Cedi fall: 'External factors part of the fundamentals' – Economist tells Bawumia

External global factors which impact the stability of the Ghana cedi are also part of the economic fundamentals and not just the internal ones which are under the control of the government, a Professor of Economics at the University of Guelph in Canada and a Fellow of the Center for Economic Studies and the Ifo Institute for Economic Research (CESifo) in Munich, Germany, has told Vice-President Dr Mahamudu Bawumia.

Prof Atsu Amegashie, who is also a D&D Fellow at CDD-Ghana and the Tshepo Institute of Wilfrid Laurier University, Canada, argued in an article titled: ‘If the fundamentals are weak, the exchange rate will expose you?’ that: “If a country’s fundamentals were the only determinants of its exchange rate, its currency will either depreciate against all currencies at the same time (for example, when its fundamentals are weak) or appreciate against all currencies at the same time”.

Prof Amegashie, whose field of specialisation are Public Economics, Development Economics, and Microeconomics, therefore, said the weakness or sturdiness of the fundamentals cannot only be of the internal factors.

In defence of his 2014 quote which he made while in opposition, with which the biggest opposition party, the National Democratic Congress (NDC) has been haunting him, the Vice-President, in April 2019, described as “warped”, the reasoning by the NDC in saying that the fact that there had been a fall in the value of the cedi necessarily meant Ghana’s economic fundamentals were weak.

Dr Bawumia said the cedi fall at the time, was largely due to external factors rather than weak internal fundamentals of the economy, unlike, in his opinion, it pertained in 2014 when he made his now-famous comment.

According to Dr Bawumia, “Factors such as the inflation rate, the balance of trade, the fiscal balance, money supply, are what we refer to as the fundamentals. But speculation and expectations about these fundamentals; external shocks such as oil price increases, can also have powerful short-term effects on the exchange rate.

“When we see pressures on the exchange rate, first we need to determine where these pressures are coming from or whether the pressures are transitory or permanent. And as every astute central banker knows, even with strong economic fundamentals, speculation, expectation and investor sentiment can exert pressures on the exchange rate.

“Ladies and gentlemen, you will recall that I stated in 2014 that: ‘If the fundamentals are weak, the exchange rate will expose you’. That was true then and it’s true now. It is 100 per cent correct.

“But it is warped logic to jump from that to a conclusion that if there is depreciation in your currency, then the fundamentals must be weak. Do you understand the logic? If the fundamentals are weak, the exchange rate will expose you, but if the exchange rate moves, you cannot jump to that conclusion that the fundamentals are weak. That defies logic”, Dr Bawumia said, adding: “There could be external factors causing the exchange rate depreciation”.

“For example”, Dr Bawumia said, “If I tell you that if your leg is broken, you are going to be unable to walk, then I’m somewhere and somebody comes to tell me: ‘This person is unable to walk, can I just conclude that the leg must be broken?’

“There can be other reasons why you are unable to walk. But the NDC logic will insist in the face of contrary evidence that since you cannot walk, it must mean that your leg has broken.

“In 2014 … the economic fundamentals had weakened significantly, and, therefore, the depreciation was easily explained. It was not caused by dwarfs or high-rise buildings as we were told. The exchange rate for 2014 had exposed the weak economic fundamentals.

“If you look on the screen, it gives you the fundamentals as we had it in 2014 and 2018. Every single one of them: real GDP growth, inflation, the fiscal balance, the wage bill, wage bill-to-GDP, gross debt, interest rate, current account, all the fundamentals, you’ll see that we were in a much weaker position in 2014 compared to 2018. So, ladies and gentlemen, how have the cedi performed recently? At the end of December 2017, the cedi had cumulatively depreciated by 4.9 per cent compared to 9.6 per cent in 2016. And this was the cedi’s best performance since 2011. And at the end of 2017, we had the best performance of the cedi till 2011.

“The cedi, however, depreciated by 8.4 percent in 2018 largely on account of the emerging market pressure and US interest rate increase.

