The Great Exchange Rate Mystery of 2010
The exchange rate is perhaps the country’s most important economic indicator. Its value is considered in nearly every transaction in a marketplace – from a sale or purchase, to investing, to importing and exporting. Therefore, when the exchange rate fluctuates in an irregular and unpredictable fashion, as during the first two months of the year, economic actors look for answers as to why.
Since early January, the colón-to-United States dollar exchange rate has varied dramatically, hitting a sell value of as high as ¢582.21 for $1 over the weekend of Jan. 9-11 to a sell value of as low as ¢550.39 as of March 10. Since Jan.1, the sell value of the colón has fallen eight colones, marking the first time in years that the colón has appreciated against the dollar during the first months of a year. Since the year 2000, the colón has devalued an average of ¢25 per year against the dollar.
So what is happening in 2010?
According to analysts, the answer to the erratic colón can be found in a combination of abnormal economic factors as a consequence of the global economic crisis, along with calculated intervention by the Central Bank of Costa Rica (BCCR).
Fewer Imports Equals a More Valuable Colón
“The simplest answer to explaining the decrease in the exchange rate is to look at the various ways that U.S. dollars are circulated in the Costa Rican market, which is in the import, export and tourism sectors,” said Ana Tomaya, an economist at Aldesa, a Costa Rican economic analysis firm. “(Activity in) all three of those sectors decreased in the last year, with the most significant drop occurring in the number of imports.”
In 2009, Costa Rican imports fell by nearly 25 percent. When Costa Rica buys good overseas, almost all purchases are made using U.S. dollars, the standard by which all other currencies are measured. Therefore, when Costa Rica wants to buy from a foreign country, it is typically the dollar that serves as the exchange medium. Costa Rican firms generally use colones to buy dollars from local banks to make their purchases. This, in turn, increases the number of dollars in circulation and devalues the colón.
But when imports have plummeted by 25 percent and firms are buying fewer products from abroad, the demand and circulation of the dollar is decreased. This, in turn, causes the colón to appreciate and the colon then carries more value in the local marketplace.
This is what has been occurring in recent months. During the last six months, the colón has appreciated by over ¢40.
While Costa Rican consumers are enjoying the fruits of the unseasonably low exchange rates, economists do not expect their good fortune to last too much longer. As the worldwide economy works itself out of the recession, the level of imports is expected to recover, as will tourism, which is another sector responsible for the accumulation of U.S. dollars in Costa Rica.
“Costa Rica, in the long term, is a country that relies on the import of goods, and that’s a fact that we can’t ignore,” said Jorge Baltodano, manager of investment strategy at Aldesa, in a presentation on Tuesday. “Because of that, the colón will again devalue in the later months of the year.”
Central Bank Intervention
Nearly every day exchange rate in Costa Rica changes. Over the course of a typical evening, a new value for the colon is established by the BCCR, together with “buy” and “sell” values, known as bands.
The buy and sell bands, which are usually within ¢10 of each other, were established by the Central Bank in 2006 to limit daily fluctuations in the exchange rate. During a 24-hour period, if more dollars than colones have been purchased in the marketplace, for example, then the colón has devalued over the course of the day and its value is then adjusted for the following day. Lately, with less demand for dollars, the purchase of colones in Costa Rica has outweighed the purchase of the dollar and, thus, the bands have adjusted downwards, which means the colón has appreciated.
On the other hand, when the presence of U.S. dollars is much stronger in the Costa Rican economy, the colón devalues on almost a daily basis. When this occurs, in order to assure that the daily depreciation of the colón does not exceed the ceiling limit of the established bands, the Central Bank must sell dollars to attempt to stabilize the exchange rate.
“Though it seems difficult to understand at first, this volatility over the past few months was precisely the objective of the Central Bank when they created the bands system four years ago,” said Alberto Trejos, a former trade minister and an economist with the Economic and Financial Advisors S.A (CEFSA) firm during his presentation about the exchange rate fluctuations. “It is only when the market goes to the extremes of the band that the Central Bank has to intervene so that the exchange rate does not exceed the band. If it is going up, the BCCR has to sell dollars because the market has excess demand. If it is going down, the bank buys the dollars that nobody wants to buy so that the exchange rate does not fall below the low band.”
At the end of each day, the adjusted exchange rate is created in response to the financial market activity of the day and the amount of intervention needed to keep the figure within the 10-colone band range.
Low Exchange Rate Has Short Anticipated Lifespan
While the unusual activity in the exchange rate during the first two months of 2010 has surprised economists, investors and national media, the slow devaluing trend is expected to return as the year moves along.
“The abnormal behavior is actually quite normal,” said BCCR President Francisco de Paula Gutiérrez. “The exchange rate is an indicator of the international markets. As the markets fluctuate, so, too, does the exchange rate…As the economic crisis improves, the exchange rate will most likely return to behave as it did before the crisis.”
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