Dollarization vs. inflation in Ghana

Thu, 3 Apr 2014 Source: Ussif, Aminu

Dollarization vs. inflation in Ghana: The case of the chicken and the egg which one came first.

Currency substitution is a situation where inhabitants of a nation use a foreign currency in parallel to or in place of their domestic currency. This phenomenon is not new and there is myriad of examples where countries in part or in full have substituted their currencies for the USD, the British pound etc. Many countries especially the developing economies have dollarized and are in part using the USD, Australian dollar or South African Rand as legal tender. A prototypical example of an African country that has recently dollarized is Zimbabwe. Some Latin American/Caribbean countries such as Ecuador, Bahamas and El Salvador have fully substituted their currencies for the USD.

Many countries have experienced or are experiencing inflation albeit at different rates. Inflation in Ghana has been one of the menaces in the Ghanaian economy and getting it under control has always been perplexing. Causes of inflation are well documented. They could stem from the demand or supply side factors, etc. In the Ghanaian economy the so called cost push inflation is of paramount importance, for instance, when fuel prices increase they automatically push prices of goods and services in the economy up leading to inflation and consequently, causing the cedi to lose value. Fuel prices do increase quite often in Ghana but they never seem to go down which is a source of worry, this experience is not unique under any particular government. In developed countries we always see fuel prices bouncing in tandem with the international markets but they seem to be stable though.

In this article I attempt to examine the relationship if any between inflation and dollarization in a qualitative framework. While dollarization is defined as currency substitution, inflation is defined as a persistent, substantial increase in general level of prices related to an increase volume of money resulting in loss of value in the local currency. I wish to make it clear here that dollarization as defined here is not synonymous with exchange rate. As recently as 2008 Zimbabwe was experiencing inflation rates in several million percent annually. Measures such as price control and redenomination could not help to control the daily galloping inflation. To fight the galloping inflation in the Zimbabwean economy dollarization was proposed, this was initially met with resistance. Many economists believe that dollarization and currency unions have made economic transactions easier and faster and even aided development. Dollarization has some obvious advantages such as stabilization of the economy, credibility and predictability which promote foreign investment. The dollar for example helps lower inflation and interest rates thus eliminating conversion fees and risk of devaluation. Of course this does not mean that dollarization does not have negative sides, for example politically, regulatory and otherwise.

People have since time immemorial acted as rational economic agents, Ghanaians not exempt and would thus substitute the good for the bad. Whence, expected depreciation of the Ghana cedi will lead to people preferring the USD or other major currencies in order to preserve value. It is obvious in the Ghanaian economy that accepting the local currency in transactions is risky because the Ghc might lose value before it is exchanged for goods-that is purchasing power risk. Therefore persistent expectations of currency depreciation lead to persistent dollarization of transactions. The USD is a stable currency with low risk of losing purchasing power compared to the Ghc. In an economy like the Ghanaian one where inflation is so high, dollarization does not fully preserve value. A simple example; In Jan 2013 1 dollar = 2 Ghc, and pure water was 10 pesewas per sachet which means that one could buy 20 sachets with 1 dollar; in Jan. 2014 1 dollar = 2.5 Ghc and pure water is selling at 15 pesewas again this means that one can only buy 17 sachets instead, after one year the loss in purchasing power of the USD amounts to circa 15 percent.

The question is: Is dollarization actually the cause of the hurting economy of Ghana? To my knowledge no such assertions have been confirmed empirically but speculatively. In fact some economists are adamant supporters of dollarization for small and developing economies. However, it appears to me that based on the actions of the Bank of Ghana and statements made by some individuals, it is a eureka, eureka thing.

Back to the old-age puzzle “the chicken and the egg which came first”. It is well documented that dollarization increases when inflation is high because the USD for example is stable, people will substitute the Ghc in order to store value. Normally when inflation attains very high peak the stable currency will be used as a medium of exchange. Back to the case of Zimbabwe where inflation slipped out of control hitting several million percent per annum which clearly led to loss of value of the Zimbabwean currency a short while ago. Redenomination yielded no desired effect neither did price control but the government resisted dollarization. Reality caught up with them and they legalized dollarization and suspended the Zimbabwean dollar. The results are staggering; inflation plummeted to levels consistent with the Federal Reserve Bank’s policy. Hence one can say that high inflation rates can cause dollarization but not the other way around. Again notice that the discussion here is about dollarization not exchange rates because it is easy to mix these up.

Is dollarization the cause of Ghana’s woes? My answer is unequivocally no, if dollarization were to be the problem, then Ghana does not have a problem, all we would have to do is “to get boots on the ground” and we are fine. In my view it rather ameliorates the harsh consequences of a local currency that cripples businesses and the hardworking citizens, whose assets and savings would have literally evaporated overnight. The underlining causes are nontrivial and are a result of myopic policies and shortsightedness. However, I wish to stress that the blame is not on a particular government but all past and present. Dollarization is an artefact of these serious factors such as our mentality, failed economic policies, corruption and lack of necessary infrastructure to build a sustainable economy. In a country where energy and water are in short supply coupled with lack of management of critical ingredients for growth and sustainability, the wages of which are economic crisis and a suffering population. I remember the ex-prime minister of Norway at international conference saying in Brazil “no energy no development”.

In conclusion, dollarization is not the cause of depreciation of the Ghana cedi but inflation is. I hope the government and the Bank of Ghana will work towards a long term sustainable solution.

Columnist: Ussif, Aminu