Reasons for the Dalasi’s Poor Exchange Rate
As Gambians, we have been lamenting over the awful exchange rate of the Dalasi, in relation to the major currencies of the world, for a better part of 2 decades. One would think nearly 2 years after a democratically elected government, and a slim—to—no–chance of expropriation of assets of foreign companies, why hasn’t the exchange rate of the Dalasi improved? The bulk of the answer to that question lies in the Gross Domestic Product (GDP). Gross Domestic Product (GDP) is the monetary value of a country’s production of goods and rendering of services during a time period, usually a year. It could be the cost of shining your shoes in front of Albert Market in Banjul, or as sophisticated as the cost of building an oil carrying super tanker. If you think about it, the shoe shiner’s earnings end up in businesses where he/she buys goods or services from, which, in turn, report their earnings on their Income Statements, to the Income Tax or Revenue departments. Therefore, his/her earnings are captured in the GDP figure. First, let us look at the methods of compiling GDP: The Expenditure method and The Income method. The Expenditure method calculates GDP through spending; meanwhile, the Income method calculates GDP through the earnings.
Here are the components of the Expenditure method:
- Consumption by Individuals (C)
- Business Investments (I) excludes sale and purchase of stocks and bonds
- Government Spending (G)
- Imports (M)
The formula for the GDP Expenditure method, therefore, is: C + I + G + (X-M)
A steady increase in spending by consumers engenders a favourable exchange rate. When consumers are spending on goods and services, earnings of businesses improve. Their spending also has a multiplier effect on the economy, which signals to the foreign exchange traders of London and New York, who set the exchange rate of floating currencies, the health of an economy. For developed countries, the “Consumption by Individuals” is the largest component of GDP. Citizens of the developed countries have a lot of disposable income (income after taxes), to spend on goods and services. An increase in business spending also is an indication that businesses are thriving and willing to take risks. One thing you learn in Economics and Finance 101: the higher the risk, the higher the potential reward. For poor countries, like Gambia, the “Government Spending” is generally the largest component of GDP. Government spending should be a small component of GDP, unless during a recession, when individuals and businesses cannot increase their demand for goods and services. A spike in government spending that is not related to building infrastructure, roads, hospitals, schools, or factories, which economists dub as “Investments in the future of a country”, results in an increase in its obligations/liabilities and an inability to pay the bills–if it gets out of hand. The foreign exchange traders of London and New York see out of control government spending as a negative, which results in an unfavourable exchange rate.
The aggregate difference between the Exports and Imports (X-M) is the Balance of Trade or Current Account of a country. The Balance of Trade or Current Account has a very significant impact on a country’s exchange rate, in the GDP formula. If your exports are more than your imports–like Qatar—which, according to Trading Economics, Inc., had a monthly trade surplus of about 17.5 billion U.S. dollars, as of August 2018, an enviable position for a country to be in. If your imports are more than your exports–like Gambia—which, according to Trading Economics, Inc., had a quarterly trade deficit of about 70 million U.S. dollars, as of March 2018, an unenviable position for a country to be in. These numbers are reflected in the exchange rates of the Qatari Riyal and the Gambian Dalasi. While one U. S. dollar exchanges for 3.64 Qatari Riyals, one U.S. dollar exchanges for about 45 dalasis. The trade surplus results in a favourable exchange rate; a trade deficit results in an unfavourable exchange rate. From another cynical angle, one can argue why one U.S. dollar exchanges for about 6.95 Chinese Yuan, even though China enjoys a large trade surplus, vis-a-vis the United States. The explanation for that is: China uses the “Open Market Operations”, which entails the buying and selling of Chinese government securities (Treasury bills and Bonds) through its Central Bank, to artificially lower the exchange rate, to cheapen Chinese goods, which ultimately increases their sales abroad. The Open Market Operation is the tool Central Banks use to target exchange rates, interest rates, or inflation. This is what Central Banks do on a daily basis, buying and selling of government securities, to align with government policies.
If you look at the trade surplus or deficit from the view point of an individual, the trade surplus means your monthly salary is more than your monthly expenditure; a trade deficit means your monthly salary is less than your monthly expenses or bills. Creditors are kinder to the former than the latter. The same scenario plays for countries. The foreign exchange traders in London and New York, who determine the exchange rate of floating currencies (such as the Dalasi) are kinder to the former (trade surplus) than to the latter (trade deficit). This is what partly explains the exchange rate of a floating currency, like the Dalasi. One could further argue that the United States has a high trade deficit, then why does the U.S. dollar have a favourable exchange rate? The answer: the U.S. dollar is the reserve currency of the world and most of world commerce is conducted in it. Furthermore, the more foreign currency reserves at the Central Bank, the easier it becomes to pay one’s foreign obligations, which are repaid in the foreign currency of the creditor or lender. Another reason for the favourability/unfavourability of the exchange rate is found in the difference in GDP between the Expenditure method and the Income method. Again, let us look at the formula of the Income method of GDP.
Here are the components of the Income method:
- Total National Income (TNI): (the sum of all wages, rents, interests, and profits)
- Sales Taxes (ST)
- Depreciation (D): gradual decrease in the economic value of an asset, over its life span
- Net Foreign Factor Income (NFFI): it is the difference between the aggregate amount of money earned by a country’s citizens and companies abroad, and the aggregate amount that foreign citizens and overseas companies earn in that country).
The Philippines, which has a lot of her citizens working abroad, has a high Net Foreign Factor Income (NFFI); on the other hand, Kuwait, which has very few of her citizens working abroad, has a low or negative NFFI.
The formula for the GDP Income method, therefore, is: TNI + ST + D + NFFI
The difference between the GDP Expenditure method (C + I + G + (X-M) and the Income method (TNI + ST + D + NFFI) is the Statistical Error–and in less charitable terms–it is called the Black Market, Underground Economy, or the Hidden Economy. If you look at the two methods of calculating GDP (Expenditure and Income) they should be the same number, because one’s spending is another’s revenue or earnings. The Statistical Error number includes income earned by illicit transactions, like drug dealing or criminal enterprises, where income is not reported. According to the IMF, Africa’s development is stunted by the large Statistical Error number in the economies. In other words, African countries lose a lot of tax revenue, which could be utilized to build hospitals, roads, schools, or provide the social safety net. Countries that have a low Statistical error in their GDP, like the United and Switzerland, have a favourable exchange rate; countries like Egypt and Nigeria, which have a high Statistical error in their GDP, have an unfavourable exchange rate. As mentioned earlier, the ability to collect taxes bodes well for the exchange rate. These are the objective, measurable, unbiased reasons for the horrible Dalasi exchange rate. The subjective and biased reason would be the perception of the stability of a country and its government, by the foreign exchange traders in New York and London. That perception cannot be objectively quantified. The GDP of a country is similar to the Income Statement of a company, or the Budget account of a family, through which all monetary transactions flow, but at a higher and more intricate level of complexity. Meanwhile, the Gross National Product (GNP) is the value of all finished goods and services produced in a country in one year, by its nationals. It is a less accurate measurement of the economic and monetary activities than the Gross Domestic Product (GDP), because it leaves out economic & monetary activities of foreigners.
The bottom line is–we have to start selling to foreigners–goods and services they want; or we reduce our demand for the goods and services of foreigners. Most of you remember when Gambia Produce Marketing Board (GPMB) and the Gambia Cooperative Union were humming on all 4 cylinders, exporting groundnuts and cotton in large quantities. During those days, we had a favourable exchange rate. Obviously, there are more subtle reasons for the setting of the exchange rates of currencies, both objective and subjective, but this posting gives you the basic knowledge of how they are set.
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