“The data on the annual rate of depreciation of the cedi in recent years show that the worst performance of the cedi so far under the NPP government, the 8.4 per cent depreciation that we saw since 2018, that worst performance is better than the best performance under the previous government between 2012 and 2016. So, our worst is better than your best. And when you say this, this one is more like boot-for-chalewote.

“Ladies and gentlemen, the start of 2019 has been characterised by another sudden sharp depreciation of the cedi which has largely been reversed. Within a week, the cedi went up close to GHS5.9 to the dollar and then it retreated back to GHS5.07 and even was threatening to go below GHS5 but this is really an unprecedented development – that you don’t normally see such a retreat when the exchange rate depreciates. And you’ll see that in this period when there was a reversal in the cedi depreciation, the Bank of Ghana had not intervened in the market”, Dr Bawumia said.

In response to Dr Bawumia’s argument, Prof Amegashie said: “Of course, logic 101 tells that the converse of a statement is not necessarily true: “If X, then Y” does not necessarily imply “If Y, then X”. Bawumia’s point was that a country’s fundamentals may be strong but other unfavourable external factors may be strong enough to cause depreciation in the external value of a currency.

The Minister of Finance, Ken Ofori-Atta, has also attributed the depreciation of the cedi to external pressures and indicated that strong fundamentals should stabilise the cedi”.

“Indeed”, he asserted, “external factors affect exchange rates”, adding: “But those external factors are also fundamentals”.

He explained: “In the determination of exchange rates, a country’s own fundamentals (e.g., inflation, interest rates, GDP growth, trade balance, budget deficits, money supply, etc) are not the only explanatory variables. In fact, the variables used are relative fundamentals (i.e., the country’s fundamentals relative to the fundamentals of a foreign country).

For example, a seminal paper published in 1983 on the determination of exchange rates by Richard Meese, then at the University of California (Berkeley), and Kenneth Rogoff of Harvard University, used the following variables: the ratio of the U.S. money supply to foreign money supply, ratio of U.S. to foreign real GDP, the short-term interest rate differential between the US and a foreign country, the expected long-run inflation differential between the US and a foreign country, and the accumulated U.S. and foreign trade balances. Thus, ‘other external factors’ are part of the fundamentals.

“If a country’s fundamentals were the only determinants of its exchange rate, its currency will either depreciate against all currencies at the same time (for example, when its fundamentals are weak) or appreciate against all currencies at the same time. In reality, this is not always the case. It is common for the same currency to depreciate relative to some currencies but appreciate relative to other currencies at the same time. It is not the absolute strength of your fundamentals that matters. It is the relative strength of your fundamentals. Therefore, if other external factors caused the depreciation of the cedi in 2019, it was reasonable to claim that Ghana had weak fundamentals relative to the fundamentals of its trading partners”.

Read Prof Atsu Amegashie’s full article below:

If the fundamentals are weak, the exchange rate will expose you?

By: J. Atsu Amegashie

January 26, 2020

The formation of the Foreign Exchange (FX) Development Committee chaired by the Minister of Finance, Ken Ofori-Atta, has revived discussions about a statement by Vice-President Dr. Mahamudu Bawumia.

In 2014, Dr Mahamudu Bawumia, while commenting on the continuous depreciation of the cedi, said that: “… If the fundamentals are weak, the exchange rate will expose you”. At that time, his party, the New Patriotic Party (NPP), was in opposition. In response to the cedi’s depreciation in 2019, Dr Bawumia, as Vice-President of Ghana and head of the Economic Management Team (EMT), defended his claim about exchange rates and macroeconomic fundamentals as follows:

“You will recall that I stated in 2014 that: ‘If the fundamentals are weak, the exchange rate will expose you’. That was true then and it is true now. It is 100% correct. So, if the fundamentals are weak, the exchange rate will expose you. But it’s warped logic to jump from that to a conclusion that if there is depreciation in your currency, then the fundamentals must be weak. It is a very warped logic. If the fundamentals are weak, the exchange rate will expose you but if the exchange rate moves, you cannot jump to that conclusion that the fundamentals are weak. That defies logic. There could be other external factors causing the exchange rate depreciation.”

