Monetary and exchange rate management: Policies and processes for stability and growth

On gaining independence in 2011, South Sudan introduced a new currency, the South Sudanese Pound (SSP), which initially traded at an official rate of 2.96 SSP to the dollar. Unlike the official rate that has depreciated by 50 per cent over the past four years, the parallel rate has depreciated more rapidly and now stands at 16.5 SSP to the dollar. Most of the SSP’s depreciation has taken place in the past year, and has accelerated further over the last six months.

A major driver of the increasing gap between the official and black market rate is the Bank of South Sudan’s (BoSS) decision to maintain a fixed official exchange rate despite a steady decline in foreign currency reserves. This decline dates back to 2012 when South Sudan shut off its oil production in response to Sudan’s unilateral decision to confiscate South Sudan’s oil in exchange for the use of Sudan’s pipeline.  The outbreak of conflict in December 2013, and its subsequent intensification, particularly in the oil producing areas, worsened the situation. The production of oil, South Sudan’s main source of foreign currency, has been reduced by nearly 50 per cent. Concurrently to this, there has been a sharp decline in oil prices, which has complicated the situation further. Accordingly, South Sudan’s gross reserves have fallen from over $800 million in December 2013 to about $108 million in July 2015, an amount that is enough to cover a mere 11 days of imports.

At the same time, the Government of South Sudan’s spending has increased. Revenues have fallen and are now far below the budget requirements, resulting in South Sudan running a large budget deficit. Currently, existing revenues are financing between 25 per cent and 30 per cent of spending, with the deficit being financed by borrowing money from the Bank of South Sudan. This, in turn, has led to a growth in the money supply, the depreciation of the exchange rate and rising inflation.

Keith Jefferis, the former Deputy Governor of the Bank of Botswana, was invited by the Bank of South Sudan to examine the exchange rate issue. This public event was the culmination of a week of meetings with policy makers and stakeholders that explored the root causes of the current economic situation and proposed options for exchange rate reform in South Sudan.

Downloads/resources

Sessions

Exchange rate reform in South Sudan - Keith Jefferis

Exchange rates

The exchange rate has become an extremely important issue for the economy in South Sudan. It is one of the most important aspects of the economy and influences how South Sudan can trade and invest vis-a-vis the rest of the world. It also affects the incentives of economic agents by determining which activities are profitable. The choice of the regime and the way the regime is managed is therefore an important choice for the economy. If the exchange rate is set at the wrong level, i.e. out of line with economic fundamentals, then it will introduce a wide range of distortions. The external economic environment is not fixed and therefore economies need to be able to adjust to shocks. If the exchange rate can adjust properly, it helps to maintain the external balance. If it does not adjust, it contributes to external imbalances and problems on the balance of payments. An overvalued exchange rate causes imports to be under-priced and exports become unprofitable. This, in turn, discourages investment in exports as well as goods to compete with imports. In the case of South Sudan, unless the exchange rate is corrected, the country will never export anything except for oil.

Current exchange rate situation in the South Sudan

The current fixed exchange rate in South Sudan is 2.96 South Sudan Pounds (SSP) = 1 US Dollar (USD), however on the parallel market the currency is currently trading at 16.4 SSP = 1USD. There is an increasing divergence between the parallel market and the official exchange rate.  Driving this is the extreme shortage of USD relative to SSP. The Bank of South Sudan have used most of their reserves of USD and commercial banks do not have much either. The parallel market rate is also driving inflation, which is now around 80% annually.  The most profitable activity currently is “round-tripping” (i.e. buying USD at the official rate, through privileged access, and then selling them on the black market). This is economically unproductive behaviour.

Fiscal deficit as the main driver

The main driver of this issue is the Government’s large fiscal deficit. The Government is only able to finance about a third of its expenditure using revenue. The rest is being financed by the Bank of South Sudan through printing money.  This, in turn, is leading to rapid growth in the money supply, which in turn is driving the exchange rate depreciation and inevitably leading to higher inflation.

Zimbabwe experience

Overall, South Sudan currently finds itself in a vicious cycle that needs to be broken, otherwise it could end up in a situation similar to Zimbabwe.  Zimbabwe also had excessive government spending that was financed by the Reserve Bank of Zimbabwe. This ultimately led to hyperinflation and eventually the abandonment of the Zimbabwe Dollar in favour of a basket of currencies (including the Botswana Pula, South African Rand, Euro and US Dollar), but primarily the US Dollar.

Other countries’ experiences

Zimbabwe is an extreme case and South Sudan, in its current state, does not necessarily have to end up there. There are other countries that have gone down the same route but managed to get back, e.g. Uganda. Zambia also had an economy based on one commodity (copper) and when the price of copper declined, the Government tried to keep its exchange rate. However, the price of copper took nearly 30 years to rise again. In the early 1990s, Zambia carried out macroeconomic reforms including complete liberalisation of the foreign exchange market coupled with fiscal reforms. Initially, in the first six months, Zambia experienced a lot of volatility. However, ultimately the situation stabilized and to this day Zambia has maintained the floating ER with some success.

