The Malawi Kwacha
The Malawi Kwacha has for the past three years been trading at K140 to the United States Dollar. In the wake of the recent global economic crisis that has seen the devaluation of some of the world’s major currencies – key among them being the United States Dollar and the British Pound Sterling, there have been calls from some sections of the Malawian society and the international donor community for the government to devalue our local currency, the Kwacha. The Bretton Woods Institutions (the World Bank and the IMF) too have been calling on the government to lessen its grip on the exchange rate. The president has however stood his ground (just as he did when he first introduced the fertilizer subsidy program) and has so far resisted all calls to devalue the Kwacha. What, though, is devaluation and what are the likely consequences of such a move? In this article I attempt to explain this and more.
The Malawi Government maintains a managed float exchange rate system, which is a hybrid of a fixed exchange rate system and a flexible exchange rate system. Unlike in a fixed rate regime, the Reserve Bank does not have an explicit set value for the currency; and unlike in a flexible exchange rate regime, it doesn’t allow the market to freely determine the value of the currency either. Instead, the Reserve Bank has either an implicit target value or an explicit range of target values for the currency, determined by pegging the Kwacha against a trade-weighted basket of currencies of the country’s major trading partners. The Bank intervenes in the foreign exchange market by buying and selling domestic and foreign currency to keep the exchange rate close to this desired implicit value or within the desired target values.
Only a decision by the government through the Reserve Bank of Malawi can thus alter the official value of the currency. The government could, if it wished, take such a measure, often in response to unusual market pressures. Devaluation, the deliberate downward adjustment in the official exchange rate, would reduce the Kwacha’s value. To illustrate, the present exchange rate is K140 to one dollar. To devalue, government, through the Reserve Bank might announce that from now on K280 will be equal to one dollar. This would make the Kwacha half as expensive to Americans or anyone intending to buy it, and the U.S. dollar twice as expensive to Malawians.
Under what circumstances might a government devalue its currency? It is often because the interaction of market forces and policy decisions has made the currency’s fixed exchange rate untenable. In order to sustain a fixed exchange rate, a country must have sufficient foreign exchange reserves, often dollars, and be willing to spend them, to purchase all offers of its currency at the established exchange rate. When a country is unable or unwilling to do so, then it must devalue its currency to a level that it is able and willing to support with its foreign exchange reserves. Going back home, there have been numerous cries about the shortage of foreign currency in the country, which climaxed with the arrests of several people suspected of externalizing forex and the closure of all unlicensed forex bureaus which were thought to be hoarding forex. This is one of the reasons why the aforementioned stakeholders have been calling for the devaluation of the Kwacha.
A key effect of devaluation is that it makes the domestic currency cheaper relative to other currencies. There are two implications of a devaluation. First, devaluation makes the country’s exports relatively less expensive for foreigners. This would seem to be consistent with the president’s vision of turning Malawi into a net exporter as it would drive up exports. Second, the devaluation makes foreign products relatively more expensive for domestic consumers, thus discouraging imports. This may help to increase the country’s exports and decrease imports, and may therefore help to reduce the current account deficit.
However, the president’s argument has been that devaluing the currency will make things more expensive for the average Malawian. “Devaluation of the kwacha would only benefit a few people, and most of them are not even Malawians,” the president is quoted as saying. “On the other hand, devaluation would impact badly on poor people as it would increase prices of commodities… the cost of raw materials and equipment importation for companies.” This is a highly valid argument as a significant risk is that by increasing the price of imports and stimulating greater demand for domestic products, devaluation can aggravate inflation. If this happens, the government may have to raise interest rates to control inflation, eventually slowing down economic growth.
One other risk of devaluation is psychological. Often times devaluation is seen as a sign of economic weakness. This would place the creditworthiness of the nation at risk. As a result, devaluation may lower investor confidence in the country’s economy and may reduce the country’s ability to secure foreign investment.
The government is thus faced with a tough choice here. In the end, it all depends on who has the most votes as the issue of devaluing the Kwacha becomes more of a political decision than an economic one. The business community, who the president argued he is trying to protect too, wants assurance that there will be enough foreign currency reserves in the country. I would not be surprised if I found the Kwacha still trading at K140 to the US$ come the World Cup in 2010!
This article was also published in Malawi’s Daily Times newspaper and the online Nyasa Times (http://www.nyasatimes.com/columns/of-devaluing-the-malawi-kwacha.html)
Memoirs of an economist | Christopher Chibwana 