Of course, logic 101 tells that the converse of a statement is not necessarily true: “If X, then Y” does not necessarily imply “If Y, then X”. Bawumia’s point was that a country’s fundamentals may be strong but other unfavourable external factors may be strong enough to cause depreciation in the external value of a currency. The Minister of Finance, Ken Ofori-Atta, has also attributed the depreciation of the cedi to external pressures and indicated that strong fundamentals should stabilise the cedi.

Indeed, external factors affect exchange rates. But those external factors are also fundamentals. In the determination of exchange rates, a country’s own fundamentals (e.g., inflation, interest rates, GDP growth, trade balance, budget deficits, money supply, etc) are not the only explanatory variables. In fact, the variables used are relative fundamentals (i.e., the country’s fundamentals relative to the fundamentals of a foreign country).

For example, a seminal paper published in 1983 on the determination of exchange rates by Richard Meese, then at the University of California (Berkeley), and Kenneth Rogoff of Harvard University, used the following variables: the ratio of the U.S. money supply to foreign money supply, ratio of U.S. to foreign real GDP, the short-term interest rate differential between the US and a foreign country, the expected long-run inflation differential between the US and a foreign country, and the accumulated U.S. and foreign trade balances. Thus, “other external factors” are part of the fundamentals.

If a country’s fundamentals were the only determinants of its exchange rate, its currency will either depreciate against all currencies at the same time (for example, when its fundamentals are weak) or appreciate against all currencies at the same time.

In reality, this is not always the case. It is common for the same currency to depreciate relative to some currencies but appreciate relative to other currencies at the same time. It is not the absolute strength of your fundamentals that matters. It is the relative strength of your fundamentals.

Therefore, if other external factors caused the depreciation of the cedi in 2019, it was reasonable to claim that Ghana had weak fundamentals relative to the fundamentals of its trading partners.

In the aforementioned paper, Meese and Rogoff (1983) compared the forecasting accuracy of various exchange rate models. Surprisingly, they found that that a random-walk model performed as well as any estimated model at one to twelve-month horizons for the dollar/pound, dollar/mark, dollar/yen and trade-weighted dollar exchange rates.

The random-walk model used the current exchange rate as a predictor of future exchange rates. It did not use fundamentals and yet performed as well as fundamentals-based models. Attempts to overturn this result, known as the Meese-Rogoff puzzle, has been the focus of researchers for several years.

It has stood the test of time. In fact, there is ample evidence of a weak or non-existent relationship between exchange rates and fundamentals over short periods. Maurice Obstfeld and Kenneth Rogoff coined the term “exchange rate disconnect puzzle” for the weak short-run relationship between the exchange rate and macroeconomic fundamentals (e.g., Obstfeld and Rogoff, 2001).

In subsequent studies, researchers found that models based on fundamentals performed better than the random walk model for horizons longer than a year. The consensus is that the macroeconomic fundamentals have little effect on exchange rates at short horizons, but do have an impact at longer horizons (e.g., Mark, 2005). Therefore, even if a country’s fundamentals are relatively strong, they may not be good predictors of daily, weekly, or monthly exchange rates.

The fact that fundamentals have much less variability than exchange rates during short periods may account for the exchange rate disconnect puzzle (Meese, 1990).

Based on surveys of foreign currency traders in the US and Hong Kong, some researchers found that interest rates matter more than other fundamentals (Lui and Mole, 1998; Cheung and Chinn, 2001). Using a large sample of individual professionals’ forecasters, Dick et al. (2015) concluded that exchange rate “… forecasters largely agree that an interest rate increase relates to a currency appreciation, but only good forecasters get expected interest rates right.”

The preceding discussion suggest that exchange rates are not only determined by current fundamentals but also by expectations of fundamentals. It turns out that expected (future) fundamentals weaken the relationship between current fundamentals and the exchange rate.

Recent models have included order flow in forex markets as a proxy for expectations of future macroeconomic fundamentals (Lyons, 2001). Order flow is defined as the difference between buyer-initiated and seller-initiated currency transactions (especially by large currency traders like banks) and is a measure of net buying pressure on a particular currency. You may think about it as the gap between demand for and supply of foreign currency.

