San José, Costa Rica, since 1956

Exchange rate instability weighs on business owners

Costa Rica´s business sector is worried about recent fluctuations in the dollar-colón exchange rate.

“Uncertainty has taken hold of the economic agents, not because of changes (in the exchange rate) themselves or their magnitude but because of their suddenness and the short period during which they took place,” said Carlos Quesada, director of the Union of Private Sector Chambers and Associations (UCCAEP), an umbrella group representing 42 business organizations. “Greater clarity in the rules of the game is necessary to avoid speculation from becoming the main determinant of the exchange rate.”

The Chamber of Commerce (CCR) sharply criticized the Central Bank´s management of the exchange rate policy. In a press release, Oscar Cabada, the group´s president, demanded that the bank take steps to ensure a more predictable exchange rate.

On July 15, the price of the dollar in colones on MONEX, the domestic money market, jumped from ¢528.84 to ¢546.35. In response, the bank´s board of directors cut the exchange rate´s upper and lower limits, with the floor moving from ¢488.73 to ¢500 and the ceiling falling from ¢572.49 to ¢555.37. The upper limit will increase each working day by ¢0.06. The colón depreciated slightly during the next four days of trading, finishing at ¢555.53 yesterday.

The Chamber of Commerce criticized the bank for once again changing the exchange rate´s parameters. Prior to last week´s narrowing of the exchange rate band, the bank had twice widened the band, first in January and later in November of last year. The chamber described the latest change a sign of “lack of clarity” on the bank´s part that could promote “further oscillations” in the exchange rate.

“It is necessary to reevaluate if the current exchange rate system is adequate for a market as small as Costa Rica´s,” said Mónica Araya, president of the Chamber of Exporters (CADEXCO).

While also concerned about recent fluctuations, Araya considers the colón´s recent depreciation positive for exporters. A weaker colón helps compensate for some of the loss in competitiveness Costa Rican exports have faced since the country adopted the current exchange rate regime, she said.

“The export sector has lost competitiveness,” Araya said. “The (colón-to-dollar) exchange rate should be higher. What is important for us is to remain competitive.”

The exchange rate hovered at around ¢520 per dollar since the system´s inception in October 2006 until November of last year when it appreciated and dipped slightly below ¢500. It depreciated in May of this year back to around ¢520, where it remained until last week´s sharp depreciation. Between May and July, the Central Bank spent $675 million of its monetary reserves (16 percent of the current $4.26 billion) to support the weakening colón.

Araya said the recent depreciation, while positive, does not compensate for how much the colón would have lost in value against the dollar had the country remained under the crawling peg.

Under the crawling peg, the colón lost value against the dollar by a small pre-determined amount each working day. This resulted in a fairly predictable exchange rate over time and ensured the currency remained competitive, thus benefiting exporters.

However, the crawling peg´s apparent strengths were also its main weaknesses. The colón´s steady loss of value generated inertial inflation that prevented monetary authorities from reducing inflation to international levels. From 1990 to 2006, inflation in Costa Rica averaged 14.5 percent a year, according to the National Statistics and Census Institute (INEC).

Furthermore, the exchange rate´s predictability encouraged the informal dollarization of the economy. A growing number of transactions began being carried out in dollars. Particularly worrisome was the trend of colón-earners taking out loans in dollars, believing that the colón´s predictable pattern of devaluation protected them from the risk of sudden and unexpected changes in the exchange rate.

It was with the intent of reducing inflation and dollarization that the Central Bank moved toward a more flexible exchange rate regime based on floating within a pre-determined band. The intention has been to gradually transition toward a freer float and an inflation-targeting regime. Inflation targeting is a policy in which the Central Bank attempts to keep inflation within a target range by adjusting interest rates.

Araya said the current exchange rate regime exposes exporters to greater risk of currency fluctuation. This could present major problems as the Central Bank has yet to establish rules regulating foreign currency risk hedging, as it had promised when it made the switch.

When a company exports or imports a product, there is a risk that changes in the value of the colón relative to the dollar could reduce the company´s profits or result in losses. Currency hedging acts like insurance that limits the impact of foreign exchange risk on international transactions.

Read this week´s Tico Times print edition for a detailed analysis of how Costa Rica´s exchange rate regime is functioning.

Comments are closed.