"DOLLAR DEVALUATION WAS PARTLY SPECULATION"
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[01:12 pm] 17 December, 2007
The demand for the US dollar has significantly fallen, the
representative of the International Monetary Fund (IMF) in Armenia
Nienke A. Oomes noted.
The dram-dollar exchange rate is like the price of the dollar,
expressed in dram terms. Just as the price of any other good, the
price of the dollar is affected by the laws of supply and demand. If
the supply of dollars rises, the price of the dollar falls – that is,
the dollar depreciates and the dram appreciates.
If the demand for dollars rises, the price of the dollar rises,
and the dollar appreciates relative to the dram.
Keeping this in mind, we can see four main reasons for the recent
dram appreciation. First, the supply of foreign currency (mostly
U.S. dollars) in Armenia has increased, as a result of large inflows
from abroad.
Second, the demand for dollars has fallen, as a result of
dedollarization or "dramatization". Third, there is some evidence
that speculation is playing a role as well. A fourth factor is that
the U.S. dollar has depreciated worldwide, which has to do with the
trade deficit of the United States, but this does not explain why
the dram has also appreciated against the euro. Let me therefore
elaborate on the first three factors.
The first reason for the appreciation is that a lot of money is coming
into Armenia from abroad, mostly U.S. dollars, causing an increase
in the supply of dollars.
These inflows of dollars are related to various factors: remittances,
the establishment of new banks with foreign capital, the capitalization
of existing banks who are expanding their activities, investment
into real estate by foreigners, other foreign direct investment,
and foreign aid.
The second reason for the appreciation is dedollarization, or a fall
in the demand for dollars.
While we do not know how many dollars are still under people’s
mattrases, we do know that the share of bank deposits that is
denominated in foreign currency has fallen significantly, from about 75
percent at the end of 2004 to about 40 percent currently. This suggests
that there has been a serious dedollarization or "dramatization"
of the Armenian economy.
Interestingly, this phenomenon of "dedollarization" is both a result
and a cause of dram appreciation.
Dedollarization is a result of expected dram appreciation, because
if Armenians expect the fall in the dollar to continue, they will
sell dollars and buy dram. But at the same time, dedollarization is
also a cause of dram appreciation, because the fall in the demand
for dollars and increase in the demand for dram implies a fall in
the price of the dollar and an increase in the price of the dram,
that is, a fall in the dram-dollar exchange rate. So appreciation
leads to dedollarization, which in turn leads to more appreciation,
which then leads to more dedollarization, etc. This also implies that,
if Armenians expect further appreciation, they start to sell dollars
and there will be further appreciation.
A third reason that may partly explain the recent strong appreciation
is the fact that the foreign exchange market is less active during
the weekend, which can create opportunities for speculation.
Speculation means that people try to make money by selling dollars
when they expect the dram-dollar rate to fall, and by buying dollars
when they expect the dram-dollar rate to rise. Opportunities for making
money in this way are made easier because the foreign exchange market
does not work well during weekends.
This is because the official foreign exchange market (ARMEX) does
not work in the weekend, and most banks and the Central Bank are also
closed in the weekend.
As a result, the exchange rate in the weekend is almost exclusively
determined by foreign exchange offices on the street, which is a much
less active market than ARMEX. This means that, if someone sells 1
million dollars on the street during the weekend, this has a bigger
effect on the exchange rate than if this 1 million dollars is sold
during the week. Therefore, the exchange rate is likely to overreact
during the weekend.
What happened during the weekend of November 24-25, when the rate
fell as low as 280 on Sunday and then rose to 305 again on Monday?
We don’t know exactly what happened, but it is possible that the story
is something like the following. In the first few weeks of November,
a lot of dollars were flowing into Armenia, related to money transfers,
the capitalization of banks, foreign direct investment, and possible
other reasons. This caused the dram-dollar rate to fall quite rapidly,
from about 330 at the end of October to about 315 by Friday,November
23. This rapid fall in the dram-dollar rate caused the population to
panic, and Armenian households and businesses started to sell their
dollars and buy dram, leading to a further fall in the dram-dollar
rate. This is where opportunites for speculation arose. Those who
were able to predict that panic and dedollarization would drive
the dram-dollar rate down further during the weekend were able to
make money by selling dollars at a rate of 315 on Friday and buying
them back at a rate of 280 on Sunday. Those who were able to predict
that the dram-dollar rate would rise again on Monday, when the banks
opened again, were able to make money by buying dollars at a rate of
280 on Sunday and selling them at a rate of 305 on Monday. We do not
know who these people were, but anybody who was able to predict the
market could have earned significant profits this way.
What should be done about the appreciation?
The IMF realizes that the appreciation of the dram has been very
painful for households who receive remittances in dollars and for
businesses who export their goods. However, unfortunately there is
little that the Central Bank can do to lessen this pain. The dram will
continue to strengthen as long as money continues to flow into Armenia
from abroad, and as long as the population continues to change their
dollars into dram. The Central Bank can of course try to reduce the
appreciation to some extent by buying dollars. They have already been
doing this very actively, for example, they bought about 175 million
dollars in November alone, which is more than what they bought in the
first 10 months of the year. If they had not bought this many dollars,
the dram-dollar rate would have fallen by much more than it actually
did. The problem, however, is that when then the Central Bank buys
dollars by selling dram, they create inflation. This is because they
increase the amount of drams that are circulating in the economy,
while the amount of goods and services does not increase, which means
that prices will go up. And higher prices are equally painful for
Armenian households and businesses. We therefore recommend that the
Central Bank only intervene in the foreign exchange market to reduce
excessively large jumps in the exchange rate, without resisting the
underlying appreciation trend.
While the Central Bank cannot reduce both appreciation and inflation,
the government can do four things to help ease the pain. First, the
government itself should spend less Second, the government should
collect more taxes by fighting tax evasion. Both of these measures
will help to reduce the demand for dram in the economy. Third,
the government should take measures to increase competition between
importers, to ensure that dram appreciation will actually result in
lower import prices, which is currently not always the case.. Fourth,
the government should implement reforms to raise productivity,
by improving infrastructure and education, by reducing corruption,
and by improving the overall business climate.
How does the appreciation affect the IMF program with Armenia?
The IMF program has quantitative targets on various monetary variables,
including net domestic assets, net credit to the government, net
international reserves, and reserve money. The first three of these
targets will still be easily met due to lower-than-projected net
credit to government and strong reserve accumulation.
However, because the CBA bought many more millions of dollars than
expected, they are likely to miss the reserve money target for this
year: since mid-November, reserve money already exceeds the upper limit
of the end-December target. (The annual growth rate of reserve money
was 59 percent at the end of November, compared to 32 percent growth in
the 2007 monetary program.) This does not have serious consequences for
the IMF program, because it is only an "indicative target"- that is,
it is not the most important condition in the IMF program.