.4 percentage points more compared to 10 years ago and for the dollar it has increased by 2.6 percentage points more for the same period.

A current response of the government is first to issue a new debt, mainly already in the domestic market, through the combination of the demand for liquidity with the monetary mechanisms that are implemented and monitored by the Bank of Albania.

On the other hand, the Bank of Albania itself has responded to inflation, as well as the weakness of the Lek, by increasing interest rates, but this has so far had the effect of slowing down the economy and may even affect a decline as far as it has an impact. in the Albanian economy that has an informal competitive parallel market.

What can the government do in coordination with the Bank of Albania to counter a strong US dollar/euro?

Several countries have recently intervened in the foreign exchange markets to strengthen their currencies by selling dollar assets in order to increase the supply side of the domestic market. But in any case, this political action does not apply to Albania, since the major risk comes from the internal monetary and fiscal policy, rather than the policy to increase the supply in the market with foreign currencies.

The dollar in Albania has strengthened not because of excessive introduction of US currency into the local market, but because the US economy is expected to be stronger than most other economies for the foreseeable future, along with higher interest rates. of the dollar and the safe haven status of the dollar for the main hydrocarbon products that directly affect the economy and the Albanian family budgets.

The US dollar is also considered a “safe haven” currency and with the war in Ukraine, as monitoring of foreign markets shows that there has been a “flight” of trade for goods and services, but also for armaments and military budgets (not only from Ukraine) to dollar-based products, increasing the US exchange rate.

In the periods when our Leku currency weakened against the dollar (as happened in the months of July – October 2022)[2], the price of imports in the markets where it was imported with this currency increased and this moment exerted pressure on the prices of goods.

On average, according to a calculation made by ALTAX experts, it turns out that a 5 percent appreciation of the dollar has been able to convey in the Albanian market an inflation level of up to 0.5 percent. This inflationary pressure extended beyond the direct import of goods from the USA, Turkey or countries that do not trade with the Euro.

Commodity prices like oil, wheat and metals are quoted in dollars, so a stronger dollar means a higher price for these things. Further, because food and energy expenditures account for a larger share of the economy’s consumption, rising dollar prices of these goods significantly increase their cost of living. Two are the major part of Albanian imports in the markets with this currency [3]: fuels and raw materials [4].

Although we are talking about a weaker Lek in the period June – October 2022, it can be seen that it could help a little in the promotion of exports and the sales of companies for export in a non-uniform way, since a part of the exporting companies also had other effects which blunted these exchange rate advantages.

The same companies that exported products were also dependent on imported inputs for production.

A weaker Lek increased the cost of raw material products that were purchased in the markets where they imported in USD.

The effect of a weaker currency is more complicated than the simple devaluation-exports link [5].

A stronger US dollar has been associated with a number of problems, including declines in production, consumption, investment and government spending.

A recent analysis by Maurice Obstfeld and Haonan ZhouMaurice [6] finds that a 10 percent appreciation of the dollar leads to a real GDP decline of about 1.5 percent relative to the trend in emerging market economies. They find that the negative impacts of a strong dollar are greater for countries that peg their exchange rates, that have not adopted inflation-targeting monetary frameworks, and that have high levels of dollar debt. The negative impacts of a strong dollar on emerging economies are magnified in the current context because many of these countries increased their levels of public and business sector debt due to the pandemic. A strong dollar increases the real dollar value of debt, higher interest rates increase the burden of debt service, and slower growth reduces business profits and government tax revenues.

In particular, the main line of defense against destructive exchange rate pressures would be for countries to adopt a coherent, stability-oriented approach to fiscal and monetary policy.

Fiscal policies have been very accommodative in recent years, to counter first the consequences of Covid-19 and now those of the energy price shock.

In particular, the large deficit in the situation of the Albanian budget, which also has high debt and in the conditions of a market with weak productivity bases, tends to continue to damage fiscal stability and strongly influence fiscal policies, perhaps anchoring expectations. for increasing inflation and accelerating currency devaluation.

In all these months of the majority of 2022, despite the continued increase in the interest rate, it can be seen that the monetary policy is not affecting the positive reaction of the market to the increase in inflation.

The concern for the future remains the fact that the Bank of Albania may further tighten the monetary policy from the point of view of increasing interest rates, while trying to limit the devaluation of the Lek in the exchange rate with the dollar.

Fiscal intervention to cushion the energy price shock can help curb inflation in the short term and stabilize household purchasing power. However, against the backdrop of supply constraints and elevated inflation, continued fiscal expansions may force central banks to tighten monetary policy even more aggressively and possibly reinforce exchange rate divergence.

But, above all, it remains for the government to increase the vigilance of institutions to activate anti-informality packages, as well as the Bank of Albania must impose further mechanisms to reduce the presence of free and informal lek in circulation, whether in the case of remittances , but also for informal money from the economy that is generated by dirty money.

 

[1] 69.7% of the country’s external debt is in Euros
https://financa.gov.al/wp-content/uploads/2022/10/Buletini-i-Borxhit-T3-2022.pdf
[2] https://www.bankofalbania.org/Tregjet/Kursi_zyrtar_i_kembimit/
[3] Turkey, China, Ukraine, Middle Eastern countries and other non-EU countries
[4] http://www.instat.gov.al/media/10596/tregtia-e-jashtme-shtator-2022.pdf
[5] If a country exports more than it imports, there is a high demand for its goods, and therefore, for its currency. The economics of supply and demand dictate that when demand is high, prices rise and the currency appreciates.
Conversely, if a country imports more than it exports, there is relatively less demand for its currency, so prices should fall. In the case of currency, it depreciates or loses value.
[6] The Global Dollar Cycle