San José, Costa Rica, since 1956

Central Bank Mulls Exchange Rate Cap

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On Jan. 1, 2009, one U.S. dollar could beexchanged for ¢550. By Aug. 1, the dollar was worth over ¢581. At its peak Thursday, the exchange rate reached ¢583.32 as a buy limit, with a sell value of ¢592.80.

Although a gradual increase in the exchangerate is normal, as the rate nears ¢600/$1,the Central Bank (BCCR) has confirmed that it is considering placing a ceiling onthe exchange rate. The ceiling rate would cap the exchange rate at a fixed amountand dismantle the “buy” and “sell” values of the colón, which fluctuate daily.

The idea of a fixed exchange rate comes inresponse to the steady devaluation of the colón during the past six weeks.Since July 1, when the exchange rate was ¢571.03per U.S. dollar, the value of the colón has fallen over ¢0.23 per day.

In a meeting to discuss the exchange rate atthe Costa Rican Chamber of Commerce on Tuesday, Francisco de Paula Gutiérrez,president of the Central Bank, attempted to ease the concerns over thecontinued devaluation.

“This is the normaloperation of the exchange rate market,” he said. “There are days that haveexcess demand for currency and the exchange rate increases, and then there aredays like today, when the market drops a little.”

Though Gutiérrezassured those present that the daily exchange rate fluctuation is typical, hevolunteered that a fixed rate of exchange is being considered by the BCCR ifthe colón continues to devalue during the remaining months of this year.

“We hope that ourintervention in the exchange rate market will be minimal and that the economic recuperation will limit ourintervention,” Gutiérrez said. “But, if intervention is necessary, we haveoutlined a plan to create an administrative exchangerate without (buy and sell)limits.”

Since the year 2000, the colón/dollar exchangerate has increased by an average of ¢27per year.

Causesof Exchange Rate Hikes

Many factors can influence the daily fluctuationin the exchange rate, but in Costa Rica the exchange rate is primarily determinedby the amount of U.S. dollars being used in the market. As a basic rule, the greaterthe amount of dollars, the lower the value of the colón.

At present, the bulk of the demand in CostaRica for U.S. dollars responds to two principal needs: the importation of goodsand repayment of foreign business loans.

“For the last three to four monthseconomic activity has been recovering, and with this comes a resurgence in thedemand for dollars, particularly for imported goods,” said Eric Vargas, managerof investment strategy at the financial consulting firm Aldesa. “The otherissue is that Costa Rican businesses are repaying the debts that they have withforeign banks. They are looking for U.S. dollars to pay off the loans, which createsa higher demand for dollars.”

As the economic crisis eases, consumersare beginning to spend again. This is evidenced by the 0.92 percent increase inthe inflation rate in July. As spending improves, there is a spike in thedemand for imports, primarily from the U.S. To obtain the products, Costa Ricamust buy the products with U.S. dollars.

“If you want to buy something from anothercountry, that means you have to buy that other currency,” said Julian diGiovanni, of the International Monetary Fund (IMF). “To do that, you have tosupply more of your currency to buy it, which, in theory, should drop the priceof your currency.”

In a country such as Costa Rica that sees ahefty amount of imports, the purchase of U.S. products strengthens the value ofthe dollar while weakening the colón. Aside from consumer goods, theimportation of gasoline, which has fluctuating value, is also a contributingfactor in the fluctuation of the exchange rate.

Foreign business loans play a similar rolein devaluing the colón. When companies receive a loan from a foreign bank, beit a U.S. or European bank, the foreign currency enters the Costa Rican market,where it is usually changed into colones. The foreign currency exchanged,however, typically remains in the reserves of the Central Bank, meaning that moneyaccumulates in the Costa Rican market.

As the amount of foreign currency,typically U.S. dollars, builds up in Costa Rica, the amount of colonesdiminishes.

“The loans received from foreign banks arein dollars,” Vargas said. “Costa Rican businesses have to buy dollars to returnthe payment. In the first quarter of 2009, the payment of loans representedmore than $440 million.”

The borrowing of U.S. dollars from foreignbanks also means that interest must be paid. Therefore, when a Costa Ricanbusiness borrows U.S. dollars, that business is expected to repay the loan,with interest, in U.S. dollars. In 2009, the average interest rate in dollarsin Costa Rica has varied between 11 and 12.5 percent.

According to Carlos Arguedas, professor ofeconomics at the National University, another cause of the devaluation of the colónis that many Costa Rican businesses pay salaries in U.S. dollars. The paymentof salaries in U.S. dollars keeps the circulation steady.

“The majority of the businesses in Free TradeZones pay salaries in U.S. dollars, including those of administrative employeesand plant workers,” said Arguedas. “Also, some of our public services are fondof payments in dollars, such as cable services, Internet services and the CostaRican Electricity Institute (ICE). When they are paid in dollars, they cantransfer them to colones.”

The continued flow of U.S. dollars in CostaRica – to obtain imports, to repay business loans and to pay salaries – causes devaluationof the colón. Economists have indicated that, to curb the swelling exchange rate,companies should aim to infuse more colones into the market. It is hoped that,as the economy recovers, the flow of colones will improve within Costa Rica and,thus, slow the increase in the exchange rate. The more colones invested in theCosta Rican market, the better the exchange rate.

“You should really think of the exchange rateas a price,” di Giovanni said. “As the economy becomes more valuable, people demandmore of it.”

Settinga Ceiling

onthe Exchange Rate

Gutiérrez has indicated that the CentralBank will wait to see how well the Costa Rican economy bounces back from thecurrent recession in the remaining months of 2009 before it decides whether to placea ceiling on the exchange rate. If the Central Bank does elect to intervene bycapping the exchange rate and setting the colón at a fixed amount, thisintervention would act as a limit on the amount of U.S. dollars distributedwithin Costa Rica. Maintaining this limitation could prove a daunting task.

“The problem with the ceiling limit isthat there is a lot of pressure for the Central Bank to keep selling dollars tothe economy,” Arguedas said. “Loans are going to continue to rise, and somehowthe Central Bank is going to have to maintain the limited amount of dollars.This could stifle the economy. If the economy begins to suffer with the ceilingrate, the Central Bank will have to change the ceiling to a higher amount,which will open the market back up to the flow of more dollars…The ceiling is agood idea in principle, but it would be difficult to manage.”

In the meantime, the rate continues toinch toward the ¢600 colon per dollar milestone while the Central Bank watches andwaits.

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