Exchange rate options

The options for South Sudan range from having no independent currency (e.g. adopting the US Dollar) to a fully free float of the currency.  For any exchange rate policy to work, a key prerequisite is credibility. This is particularly the case in any managed system. A second prerequisite is that other economic policies must be complimentary. If there is a large budget deficit, it will make any exchange regime unstable.  In a fixed exchange rate regime, the only monetary policy is to maintain the exchange rate. This type of regime is particularly relevant for a mineral exporting economy as it can lead to lower inflation. However, it can also be dangerous when the fixed exchange rate is overvalued with no mechanism to adjust. A floating exchange rate can allow an economy to adjust but it can be volatile. In a floating regime, you still need to have mechanisms to supply foreign exchange to the market. If the Government is the main earner of foreign exchange, as is the case in South Sudan, then it has to be supplied by an auction system. Additionally, in a floating regime you need to have a monetary policy framework. A managed float requires reserves, which South Sudan does not currently have and the possibility of raising reserves are limited. Additionally, if reserves are raised, there is the distinct risk that they will only help to stabilize the exchange rate for 1-2 months before running out.

Move to a freely floating exchange rate

A free float could be achieved in South Sudan through a gradual approach. Upfront, an immediate and fairly non-contentious option would be to allow commercial banks to buy and sell foreign currency at a market rate. This would mean that the parallel market would move off the streets into the commercial banks. Additionally, it would mean firms, development partners and non-governmental organizations funds could start flowing through the commercial banking system again in larger volumes. The Government would still trade at the official rate, but over time this would be phased out.

Timing

South Sudan has just signed a peace agreement and as it is implemented, this will restore political credibility to the country. At the same time, it is important to restore economic credibility. Reforming the exchange rate system would assist in this. Building reserves is not essential to moving towards a floating exchange rate. If the move to a free float could be timed with the opening of the oil wells that have been closed during the conflict, as well as the fact that increasing dollars should flow through the banking system, then this could provide the dollar buffer to ensure that even if the exchange rate overshoots, there would be a floor.  However, if the underlying budget deficit is not fixed, then there is the continued risk that a floating exchange rate would be unstable and depreciate further.

Conclusion

The main three requirements for South Sudan at this point in time are:

  1. Devalue/depreciate the currency;
  2. Ensure post-devaluation the situation does not arise again;
  3. Re-establish economic credibility and confidence.

Reversal of reform has to be avoided at all costs. There is the fear of the unknown, however, the risks of not reforming are greater than reforming, and the risks of delaying are greater than the risks of implementing reform now.

Discussant: Fiscal side of exchange rate reform - Peter Biar Ajak

Approximately 600 million SSP is injected into the market every month. Most of the resources are going into the security sector. Even before the crisis, the majority of the budget was being funnelled towards the security sector. Expenditures are not driven by the budget but by revenues. South Sudan has become accustomed to supplementary budgets. Most of the current resources are going to paying salaries. However, quite a substantial portion of those people receiving salaries do not exist. For any exchange rate change, the fiscal situation needs to be reformed to institute discipline on the budget in particular.  Currently, even when revenue collection is low, the government is still spending highly. Therefore, the government has to adjust to the revenue situation. Spending is set to increase due to the creation of the 28 states and this will lead to increase in staffing. Political will is needed to keep the budget in line. The end of the war should be the time to discuss what level of expenditures is sustainable.

Discussion summary (question and answer session)

Credibility in the system

The credibility in the South Sudan’s financial system has already been greatly eroded. Additionally, peace will bring a lot more fiscal demands on the government. However, the need to re-establish credibility is very important and this has been undermined. The further the loss of credibility, the bigger the steps needed to restore it. Countries where loss of credibility has been extreme tend to go for a big bang approach in terms of economic reform to help restore it.

Sales of foreign exchange to the commercial banks

Previously, the Bank of South Sudan was a net seller to the commercial banks. Recently, however, these sales have been very small and there have been no sales now for a couple of months. Additionally, some commercial banks have their own rates too (“competitive rate”) which corresponds to neither the official nor the black market rate.

Fixing the current economic situation

There is the need to present this information to key decision-makers as they need to use it to fix the economic situation within the country. The technocrats understand the gravity of the problem but it seems that the top policy makers do not. The presentation has confirmed the fears that many people have in the country at this time, i.e. that the direction South Sudan is taking is not sustainable. Although many people are excited about the new states, the establishment, operation and maintenance costs for them will be very high and put additional pressures on the fiscal situation.

Legislation

The Banking Act says that there should be central bank independence, but at the moment it is not independent. There are other things in the Banking Act that are also not being adhered to. In May 2015, there was a big workshop held together with the Bank of Uganda on reforming the economy, and the points that came out of the workshop were presented to the Council of Ministers. However, little reform has been done to date. There is a need to establish a crisis management committee to build the political will for reform.

Current government plan

In this case, people are not afraid of what is unknown, but rather afraid of what is known. The Government of South Sudan wants to build reasonable currency reserves to do two things: 1) create a stock for the economy to buy essentials, and 2) to provide a buffer for the people psychologically. The Government will not be able to reduce the expenditures in the next three years because of the need to implement the peace agreement – peace is not simple and it comes with costs.

Freely floating vs managed float

No sustainable currency can be achieved without the necessary reserves to back it up. In South Sudan, neither the demand nor the supply of foreign reserves have been managed properly and there is no transparent mechanism to allocate foreign exchange to the market. To maintain stability, it seems that it would be better to establish a managed float with a ceiling and a floor.  For this option, the Government will have to raise reserves. However, if the reserves cannot be raised, then policy makers will have no choice but to allow a free floating market.