My friend Michael Browne last week sent out a challenge to the economists in our midst via email.
“Greetings to the economists,” he wrote, continuing, “There are a number of laypersons, who currently outnumber the economists, who would like to understand what is happening with our economy and how we need to proceed.”
I had visions of a mass of demonstrators encircling an ever-tightening band of defenceless economists and shouting, “Explain! Explain!”
Mr Browne noted that “there seems to be no agreement on the way forward,” and pleaded thus with the embattled economic majors: “Help us out by commenting on the question below:
“What is the relationship between fiscal deficit, foreign reserves and exchange rate in general, and why is the fiscal deficit such a threat to the exchange rate in Barbados in particular?”
So far I’ve only seen one attempted response coming in on Mike’s email loop, and that one, written somewhere in Paradise, was so long I lost concentration halfway through.
Not being an economist, I acknowledge I would already have failed the exam. But, just for fun, let us tackle the question. The first part is easy: A fiscal deficit is the amount you spend over what you take in.
The supposed range for a “sustainable” fiscal deficit is said to be 2.5 per cent to 3.5 per cent. We have been running them up to nine per cent of late.
Note that the dollar amount of the fiscal deficit is not as important as its relationship to your country’s total output. Like when you go for a mortgage and they want to know your salary so they can see what percentage of the gross would be your monthly payback.
If we have a fiscal deficit of, say, seven per cent, that means we are looking to borrow for something like $600 million just to pay our way that year.
When you keep borrowing so much you can easily balloon your national debt, which is what we have been doing lately.
So what does this all have to do with the foreign reserves?
Not much, as long as they remain where they are or continue to grow. If, like Trinidad, you are earning so much foreign exchange from your oil and gas exports that you always have a surplus, you can do anything you like.
We know from our home economics that whatever we spend over what we take in has to come from somewhere. You go and take the extra money out of your savings account, or you defer it to your expensive loan account called your credit card.
However, this overspending, which on a government’s books is called the fiscal deficit, affects the foreign reserves even if we are able to borrow all of the extra money we need in local currency.
Why? Because, according to economists, anywhere from 60 per cent to 80 per cent of every local dollar spent eventually goes out in foreign exchange to replenish stock or buy raw materials.
That is a good couple of hundred million in foreign exchange going out the door from our reserves each year, just by maintaining a high fiscal deficit.
In better times, it might never hit the reserves. That is because the Central Bank’s books technically receive every dollar of foreign money that comes in to this country legally, even if it is going back out somewhere soon.
An investor brings in money to buy land or set up a business or build a house. In the period between the money coming in and then being drawn down, our economy gets to use it. As long as this money, called Foreign Direct Investment (FDI) keeps coming in year after year, it provides a cushion for us to use instead of our own foreign reserves. Like any other commercial bank.
It is to be noted that the Central Bank only began ringing the alarm bells a few weeks ago when it had to finally admit what people like Ryan Straughn have been publicly stating for at least a year or two – that our reserves were coming under too much pressure due to the fall-off in FDI.
And finally, what does all this have to do with the exchange rate? If you have a store and things are not selling, what is the first thing you do?
Okay, if you are the Barbados Government you have a Rihanna concert. And then another one. But in the end you will have to lower your prices. No?
Okay then, if the forex isn’t coming in and you don’t want to lower your prices [devaluation] to try to attract more “sales”, then you have to slow the amount going out, otherwise you will not be able to function in the world, where they don’t take Bajan currency. They take the United States dollar.
Which means starting with the fiscal deficit. Which means three-day weeks, cutting back staff, privatization, less free education, anything to reduce the government’s annual spending. And the one I like most of all so far, paying Simpson Motors to fix the buses.
When paying Simpson Motors works out cheaper than what you are doing now, you can imagine how much we have been spending on those buses.
Don’t like it?
The alternatives are much worse. They include the D-word.
Of course, there are plenty of things we could and should be doing to attract more FDI, and we are awaiting the Budget to hear which package of such incentives the government may decide to incorporate into its strategic plan. Austerity alone will certainly not work.
And that, my dear friend Mike, is what the fiscal deficit has to do with the exchange rate.
• Pat Hoyos is a long-standing journalist and publisher of the Broad Street Journal.