Evans and Lyons (2007) showed that Citibank customer order flow had substantial predictive power for future GDP, inflation and money supply. Rime et al, (2010) also found that order flows were linked to macroeconomic fundamentals.

According to Rime, Sarno, and Sojli (2010), “Previous research has found that order flow has strong explanatory power for exchange rate movements, whereas macroeconomic fundamentals have weak explanatory power… We provide evidence that (i) order flow is intimately related to a broad set of current and expected macroeconomic fundamentals and (ii) more importantly, order flow is a powerful predictor of daily movements in exchange rates … This finding may provide a rationale for the high explanatory power of order flow found in the literature. Furthermore, it suggests that macroeconomic fundamentals are indeed relevant for exchange rate determination, but that the order flow channel is key to link exchange rates to fundamentals.”

The seasonal, short-run, or periodic episodes of significant deprecation of the cedi are unlikely to be affected by moderate and favorable levels of conventional and current macroeconomic fundamentals (e.g., current inflation and growth rates). Thus, in the short run, we should go back to what everyone knows: basic demand and supply analysis, something akin to order flows and expected macroeconomic fundamentals.

These are the outflows and inflows of dollars: demand for imports; dollar inflows from COCOBOD, FDI; periodic repatriation of profits and dividends by foreign firms; unfavourable foreign exchange retention agreements or weak enforcement of such agreements, etc.

For example, the cedi — having depreciated for several months — appreciated from GH¢5.9/US$ in the last week of March 2019 to GH¢5.1/US$ in the third week of April 2019 after the government of Ghana raised $3 billion through a Eurobond issue (see Addison, 2019). Ah, demand and supply of dollars. Borrowing money to prop up the cedi is not a sustainable solution.

Ultimately, the most important fundamental is the heavily import-dependent nature of our economy. I am not the first to make this point. It is not rocket science.

In conclusion, “if the relative fundamentals are weak, the exchange rate will expose you in the long run” and “If the exchange rate exposes you in the long run, then the relative fundamentals are weak.”

References

Addison, E. (2019). Achieving Sustainable Exchange Rate: Our Options. Graphic Business/Stanbic Breakfast Meeting, April 23, 2019.

Cheung, Y-W., and Chinn, M.D. (2001). Currency traders and exchange rate dynamics: a survey of the US market. Journal of International Money and Finance 20: 439 – 471.

Dick, C.D., MacDonald, R., and Menkhoff, L. (2015). Exchange rate forecasts and expected fundamentals. Journal of International Money and Finance 53: 235-256.

Evans, M.D.D. (2002). FX Trading and Exchange Rate Dynamics. Journal of Finance 57: 2405 – 2447.

Evans, M.D.D. and Lyons, R.K. (2002). Order Flow and Exchange Rate Dynamics. Journal of Political Economy 110: 170 – 180.

Evans, Martin D. D. and Lyons, R.K. (2007). Exchange Rate Fundamentals and Order Flow. National Bureau of Economic Research Working Paper 13151.

Lui, Y-H., and Mole, D. (1998). The use of fundamental and technical analyses by foreign exchange dealers: Hong Kong evidence. Journal of International Money and Finance 17: 535 – 545.

Lyons, R.K. (2001). The Microstructure Approach to Exchange Rates. MIT Press.

Mark, N. C., (2005). Exchange Rates and Fundamentals: Evidence on Long-Horizon Predictability. American Economic Review 85: 201 – 218.

Meese, R. (1990). Currency Fluctuations in the Post-Bretton Woods Era. Journal of Economic Perspectives 4: 117-134.

Meese, R. and Rogoff, K. (1983). Empirical Exchange Rate Models of the Seventies: Do They Fit Out of Sample? Journal of International Economics 14, 3 – 24.

Obstfeld, M, and Rogoff, K. (2001). The six major puzzles in international macroeconomics: is there a common cause? In NBER macroeconomics annual 2000 15: 339 – 412.

Rime, D., Sarno, L. and Sojli, E. (2010). Exchange Rate Forecasting, Order Flow and Macroeconomic Information. Journal of International Economics 80: 72 – 88.