Dollar Strengthens Against Colón – but Why?

May 16, 2008

For the first time since the launch of the dollarcolón exchange policy in October 2006, the Central Bank dumped dollars onto the market last week in an effort to curb the fall of the national currency.

The amount and price that the financial institution paid on Monex, the market in which banks trade currency, have yet to be announced.

The Central Bank’s move came after the leading state bank, Banco Nacional, raised its dollar exchange rate – on the buying and selling end – by roughly 5 colones on May 6.

Other national and private banks soon followed suit, causing the colón to dip drastically in value.

Under its 2006 policy, the Central Bank established an upper and lower band within which the colón can fluctuate against the dollar. The so-called ceiling is set at ¢569, while the floor is ¢491.

When the price of a dollar gets close to either limit, the Central Bank buys or sells currency on the local market to influence the supply and demand – basically, controlling the price.

Over the past week, the average exchange rate for the purchase of colones jumped by ¢21 at all local banks – with the rate rising to ¢522.35 per dollar as of Thursday, according to Aldesa. The average selling rate also rose by ¢10, settling at ¢511.58 per dollar.

Several factors contributed to the Tico currency’s drop, according to Carlos Palma, a professor of economics at the University of Costa Rica.

Speculation by foreign currency traders can be blamed for some of the colón’s drop. Their bet, as Palma explained, was that the currency could not continue to strengthen against the dollar, considering the difficult situation playing out across the country.

By dumping colones and buying dollars, the speculators created a higher demand for the dollar, further debilitating the colón.

Palma pointed to another ominous cloud over the colón horizon: the potential recession threatening the U.S. economy.

The United States is Costa Rica’s leading trade partner, shipping 41 percent of exports to its northern neighbor.

“There’s a situation that is harming us, harming exporters (in Costa Rica),” he said.

Fewer exports mean fewer greenbacks in local entrepreneurs’ pockets. And – as economic law dictates – the smaller the supply, the greater the demand.

With a weakening dollar on the world market, the price of basic goods also continues to climb. Palma listed petroleum, rice and wheat – all major local imports – as some examples.

Inflation over the past 12 months reached 10.95 percent in April. Interest rates are also on the rise. The Central Bank’s average loan interest rate this week for colones rose by 1.1 percent – to 14.53 percent, while that for dollars dropped by 0.3 percent – to 9.33 percent.

The Costa Rican currency market is relatively small. So when a few major players make big moves, waves ripple throughout the entire economy, Palma explained.

After seeing what the economist called an “extraordinary increase” in the exchange rate, the Central Bank found it hard not to intervene to stabilize the currency by selling dollars.

More dollars in the mix lowers the demand, decreasing some of the negative pressure against the colón.

“In the future, we are going to continue to see this type of behavior,” Palma predicted.

The Central Bank would prefer to let the market dictate the exchange rate, letting the colón float freely between the two bands, according to Mauricio Avila, the institution’s director of the asset and debt management division.

Still, “the Central Bank reserves the right to intervene to calm the markets,” Avila said.

 

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