Capital control not the answer

Macro-economic balance is a pre-requisite for exchange rate stability.

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The Maldives had a free-floating exchange rate between 1987 and 1994, and the exchange rate of US dollars (USD) in terms of Rufiyaa (MVR) ranged between MVR8.50 and 11.50. In 1994, the country moved to a pegged exchange rate regime, where the value of the Rufiyaa was pegged to the US dollar. However, the value of other currencies in terms of Rufiyaa was allowed to fluctuate vis-à-vis their value in terms of the US dollar. 

The Rufiyaa was last devalued in April 2011, by almost 20 percent, after an announcement that the exchange rate was to be changed into a floating band system, to range between MVR10.28 and 15.42 per US dollar. Since then, there has always been a mismatch in the foreign exchange market and a parallel market has existed in the country. 

The mismatch and the parallel market premium had been relatively stable and contained between 2017 and 2019, with the rate maintained at MVR15.85 per dollar and rarely exceeding MVR16.00. However, since the second half of 2020, the premium has increased significantly, as the country went into deep recession due to the COVID-19 pandemic. 

At present, there is a significant mismatch in the foreign exchange market, with the parallel market rate around 16 to 20% above the official upper band of MVR15.42.

Mis-match in the foreign exchange market and the current account deficit

With the Maldivian economy’s over-reliance on the tourism industry almost 90% of foreign currency flows into the country is from the sector. According to statistics published in 2019, tourism receipts inflows were estimated at USD3.4 billion in 2019, while Inflows from fish exports and other merchandise exports were estimated at USD360 million. The total inflows recorded in the current account of the Maldives was estimated to be USD3.8 billion during the year. However, the total outflows during the same year were at USD 5.3 billion, resulting in a USD1.5 billion deficit in the current account. In other words, a net outflow of USD 1.5 billion. 

The Maldives spent almost 73% of its foreign currency earnings on the imports of goods — USD2.8 billion in 2019. There was also a significant 36% of receipts — USD1.3 billion — that flowed out as travel and transportation expenditure by Maldivians abroad. Further, an alarming 16% of the receipts — USD595 million — flowed out as foreign workers’ remittances. At the end of the year, there was an outflow of 140% of total inflows, that is, for every USD100 earned an additional USD40 was spent during the year.

How has the country funded the over one-billion-dollar imbalance per year over the past five years? It has been financed by a combination of government and private sector borrowings, foreign grants, and foreign direct investments. Considering the total direct Government borrowings during the past five years, as per the published debt statistics, it was financed by the private sector in the form of borrowings and equity investments to the tune of USD4 billion.

When a significant component of the current account imbalance is financed through external borrowings from the private sector, such borrowings will incur debt repayments every year. 

How have things changed due to COVID-19 and the resulting recession?

The Maldives closed its borders due to the COVID-19 pandemic and as a result all tourist facilities in the country were shut-down towards the end of March 2020. This was soon after a record-breaking year in 2019 with almost 1.7 million tourist arrivals. This was the first time in history that the Maldives had experienced a total shut-down of the tourism industry. On 15 July 2020 the nation re-opened borders and welcomed tourists; initially with a limited number of resorts coming back into operation. 

With all resorts out of operation for more than three months, and limited occupancies projected for the rest of the year, total imports of the country declined by more than USD1 billion in 2020, saving the country about USD90 million in foreign currency outflows per month. Similarly, with international borders closed, and Maldivians unable to  travel abroad, outflows from outbound travel also declined by USD694 million in 2020. Income transfers and workers’ remittances combined declined by USD676 million. As a result, total outflows during the year recorded a reduction of USD2.4 billion, and the country obtained a saving of USD414 million as the fall in inflows was estimated to be at almost USD2 billion.

What has caused the misalignment?

In addition to current account deficit exceeding 20% of GDP over the past years, the present imbalance in the foreign exchange market is due to unfavorable macroeconomic fundamentals; in the form of over 45% monetisation of government expenditure. 

The Ministry of Finance had borrowed about MVR4 billion from the Maldives Monetary Authority by July 2020 — however by January 2021, part of it had been paid back. As of January 2021, net borrowings over the past 12 months had remained at MVR2.7 billion, which is a 45% increase in money supply in the form of newly printed currency. Financing government expenditure by printing money is the worst macroeconomic management prescription, and one that will definitely bring about imbalance in the foreign exchange market. With such an imbalance, mere administrative measures and new regulations on capital controls would only make things worse by reducing business confidence. It will undoubtedly lead to further speculation.

Will the de-dollarisation measures stipulated in recent media reports increase foreign currency inflows and solve the present imbalance? Assuredly not. Cosmetic changes in regulations or bringing in further controls will not only fail to correct the present misalignment, but it could also lead to further deterioration of confidence in the economy and the Rufiyaa.

It will be particularly arduous to bring about de-dollarisation measures at a time when there is a huge imbalance in the foreign exchange market, and when business confidence is at an all-time low. It stands to reason that no one will want to convert their own foreign currency savings at a time they definitively know that the value of their own national currency is falling by the day.

In the absence of capital controls, the country’s exchange rate would reflect the fundamentals of the macro economy; including interest rates, inflation, fiscal prudence, and the monetary stance. Hence, a fiscally irresponsible government budget will always be reflected as an increased pressure for depreciation of the exchange rate, and rising inflation rates in the domestic economy. In flexible exchange rate regimes, fundamentals such as these are easily reflected through an automatic adjustment of the exchange rate via depreciation or an appreciation.

When domestic policies, especially fiscal policy, is credible, demand is stable at the prevailing exchange rate. However, if domestic policies lose credibility, there is currency substitution on a massive scale, and the demand for foreign exchange tends towards infinity, overwhelming the exchange rate. The exchange rate is also affected by external shocks, further exacerbating the mis-alignment.

The bottom line

When macro-economic fundamentals are mis-aligned, there will always be imbalance in the foreign exchange market. That has been the case in the Maldives. Administrative changes or capital controls will only make the situation worse. Direct controls on capital outflows and direct instruments of monetary policy are never an option in small open economies, because firms and households always have options to go around such controls.

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