For the last few months we have heard the Colombian government pressing the central bank to use any means necessary to prevent the further appreciation of the Colombian peso. Even in its latest monetary policy meeting minutes, the Central Bank has stressed its concerns over the current appreciation of the peso, letting know the markets that it may take measures to slow the peso´s rise.
One of the major arguments for this kind of intervention in the free-floating currency is that in the current crisis the peso´s further appreciation could endanger thousands of jobs. as exporters may cut the labor force as a mechanism to reduce administrative and operational expenditures and boost their profits. This indeed may have a negative impact on the actual lackluster economic recovery.
So that´s why some have argued that, to some degree, the recent benchmark rate cuts have tried to achieve this goal by cutting the interest rates differentials with the United States, so that the local currency will have to depreciate.
Classic monetary policy argues that one factor that often seems to have a short-term effect in determining exchange rates is interest rates differentials. For instance, when the U.S. raises its interest rates more Colombian investors will want to buy U.S. dollars in order to have better returns on their investments, so the demand will exceed the dollar’s supply, weakening the Colombian peso while strengthening the U.S. dollar. Some argue that what really matters is the real interest rates differentials between the two countries as this includes inflation in the equation.
So the Banco de la República has basically pursued this strategy, minimizing the real interest rates differentials with the U.S. to 1.15%, the lowest level ever, and it is expected that the differentials will decline further given the flexibility the central bank has because of lower-than-expected inflation.
Nonetheless, there is ample clear-cut evidence that this theory has not proven true in the Colombian case as the effects of benchmark rate cuts on the exchange rate has been less than temporary. It seems the Central Bank forgets that in a market of floating exchange rates, with or without government interferences, the exchange rates are determined by the forces of supply and demand.
As we see in graph 1, the correlation between interest rate cuts and the exchange rate for the Colombian market is null. Should I run an econometric regression to prove whether or not there is a correlation between both variables, I am quite sure it would simply confirm what the graph is clearly showing us.
It is clear that neither the government nor the central bank have understood the effects of some very important endogenous and exogenous variables that have driven the appreciation of the Colombian peso during the last few years.
The success of the Democratic Security Policy, the boom of the export sector in the 2004-2008 golden era, the remittances sent by Colombians living abroad to their families in the country and the increasing confidence of foreign investors in Colombia are some of the most important variables in creating a wave of US dollars inflows into the country that has overwhelmed the demand for the U.S. currency.
On the other hand, since late 2004 and early 2005 there has been a high correlation between the peso and the Dow Jones and the Brazilian real as local traders and investors look for signals to trade. It has been the modus operandi in the Colombian FX market, and one that we cannot ignore.
Nonetheless, some may point out the Colombian peso has actually weakened in the last eight weeks or so. That will be a topic to discuss in another op-ed, but just to introduce it let me say that the sharp fall of exports to Venezuela, the weak economic growth, the political uncertainty for 2010 and an increasing fiscal deficit will prevent the peso from strengthening sharply in the next six months.
In consequence, let me give a piece of advice to policy makers. The peso will adjust itself to the new realities, risks and expectations of the market forces. Government intervention in the Colombian currency exchange to save jobs is a noble effort, but it will prove to be futile, inefficient and unnecessary, plus it will perpetuate the ineptitude of the Colombian export sector which, instead of diversifying the markets to which it sells, stubbornly focused on Venezuela and is now paying the price of its own irresponsibility.
Author Luis J. Rodríguez is CEO of e-Bursatil.com.co, a website focused on Colombia’s financial market