Some common sense about the exchange rate and competitiveness

The exchange rate and competitiveness, which time and again resurface in the public debate, are among the more crucial and complicated aspects of economics. We would like to share some common sense thoughts, which are equally important in life as in economic policy management, in an attempt to clarify a few of the more vital aspects of this topic.

1. Beliefs are valuable. Consider possible reactions in the improbable situation of finding a Lm10 note lying on the ground. Very few persons, if at all, would leave the note where they found it. This shows that we believe that an intrinsically valueless piece of paper, bearing the coat of arms of the Central Bank of Malta but with hardly any practical application, can allow us to obtain what we need and want, now and in the future.

Life would be far more difficult if we were to stop believing in the value of our currency, or start to suspect that it is not really as valuable as we thought it to be. Producers of goods and services, including workers, would demand more money to compensate them for their efforts and costs. Prices would increase frequently and consumers would want to spend their money in all haste before it loses further value. Saving would become highly unattractive, thereby curtailing productive investment.

Property prices would soar, in the belief that real estate provides a safe haven against the dwindling value of the currency. Overall economic welfare would be severely dented, particularly for persons who have little power over the determination of their income, such as workers and recipients of welfare benefits.

A currency with a stable value, implying low rates of price and wage increases, is one of the greatest assets an economy can have.

2. Keep your promises. In Malta, we have firm reasons to believe in the value of our currency. This is because the bank promises us that we can exchange our Maltese liri into valuable foreign currencies at rates which are maintained relatively stable over time. The Central Bank promises us, in exchange for every Maltese lira we have, around 2.3 euros, 3.1 US dollars, or 1.6 pounds sterling.

Compared to five years ago, every Maltese lira now buys somewhat more dollars and pounds sterling but fewer euros, reflecting the way in which the value of the lira was maintained relatively stable in the wake of the appreciation of the euro in the international markets.

Can the bank keep its promise? The answer is 109% yes. This is because, according to the latest published balance sheet, the bank is holding close to Lm900 million in foreign assets, which amounts to Lm1.09 for every Lm1 which it issued in the economy. In other words, while the bank is promising €2.3 in exchange for every Lm1, it can actually afford to offer €2.5. Identical arguments can of course be made in relation to other currencies. There are not many countries around the world which are backing the value of their currencies to such a strong extent.

3. Provide for rainy days. If the Central Bank is so rich in foreign assets, why does it not offer us more foreign currency in exchange for our Maltese liri, so as to increase our purchasing power and make us wealthier? This would be tantamount to a revaluation of the Maltese lira.

The answer lies in the fact that it is infinitely better to make a small promise and be able to keep it rather than to break a big promise. In other words, the bank must avoid a situation where its foreign assets decline to the extent that they cannot continue to sufficiently - albeit not necessarily fully - back the Maltese liri issued. Otherwise, the bank would have to reduce the promised value of the Maltese lira, that is effectively a devaluation.

A devaluation necessarily reduces the worth of the currency and results in higher prices and wages, with the implications discussed earlier on. To avoid this, the bank needs to maintain sufficient foreign reserves against risks which threaten their level. And such risks are indeed present. The Maltese economy is one of the slowest growing in the EU and also among those with the highest fiscal deficits. If this situation persists, we could be facing sluggish exports and increasing imports - as we already to an extent are doing - and possibly outflows of capital.

4. Encouragement, not punishment, is the key to the discipline needed for success. A reduction in the value of the Maltese lira is thus a punishment that would have to be borne by the economy if it is unable to maintain sufficient foreign reserves to back its currency. But can such a punishment serve to instil the discipline required to help the country increase its exports and economic growth?

Some economists claim that a devaluation of the lira would make it cheaper for foreigners to buy our exports, especially because the real value of the lira has appreciated significantly over the past decade or so. A devaluation could help exports only in the very short run, because after a few months, wages would rise in response to the higher prices of imports.

This process is almost automatic in Malta through the cost of living adjustment of wages. And it is not realistic to contemplate successive devaluations, as this would completely destroy confidence in the use of the currency. It is thus probable that a currency devaluation would need to be accompanied by some kind of wage and price freeze policy. This in effect entails competing on the basis of low costs, but it is not tantamount to increasing competitiveness.

For a country to be competitive, it must be successful in the international markets without relying on protection while ensuring ever increasing standards of living for its citizens. To achieve this, the emphasis must not be on maintaining low costs in artificial ways which are only effective in the short term, but rather on encouraging our resources to work harder and better, to deliver products and services efficiently enjoying international demand and which can afford the payment of incomes to support the standard of living to which our society has grown accustomed.

It is to an extent true that the real value of the Maltese lira has appreciated over the past decade. This is quite normal for an economy that is developing and can actually be a sign of success rather than failure if it is sustained by higher productivity.

It is also to be considered that the data usually quoted for the real exchange rate give a warped indication, because they are based on consumer prices which in Malta bear little relation to actual export prices. It is a well known fact that prices and wages in the export sector in Malta are quite responsive to international market conditions, with the unions and employers actively working to safeguard jobs and activity.

In the light of this, a reduction in the value of the currency is not warranted. Other measures aimed at genuinely improving competitiveness, such as those we proposed in the National Competitiveness Strategy document last year, or those contained in the Report of the chairman of the Malta Council for Economic and Social Development on the Social Pact, are by far more desirable.

Chief among these are the reforms required to reduce the fiscal deficit and improve the efficiency and sustainability of public sector activities together with labour retraining and redeployment to improve productivity.

5. Safeguard your reputation as your most valuable asset. Thus, the exchange rate cannot and should not be used as a substitute for the real measures which are essential to promote Malta's competitiveness. The ultimate aim of exchange rate policy in Malta should be to maintain currency stability, thereby creating the environment within which export, import and international investment activity can take place with the least possible risk.

If a devaluation is resorted to, or is expected to happen, the Central Bank of Malta would be breaking its promise regarding the value of the lira. With this loss in the reputation of the currency, investors would get rid of their Maltese lira investments and hold foreign currency instead.

This is nowadays quite possible in an environment of liberalised exchange controls. Through this behaviour, investors would be reducing the bank's holdings of foreign assets, leading to further currency instability. These were the experiences of a number of countries which underwent painful financial crises.

There might however still exist the temptation for policy-makers to reduce the value of the currency to obtain some short-lived gains in employment and output. As long as this temptation is perceived to exist, investment would be jeopardised.

It is for this reason that it is essential that the exchange rate policy is completely detached from the political debate, and be left in the hands of independent and capable central bankers whose ultimate objective is to safeguard the reputation and value of our currency to enable our economy to prosper.

Professor Lino Briguglio is head of the Economics Department and director of the Islands and Small States Institute of the University of Malta. Gordon Cordina lectures at the Economics Department of the University of Malta.