Seasonal Phenomenon or New Economic Reality?
What has happened on the currency exchange market? The Georgian national currency, the lari (GEL), has depreciated against the US dollar by 0.07 points (4%) since March 2013. Prices on food products have increased. Importers have sustained significant losses. Consumers have felt that their lives have become more expensive.
Politicians and experts have made controversial and confusing statements on these issues. The official position of the Georgian government and the National Bank is that nothing extraordinary is happening in the economy of the country and these developments are logical parts of daily life. Government representatives point towards seasonality, attributing the changes in the currency exchange rate and the rise in prices on food products to the pre-New Year period and trade operations related to that. Today, the Georgian government pretends to see nothing and will engage in any sort of theory to justify these developments because it refuses to even hypothetically entertain the theory that since 2012 the country's economy has deteriorated and a new economic reality has emerged as a result.
Let me quote an excerpt from my article published in Tabula (English Issue #27) in March 2013: "[w]e must assume that after a drop in total supply the price level will again reach the indicator of the base period. To explain that in simpler terms, a drop in total demand will decrease the price level, but the total supply will also decrease by almost the same amount and so the price level will rise again. That the price level has been decreasing at present represents a short-term economic fluctuation that creates false signals and incentives in the market.
n short, the economy is moving into a new reality characterized by shrinking economic activity. However, it takes time for such a reality to become established and this will not occur until the price level, together with increased unemployment, rebounds to the base level of prices. Before that happens, economic fluctuations will take place, with the price level first falling and then rising, which will hinder the performance of rational economic transactions. The change in the price level affects not only consumer prices, but also the GEL exchange rate on the foreign currency market and interest rates on the capital market. The wider the range of fluctuation, the greater unemployment is pushed up."
I will now try to explain the main causes of those logical results that led to the rise in prices on food products, the depreciation of the lari, and ordinary Georgian citizens feeling that the country's economy has entered a new reality because trends of a deterioration in living standards have been observed.
In order to clearly understand what happened, we must discuss ongoing operations on the loan capital market, on the one hand, and the currency market, on the other. These two markets are closely interconnected and dependent on each other. Purchase of assets both inside and outside Georgia take place on the loan capital market. The source of the purchase of assets in Georgia are the national savings, which comprise private and public savings. Public savings are generated when the country's budget revenues exceed its expenditure, i.e. when a budget surplus occurs. Bearing in mind that Georgia's budget for the past few years has been more deficit-ridden than surplus-ridden, let's, for the sake of simplicity, assume that only private savings play a determining role in the purchase of assets, because no public savings are generated in the country. Private savings represent liquid assets (for example, national and foreign currency) accumulated by citizens of Georgia and other countries, which are deposited in indirect market intermediaries (for example, banks) or/and are supplied to the markets of direct intermediaries (the stock exchange), which is evidenced by purchased securities (shares, bonds, et cetera). Given that the stock exchange is not developed in Georgia and that it cannot influence the capital market because the scale of transactions on the stock exchange is insignificant, private savings comprise the amount that is deposited in the commercial banks of Georgia.Representatives of society spend part of their income. Some of that spending is used for the purchase of goods and services produced abroad (import), thereby decreasing the national income. However, an additional source of national income is the sale of those goods and services produced inside the country abroad (export). Therefore, in purchases, the acquisition of locally produced goods and imports must be separated. Consequently, the saving is the part of income that remains as a result of the purchase of local goods and net exports (the difference between exports and imports).
There are two buyers in society: citizens and the state. Consequently, purchases can be considered as both consumer and state procurements. Hence, S = Y-C-G-Nx (where S means savings, Y is national income, C is consumption, G is government procurements, whilst Nx means net export). Citizens view their savings as income to be spent in future. Until that future time arrives, citizens entrust their savings to banks. When banks offer higher prices (interest rates) to clients, this encourages citizens towards higher savings and, vice versa, when this price decreases, the amount of savings drop too. The price is thus proportionate to the amount deposited whilst the savings are a significant component in determining the supply of capital to the loan capital market. While one segment of society views their savings as expenditure for a future period, another segment of society experiences a shortage of income and expresses the desire to spend more than their income can afford, hoping that their income will increase in future (or that they will be able to redistribute the costs of expensive goods over their entire income of an accounting period). Since taking out a loan means the purchase of an asset, it is called an investment.
Here, we must take into account the following three components: one segment of society takes out a loan to purchase assets abroad, whilst another segment borrows to purchase assets in the country. Most significant is the third component – the purchase of assets in the country by a third country – a process called foreign direct investment. Thus, the demand for loan capital is created by those citizens of Georgia and foreign countries who express the desire to purchase assets. Consequently, the real demand for loan capital is determined by domestic investments and the difference between assets purchased inside and outside the country (net capital outflow). The price of loan capital (the real interest rate) is determined on the basis of savings and domestic investments plus net capital outflow, i.e. supply and demand. At the same time, the higher the price, the fewer the people who express the desire to purchase assets in the country and, vice versa, the lower the price, the higher the number of people willing to purchase assets in the country. Thus the supply curve on the loan capital market is upward sloping, whilst the demand curve is downward sloping. In the absence of state interference, the changes in prices are conditioned by processes underway in the economy, which, in turn, are influenced by changes in supply and/or demand.
