IMF SUPPORTS CBA’S DECISION TO RETURN TO FLOATING EXCHANGE RATE REGIME

Noyan Tapan

M arch 4, 2009

YEREVAN, MARCH 4, NOYAN TAPAN. The Central Bank of Armenia (CBA) on
March 3 stopped its interventions in the currency market and returned
to a floating exchange rate regime. The International Monetary Fund
(IMF) Armenia Office has presented its approaches to this fact,
responding to a number of questions.

Question: What is the IMF’s view about the exchange rate adjustment
announced by the CBA?

Answer: The IMF strongly supports the decision of the Central Bank of
Armenia to return to a floating exchange rate regime. In recent days
and weeks, the CBA has had to sell large amounts of dollars almost
every day in its attempt to keep the exchange rate stable at around
305 dram per dollar.

This policy has proved to be unsustainable. Moreover, maintaining a
dram that is too strong is bad for Armenia’s competitiveness. A weaker,
cheaper dram will help to make Armenian exports more attractive.

Q: Why is a floating exchange rate necessary? Why not just move to
a new, depreciated, fixed rate?

A: The IMF has for many years been of the opinion that a floating
exchange rate regime is the best choice for the Armenian economy,
because Armenia has a small, open economy that is dependent on
what happens in the rest of the world. The problem with a fixed
exchange rate is that it is very difficult for any central bank to
correctly choose the optimal level of the exchange rate, and in fact,
the optimal level is constantly changing, depending on what happens
to international prices, the economies of trade partner countries,
etc. If the exchange rate is fixed at a level that is too strong,
like we believe was recently the case in Armenia, this means that
Armenian exports become too expensive, which negatively affects
economic growth, and could lead to a loss of jobs and an increase in
poverty. On the other hand, if the exchange rate is fixed at a level
that is too weak, this means that the economy can overheat, which
can lead to high inflation. Therefore, it is best to let the exchange
rate float and let the market find the optimal level at any time.

Q: Why was the rate previously appreciating?

A: For the last several years, there were large inflows of foreign
currency, mostly dollars, into Armenia (in the form of remittances,
foreign direct investment, exports, and foreign aid). Expected
appreciation also led to dedollarization, which further increased the
supply of dollars. More supply of dollars meant that the price of the
dollar was falling, which is why the dram was previously appreciating
against the dollar.

Q: Why does the rate need to depreciate now?

A: Because of the global financial crisis, there is a significant
reduction of foreign currency inflows into Armenia. In particular:

Export prices have fallen significantly (copper and molybdenum prices
lost about 2/3 of their value), leading to lower export revenues
for exporters.

Global demand for Armenian exports has fallen, meaning a further
reduction in export revenues.

The Russian economy is experiencing serious problems, meaning a
reduction in remittances (money transfers) from Russia to Armenia,
as well as in foreign direct investment from Russia.

In short, there are now significantly less dollars coming into Armenia
than before. Now that the CBA has decided to let the exchange rate
float and to let the market determine the equilibrium level for the
dram, fewer dollars means that the price of the dollar should go up,
which means that the dram should depreciate.

Q: By how much will the dram depreciate?

A: Neither the CBA nor the IMF can tell you exactly by how much the
dram will depreciate, because under a floating exchange rate regime,
it is the market that will determine what is the optimal level of
the dram, and this depends on the total demand and supply of dram
and dollar in the economy.

However, we have tried to estimate the so-called equilibrium exchange
rate for the dram, and based on these estimations, we expect that
the dram will depreciate by about 20 to 30 percent. We in fact used
three different models for estimating the equilibrium exchange rate,
and each model gave a similar result, which was that the dram is
currently overvalued by 20 to 30 percent (see chart). We will soon
publish a paper on our website where we explain the details behind
these estimates. The CBA has also made similar estimations, posted
on its website, which are within the same range.

Note that Armenia is only just catching up with other countries in the
region: Belarus and Kazakhstan both recently devalued their currencies
by 20 percent, and Georgia devalued by 11 percent. The Russian economy
has been the most seriously affected, due to the large fall in oil
prices, as a result of which the ruble has gradually lost 35 percent
of its value. For Armenia, we expect less depreciation than in Russia,
but more depreciation than in Georgia. Probably it will be something
similar as in Belarus and Kazakhstan. However, from now on, it will
be the foreign exchange market that will determine what the new dram
rate is going to be on any given day.

Q: Will the central bank continue to intervene, and if so, when?

A: The authorities’ program will allow for some, but only very limited
central bank interventions. The fact that the CBA has decided to
return to a floating exchange rate does not mean that the CBA will
not intervene at all.

Our recommendation for Armenia is that central bank interventions
should be used only to reduce excessive exchange rate volatility
(that is, to avoid large changes from one day to the next), and the
central bank should not target a specific level or specific path
for the exchange rate. By the way, the CBA can use these limited
interventions also to purchase foreign exchange, not just to sell it.

Q: What will you (or the CBA) do if the exchange rate overshoots?

A: We are not concerned about a temporary "overshoot". In fact, it is
quite normal for exchange rates to overshoot, that is, to temporarily
go above the expected equilibrium level. It is therefore possible
that we will see first a fairly large depreciation, followed by some
appreciation. If this happens, there may not be any need for the CBA
to intervene, because if the exchange rate overshoots sufficiently,
people will start using this opportunity to sell their dollars for
a very good rate, and as a result, the exchange rate will come back
down to its equilibrium level.

Q: Is there a risk of bank failures? Should we take our money out of
the banks?

A: There is no reason why Armenians should take their money out
of the banks. In fact, the banking system is very liquid, very
well capitalized, and very well prepared for this depreciation. In
particular, banks’ liquid assets to total short-term liabilities are
above 100 percent, and their average capital adequacy ratio (CAR)
is well above the CBA requirement of 12 percent (it was 27.5 percent
at the end of 2008). In addition, there is a good deposit protection
system in place. And finally, the CBA stands ready to inject more
money into the banking system if needed.

Q: Why is there a need for an increase in the refinancing rate?

A: A temporary increase in interest rates is needed for several
reasons.

First, it will help to increase confidence in the banking system,
by rewarding Armenians for keeping their money in the banks. Second,
it can help to reduce the inflationary pressures that are likely to
result from the depreciation, and sends a signal that the central
bank is still serious about inflation. Finally, it will help to reduce
incentives for banks to engage in speculative behavior, because it will
become more expensive for banks to borrow dram from the central bank.