San José, Costa Rica, since 1956

Exchange System’s Training Wheels Wobbling

Costa Rica’s international monetary reserves fell by $700 million in less than three months, dealing a blow to the national fiscal conscience.

Adding to the sting, the colón dropped 5 percent against the U.S. dollar in less than a week.

While the Central Bank president interprets these events as the growing pains of a relatively young exchange rate regime, others – from exporters and importers to economic analysts – call for a redirection of the nation’s monetary policy.

“The community, the entire country, has to begin to learn how … to adapt to having a flexible exchange rate,” says Central Bank President Francisco de Paula Gutiérrez.

But some have little patience for adaptation. Ronulfo Jiménez, a former Central Bank director and analyst at the San Josébased Academia de Centroamérica, an economic policy think-tank, saw the colón’s significant jumps in recent months as proof the system does not work.

He favors returning to the “crawling peg system,” in which the currency is devalued at a set rate over time.

“Economists who say the system works are not seeing the empirical evidence that proves the contrary,” Jiménez says. “Maybe they are saying it from pure faith. If it’s because of faith, they should do the Aug. 2 pilgrimage (to the Cartago Basilica) and beg that the current system start working.”

Central Bank reserves were at an all-time high in April, reaching $4.9 billion. They have since fallen about 14 percent, to $4.2 billion.

The bank acknowledges that it sold a good chunk of its dollar reserves in May, scooping colones out of the market to halt the currency’s depreciation against the dollar.

A dollar fetched about ¢500 on MONEX, the domestic money market, at the beginning of May. The colón weakened by the end of that month, trading for ¢525, and drew the Central Bank’s intervention.

The colón floated around ¢520 per dollar through June and into July. Then, on July 15, it depreciated by a full ¢20 and continued to drop for the next week.

In response, the bank’s board of directors cut the exchange rate’s upper and lower limits, also called “bands,” with the floor moving from ¢488.73 to ¢500 and the ceiling falling from ¢572.49 to ¢555.37. The upper limit increases each working day by ¢0.06.

As of Wednesday, the average exchange rate on MONEX was ¢555 per dollar.

Scrambling for Change

The reserve’s sharp fall has some observers wondering where to draw the bottom line.

As long as reserves cover at least three months of total imports – which they do now – Costa Rica’s financial situation is secure, according to Eric Vargas, strategy director for San José brokerage firm Aldesa.

Vargas says he supports the Central Bank’s choice of exchange systems, despite its current volatility.

“People are afraid of movements that are (considered) completely normal in other countries,” Vargas says. “Little by little, people will get used to that movement.”

Oswald Céspedes, project director at Academia de Centroamérica, called the Central Bank’s intervention part of the “learning process” for a country adapting to a new exchange rate system.

While some critics say Costa Rica should ditch the band system and move to a freefloating currency – in which the currency’s value is determined solely by market forces – Céspedes thinks the country should first establish guidelines to protect investors from risky fluctuations.

“As long as that does not exist in Costa Rica, it is very difficult to launch a floating system,” Céspedes says.

Rodrigo Bolaños, former Central Bank president and a partner at consulting firm Ecoanálisis, says it is too early to tell if managed flotation will work in an economy as small and open to trade as Costa Rica.

The Central Bank had two goals when it abandoned the crawling peg model in favor of flotation within bands in October 2006.

The first goal was to reduce inflation, fueled in part by the colón’s daily loss of value against the dollar. The second goal was to reduce the widespread use of the U.S. dollar within the country’s financial system, a “dollarization” that was fueled largely by the perception that the exchange rate’s predictable behavior all but eliminated borrowing risks for colón-earners who took out loans in dollars.

Inflation reduction has been derailed, not because of flaws in the new system, but because of imported inflation in the form of higher food and fuel prices. Recent fluctuations in the exchange rate, however, are likely to deter colón-earners from going into debt in dollars, Bolaños says.

Given the difference between inflation levels in Costa Rica and the United States, Bolaños expects the colón, despite ups and downs, to depreciate by 8 to 9 percent a year against the dollar, for the time being.

The business sector is worried about recent fluctuations in the 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,” says Carlos Quesada, director of the Union of Private-Sector Chambers a and Associations (UCCAEP), an umbrella group representing 42 business organizations.

“Greater clarity in the rules of the game is necessary,” he says.

The Costa Rican Chamber of Commerce sharply criticized the Central Bank’s management of the exchange rate policy. In a statement, Oscar Cabada, the group’s president, demanded the bank take steps to ensure a more predictable exchange rate.

The chamber 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.

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

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 says.

Yet imported raw materials, priced in the ever-strengthening dollar, also threaten to slash exporters’ profits.

Meanwhile, importers pass the buck’s strength onto consumers.

Costa Rica imports roughly half of the 18,300 metric tons of rice consumed here each month. Beginning in August, a twokilogram bag will cost about ¢1,190 ($2.20), up from ¢914 ($1.69) today, says Economy Vice Minister Eduardo Sibaja.

The cost of imported materials such as fertilizers and pesticides has increased as well, according to Carlos González, president of the National Rice Corporation (Conarroz).

With the spike recently in oil, the National Oil Refinery (RECOPE) has seen its monthly bill grow exponentially, with 2008 imports estimated at 20.2 million barrels for a total of $2.8 billion – double last year’s expenditures for oil.

RECOPE purchases dollars from Central Bank’s reserves to buy petroleum.

A spokesman says the company is not concerned about having enough money to pay its bills unless “volatile situations arise in the world and national economy.”


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