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.