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Domestic foreign exchange market: on-going volatility
Iurie Gotisan, 12 May 2004
In the last two weeks Moldova Lei constantly appreciated against USD by 11.2% and reached its highest in the last five years being traded over 11,5 Lei per USD. According to the National Bank experts and economy-watchers the fluctuations are largely due to strong supply of foreign currency, mainly money sent home by Moldovans working abroad.
At the same time, recent evolutions on the domestic foreign exchange market, in particular price hike (implicitly inflation rate that has reached 3% in the first quarter of 2004) amidst considerable appreciation of the Lei, signals major pitfalls for National Bank. Apparently, appreciation in real terms of the exchange rate is an outcome of the National Bank's monetary policy focusing on strict control of the monetary base (M0), i.e. cash in circulation and money banks hold on the Central Bank account.
Of course, foreign exchange market, as are other markets, is regulated by economic rules, respectively, exchange rate is shaped demand and supply on the market. It is known for a fact that foreign exchange markets are heavily influenced by two factors: trade deficit that needs to be financed and capital flows invested in economy. Then, what's the impact of exchange rate on the economic realities in the Republic of Moldova from the perspective of those two factors?
For a start, foreign exchange policy announced and employed by the National Bank of the Republic of Moldova allowed for a real appreciation of the Leu, which affected the trade balance. That this policy does not help keeping inflation under control is yet another story. Another major pitfall, for Moldova, which is facing a huge external pressure, is the appreciation of the real exchange rate. That is, currency appreciation discourages exports and boosts imports, which as a result propels trade deficit further upwards. According to the latest press releases issued by the National Bank, trade balance deficit has reached 107 million USD in the first quarter of the year.
To diminish strong fluctuations of the exchange rate Moldovan economists recommend establishing Foreign Exchange Council, that is an exchange rate of the national currency against a single reference foreign currency (in contrast to a Central Bank that may issue money at any time, Monetary Council issues national currency only in exchange for assets in reserve, that is, foreign currency reserves of the central bank). A fixed exchange rate would protect domestic foreign exchange market from negative evolutions on the international financial markets. In a small and open economy as Moldovan is, heavily reliant on foreign markets (Moldova's dependence on foreign trade exceeds 70% of the GDP), fluctuating exchange rate wields heavy inflationist pressure that may at any time lead to disastrous effects in economy. Bulgaria established a Foreign Exchange Council in 1997 as a cornerstone of an ambitious program of stabilizing inflation, which dropped by 580% in 1997 accounting for less that 1% in 1998.
Ongoing negative balance of the current account stems from the persisting swelling trade balance deficits of the Republic of Moldova amounting to 408 m USD in 2002 and 666 m in 2003. If we are to consider private transfers made by Moldovan citizens working abroad that according to Minister of Economy Marian Lupu reached 1 billion USD throughout 2002-2003, they practically covered for trade balance for the last two years. However, albeit constantly swelling, foreign currency transfers that are so much praised by media outlets as being very important and able to cover for the amount of trade deficit, they are still an unreliable source of funding. In their turn, foreign direct investments are easily reversed, not to speak of the instability of the "hot money", i.e. speculative flows on the foreign exchange market. Having said that, at the first glance financing trade balance via autonomous flows seems less certain.
Secondly, in the structure of the current account transfers from abroad, especially from citizens working abroad are far from diminishing trade balance deficit. To put it differently, albeit these are still considerable they loose grounds due to growing imports over to exports. In this respect, negative trade balance in the first quarter of the year rose to 34% or 28 m USD over similar period last year. Finally, one may not speak of a foreign direct investments flow into Moldova able to automatically finance the swelling trade deficit. Therefore, foreign direct investments placed in Moldova throughout 2003 amounted only to around 70 m USD.
Finally, amidst nominal appreciation of the Lei against USD, commercial banks would not be willing to make placements in foreign currency and as a result would have to diminish the amount of credits granted to the real economy sector, thereby propelling interest rates further upwards. Being affected by high interest rates, economy would attract only short-term capital that might lead to a sharp appreciation of Lei in real terms, thereby dropping export revenues and swelling trade balance deficit.
One may argue that swelling interest rates would lure foreign capital that would automatically increase the supply of foreign currency and would reduce the monetary base to its initial state. Unfortunately, though, realities of Moldovan economy make us consider the opposite scenario, especially given state's deficient investment policy. The type of capital that might be lured by the swelling interest rates would most certainly be a speculative one, ready to exit the country at the first sign of risk. Therefore, it may well happen that we would end up in a vicious circle that might as well lead to massive capital outflows.
It is not certain how long would National Bank be able to support the financial pyramid that is on the verge of collapse. Nevertheless, let us hope that autumn 1998 was the greatest ill we had to experience.