Exchange Rate – Costa Rica Colons and Dollars

How to Ruin an Economy?

The short answer to that question is: overvalue the national currency. That is exactly what Costa Rica has been doing for more than two decades. Throughout the years since 1984, under a system of daily mini-devaluations, the dollar exchange rate for the Costa Rica colon was gradually increased. But in most years the domestic rate of inflation exceeded by several percentage points the devaluation rate. In 2006 the Central Bank replaced the mini-devaluations with a system of bands in which the colon was allowed to float between lower and upper limits with the upper limit gradually increasing, in July 2010 reaching 610 colons for one dollar with a floor of 500. Then, beginning in October 2009 the colon gained value precipitously, the exchange rate falling from 590 in October 2009 to 510 in May, 2010. From May to July 2010 the rate has fluctuated between 515 and 530. If this continues for any length of time the Costa Rican economy will greatly suffer.

An overvalued currency harms exports, subsidizes imports, exacerbates balance of payment problems, negatively effects tourism and foreign residents with dollar incomes, deters foreign investment, inflates real estate prices, and invites currency speculation.

Costa Rica has an economy highly dependent on export earnings. If exporters try to increase their prices to compensate for a weak dollar a strong colon means less competitively priced products on international markets. If prices cannot be increased, as is usually the case, businesses must nevertheless pay their operating costs in colons while receiving fewer in return for the dollars earned– 92% of export earnings are in dollars, but 70% of costs are in colons.

With an overvalued colon imports become relatively cheaper. This has the adverse consequence of encouraging import of goods that compete with locally based production. The consumer goods industry in Costa Rica is relatively well-developed, with some sectors also geared to exporting to Central America. Historically, national production has been to some extent protected by import tariffs. These are now largely being eliminated under the provisions of CAFTA, the Central American Free Trade Agreement with the United States implemented under the Arias Administration. The combination of an overvalued colon and the elimination of protective tariffs could mean that some sectors of domestic industry will go under.

While the economy began to recover in late 2009 from the internationally induced recession, Costa Rica maintains a chronic problem with balance of payment deficits. The combination of reduced or lower valued export earnings and increased import expenditures impels the balance of payments into further deficit. During the first Quarter of 2010 exports, lead by pineapple and bananas, grew 11% with respect to Q1, 2009. However, as might be expected with cheapened dollars, imports increased 24% in the same period, widening the current account deficit.

The principal foreign exchange earner in Costa Rica is tourism, an industry with income in dollars but expenditures in colons. For visiting foreigners Costa Rica is no longer a bargain. When word gets around in the United States and elsewhere that their dollars don’t go very far, tourism will suffer.

An overvalued currency is a deterrent to foreign investment, a central element in the development strategy of the Arias government and the current administration. For a foreign company to establish and operate a business in Costa Rica they must exchange dollars for colons and these won’t go nearly as far as they should.

There are many thousands of foreigners resident in Costa Rica that depend upon pensions or other income in dollars. In the months since late 2009 foreign residents have been hit hard in their pockets, a 15% decline in value of the dollars they exchange, plus suffering additionally from a 4% domestic inflation in the cost of goods and services. The nation has programs to attract foreign retirees that will fail if their dollars won’t go very far. So too will programs like medical tourism suffer.

The real estate market is negatively effected by overvaluation of the colon. Sellers almost always list their property in dollars, so there is now a higher price. This is a problem in that many real estate sales are to foreigners. This problem is seriously compounded by the appreciation of real estate values over the last decade. Even during the 2008 and 2009 financial bust and international recession, when real estate most everywhere in the world was falling in price, this was not generally the case in Costa Rica. There has been a highly inelastic price response to abundant offerings of properties of all types and falling demand. All real estate companies report a substantial decline in business.

The current exchange rate opens the door to currency speculation. Windfall profits will accrue to those who buy dollars when the rate is near the floor and sell them for colons when the rate returns toward the upper limit, as should eventually happen, assuming the Central Bank authorities have any sense.

In fact, the drop in the value of the dollar when the same currency is strengthening against the Euro is related to an apparent influx of speculative capital and wealthy Costa Ricans changing currencies. In the United States and Europe interest rates are very low and the economies stagnant, whereas in Costa Rica interest rates are quite high and the economy, so far at least in spite of high interest rates and tight credit, is modestly recovering.

Why the Central Bank maintains high interest rates while the economy needs stimulation is one more indication that something is wrong in the higher circles of power. So dollars and Euros enter and the local moneyed elite move around their liquidity, but not necessarily into productive investments. The interest rate on bank issued Certificates of Deposits has fallen in the last nine months to an average of 2.5% so this is not where capital is flowing. Both private and state banks here carry their accounts in dollars and banking assets have fallen as the devaluation is recorded as operating losses. However, this does not mean that banks and other financial entities are not in receipt of these dollars. Data is just not publicly available to determine where the dollars are coming from and where they land– or how much money is entering and being laundered from illicit activities.

In reading what little is available on the Costa Rican exchange rate there are some innuendos that the wealthy friends of Central Bank officials and the PLN hierarchy are scheming to enrich themselves through currency speculation. It is certainly the case that PLN personalities have a cozy relationship with the moneyed interests; this became very clear in the great debate over CAFTA. However, I have found no evidence to lend these assertions any credibility. After all, Costa Rica has indicted three former presidents for graft, so it is difficult to believe that corruption on this scale could be involved. Rather, it is the ideological blindness of official thinking that is the problem.