The exchange market largely depends on the interest rate because the net capital outflow represents a significant element of the currency market. In particular, the difference between the outflow and inflow of capital creates a source for foreign currency reserves. Foreign direct investments bring foreign currency into the country because investors need to convert their foreign currency into lari in order to purchase assets inside the country, whereas in the case of the outflow of capital, foreign currency flows out of the country because those willing to buy assets abroad need to exchange lari into a foreign currency. The lower the indicator of net capital outflow, the greater the amount of foreign currency inflows. Thus, net capital outflow generates supply on the currency market. On the other hand, by purchasing goods and services on the market, society and the state create demand on the currency market. In reality, demand is created by imports because importers need foreign currency to purchase goods in other countries. Consequently, they have to convert lari into the currency of another state. One should also take into account here that, in contrast to imports, exports decrease the demand for foreign currency because the sale of products on foreign markets generates the inflow of foreign currency into the local market. Thus, the real demand for foreign currency is determined by net export, i.e. the difference between exports and imports. When imports exceed exports, the trade balance is negative, which creates the demand for foreign currency.
The size of the exchange rate depends on the size of net capital outflow and net export. The higher the rate of the US dollar against the lari (i.e. the more lari that is paid for one USD), the lower the demand for USD, because the price on imported goods rises, thereby decreasing the amount of imports; at the same time, the price on export commodities drops, thereby increasing the amount of exports and, with it, net exports. Consequently, there is a negative correlation between the price and amount of demand, and the demand curve (net exports) on the foreign currency market is downward sloping. As regards the net capital outflow, it is absolutely unsusceptible to price (the real exchange rate) because the citizens of Georgia willing to purchase assets outside the country define the amount of lari that should be exchanged into foreign currency. For example, the purchase of shares on the New York Stock Exchange cannot affect a decision to purchase when the real exchange rate of the lari changes. Consequently, no matter whether the real exchange rate of the lari changes for better or worse, this cannot affect the net capital outflow. As already mentioned above, the size of net capital outflow depends on the interest rate of the loan capital market. Therefore, the net capital outflow market generates supply on the currency market (in contrast to the loan capital market, where it generates demand) which is expressed as a vertical curve.
Proceeding from the macroeconomic model of an open economy discussed above, we can understand what has happened in Georgia over the past year. According to the National Statistics Service of Georgia (Geostat), the real economic growth of Georgia, by exaggerated assessment, comprises 1%. This does not provide grounds to expect an increase in savings. Consequently, the supply to the loan capital market has not changed. The amount of foreign direct investments in 2012 dropped by 200 million USD compared to 2011. Current statistics, namely, the total indicators for the first three quarters of 2013, show that the total amount of foreign direct investments in 2013 will most likely decrease further by at least another 200 million USD as compared to 2012. This means that the indicator of net capital outflow will increase because, on the one hand, the amount of assets purchased by Georgian citizens abroad remains unchanged, whilst on the other, this will remain insignificant and cannot influence the total indicator. Consequently, the difference between capital outflow and foreign direct investments decreased, thereby pushing up the demand for loan capital. The amount of demand on the currency market corresponds to the amount of the supply of net capital outflow. The increase in the amount of supply to the currency market, however, led to the increase in the price of USD, which resulted in the depreciation of the lari (see figure).
It is worth noting that, in this setting, the National Bank of Georgia decreased the rate of refinancing by almost 3% as compared to November 2011. Against the ongoing deflation, the policy of the National Bank served the aim of increasing total demand. To this end, it used monetary policy instruments which were expected to encourage an increase in money supply on account of a decrease in the nominal interest rate. The availability of short-term loans has indeed increased. However, this policy caused an increase in demand for domestic investments in the short term. Consequently, the demand on the loan capital market has further increased and this contributed to the depreciation of the lari.
As a rule, the market price provides participants in transactions with important information enabling them to take correct decisions on the market so as to ensure that transactions are mutually beneficial for both participants. When banks have excess monetary resources they try to increase their revenues through issuing more loans at lower interest rates. Given that the loan expenditure structure does not change and the lion's share is still accounted for by the financing of imports, the level of prices increases, thereby further enhancing the expectation of inflation and dispelling the illusion of an increase in revenues.
Let me go back to my article published in Tabula in March. The economy has entered a new economic reality. All in all, society proved to be the loser. The most damage has been sustained by importers and the people employed by them, thereby pushing up unemployment – something that is also reflected in the existing statistics. The depreciation of the lari will lead to an increase in the prices of imported goods. Given that imports comprise 73% of total trade turnover, this will encourage a rise in the prices of other goods. More important in this story, however, is the policy of increasing total demand, as launched by the National Bank through putting monetary policy instruments in action. The most important issue awaits us ahead: the budget burdened with huge domestic debt that is intended to cover increased social liabilities. Every condition favoring inflation has been created. Taking into account that 1) the domestic debt is to be covered by the future generation(s) and 2) that the debt represents the value which could have been used to further grow the economy, it is easy to figure out what it costs for the current government to deliver on its pre-election promises.