It is important to keep in mind the experience of Argentina in 2001-2003. That country experienced a complete economic collapse due in good part to pegging the peso to the dollar so that the peso was overvalued by a wide margin. Dollarizing meant surrendering control over monetary and fiscal policy. Then to make matters worse productive state enterprise were privatized at bargain prices to local and foreign capital. State policies allowed a great inflow of foreign loans and speculative capital. Argentina under the left of center Kirchner government recovered in subsequent years by devaluing the peso, defaulting on foreign debt, ending speculation, renouncing the neo-liberal policies that created the disaster and reorienting its monetary and fiscal policy toward national development.

The overvaluation of the colon is a direct consequence of the policy of the Central Bank. According to the President of the Central Bank where the colon falls within the band is a strict function of the number of dollars as versus the number of colons in circulation. More dollars exchanged on the Monex, the money market for the large players, and at the state and private banks, means a fall in the value of the dollar.

I suppose such narrow criteria for establishing the exchange rate is to be expected from Costa Rican economists with a U.S. education and business administration graduates of Harvard, Wharton or other bastion of monetary orthodoxy. They are fully indoctrinated in the conventional wisdom of neo-liberalism. Two of key elements of this narrow thinking are that the purpose of monetary policy is to control inflation and that state guidance of the economy is contrary to the economic principles of free enterprise.

Central Bank officials have stated that the elimination of the mini-devaluations and adopting the system of bands was to have better control of inflation, moderate the trend toward dollarization, and to avoid Central Bank injection of dollars to protect the exchange rate, causing Central Bank deficits. Actually, the mini-devaluations worked reasonably well. For businesses the rate was predictable and it facilitated the export development strategy adopted since the 1980s. The rate was adjusted on the value of dollars and other traded currencies in relation to domestic inflation, although the spread between inflation and devaluation in most years meant an appreciation of the colon. Contrary to Central Bank spurious rationales, Costa Rica’s high rates of inflation, as well as the partial dollarization of the economy, have been consequences of its export-led integration into the global economy and really not to exchange rate policies. The current 4% rate of inflation, down from double digit levels previously, is a consequence of the slow economy, certainly not an overvalued colon.

One of the more absurd pronouncements by international business publications espousing the doctrines of monetarism and globalization is that every country should peg its exchange rate for dollars to the price of a McDonalds hamburger in the United States. Well, today a Big Mac in Costa Rica is about the same price as in the U.S. In this wisdom, it does not matter that the cost of labor that serves up the burger in a local franchise is 1/5 the cost in the U.S., or that the cost of constructing a fast food joint is 1/5 that in the U.S., or that buns and meat are lower priced, or that commercial land to locate a franchise is cheaper.

The McDonalds idea has more relevance if it is reversed. An intelligent exchange rate policy would at least in part evaluate the cost of the factors of production– labor, materials, and capital–in the national economy in relation to the values in the economies of trading partners. If these were the criteria than a $3 Big Mac in the United States would cost the equivalent of $.60 in colons. This price would have the added virtue of making the Big Mac affordable for the low-waged Costa Rican servers who dish out the burger. It would also help the deteriorating standard of living of ordinary Costa Ricans if the government development strategy would provide incentives for domestic production of food staples like rice and beans, also helping to keep famers on the land and out of the urban slums, instead of removing tariffs on the import of foreign foodstuffs.

Certainly controlling inflation and adjusting disequilibrium’s in the supply of currencies need be factors in monetary policy. But the essential goals of the policies of the Central Bank should be those of development of the national economy. This is accomplished by fiscal policies that allocate resources into chosen sectors vital to economic and social development and monetary policies that support the development goals established. The current and past political administrations in Costa Rica, blinded by their neo-liberal ideology, have no idea how to go about this.

An undervalued national currency is better than an overvalued currency, at least in relation to export booms. Perhaps Costa Rica should look closer at the example of China. The United States charges that China undervalues the Yuan to the detriment of the U.S. economy by the flood of cheap Chinese imports. While this is no doubt overstated, it is true that China carefully controls its currency exchange to promote its own economic development. Of course, this is not the main factor in China’s unparalleled success story. China rather turned Marx on his head; socialism laid the groundwork for a transition to a raw but vital capitalism. Not the neo-liberal global capitalism of the West, but a capitalism that utilizes the socialist tradition of strong state institutions that centrally plan the social and economic development of the nation.

Establishing an exchange rate that makes economic sense is just a first step for national development. Costa Rica would do well to strengthen its state institutions and define development goals, not by emulating China, but by leaving aside the dogmas of monetarism and neo-liberalism and replacing the Central Bank personnel with figures that look to Costa Rica’s strong tradition of social democracy and social justice and to its South American neighbors who have learned their sad lessons from 20 plus years of globalization orthodoxy and taken new, progressive directions.

China’s export-led development has meant that tens of millions of peasants are displaced to barracks in the industrial centers, work for a pittance and live in the most unjust of social conditions, while the bureaucrats and businessmen accumulate incredible wealth. On a lesser scale than China, growing inequality and social injustice are prime features of Costa Rican society. And this is mainly a result of the export-led development strategy, the abandonment of programs of genuine national development, such as food sovereignty, the permissive attitude toward business regulation and business activity while strong arming labor unions, the lack of effective ameliorative programs for the increasing problems of social inequality, and now the privatization of the very state enterprises that once formed the economic basis of Costa Rica’s social democracy. It is time for real change.

Source by Dale L. Johnson

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