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    What determines the value of the Cedi?

    The most carefully watched economic indicator in any developing country is the exchange rate i.e. the price of the country’s currency. This is because many developing or emerging economies are likely to run a trade deficit.

    A trade deficit is the amount by which a country’s import value exceeds the value of exports. In this situation, prices of imported goods are determined by the value of the foreign currency. So, it is not surprising that Ghanaians have taken a keen interest in the performance of the Ghana Cedi compared with the major trading currencies.

    At any given time, the value of any currency is not absolute but relative to those of other economies meaning that trade plays a very important role in determining the long-run value of a currency.

    While the exchange rate is usually a snapshot of current economic performance, it is important to note that at any given time, several factors come into play to determine the exchange rate of a currency. These factors can be categorised into the short and long run.

    In the short run, factors such as the interest rate offered on a three-month treasury bill and inflation affect the value of a currency. When the central bank raise interest rates, local assets offer a higher rate of return to investors. The demand for local assets raises the value of the currency compared with a basket of major trading currencies. So that assuming other determinants remain fixed, interest rate and exchange rate should move in the same direction.

    From the diagram above, there is co-movement of exchange and interest rate from 2008 to mid 2011 after which their paths diverge. This implies that for Ghana, the short run relationship between exchange rate and interest rate is non-existent. This suggests that interest rate alone does not determine the exchange rate on its own but rather its part of a set of factors that comes into play at any given time to determine the value of the Cedi.

    Econometrically, Granger Causality tests for the period 2008-2016 showed that interest rates do not cause or affect the value of the Ghanaian Cedi and the results are shown below. The results also indicate that movements in exchange rate seemed to predict the path of interest rate in Ghana between 2008-2016. Therefore, it is not surprising that raising interest rates in response to the steep fall in exchange rates between 2013 and 2015 did not yield the expected result. For the benefit of readers when conducting causality tests, F-statistic greater or equal to 3.84 means that the null hypothesis is rejected.

     

    Pairwise Granger Causality Tests

    Sample 2008-2016

    Lags 2

    Null hypothesis F-statistic Probability
    Interest rate does not granger cause exchange rate 0.89879 0.5267

     

    Exchange rate does not granger cause interest rate 73.6537

     

    0.0134

     

    Inflation is another short-run factor that determines the price (value or exchange rate) of the Cedi. Specifically, when prices rise, Ghanaian goods and services become expensive. Investors move to alternative assets reducing demand for the Ghana Cedi which causes the value (price or exchange rate) to plummet.

    This means that inflation and exchange rate should move in the opposite direction. However, from the diagram above, inflation and exchange rates move in the opposite direction only after 2013 implying that the short-run relationship between inflation and exchange rate is tenuous for the period under consideration. Granger Causality tests lend support to this observation and the results are shown below.

     

    Pairwise Granger Causality Tests

    Sample 2008-2016

    Lags 2

    Null hypothesis F-statistic Probability
    Inflation does not granger cause exchange rate 6.11326

     

    0.1406

     

    Exchange rate does not granger cause inflation 30.6585

     

    0.0316

     

     

    The results above indicate that movements in exchange rate predict the path of inflation implying that the short run relationship between inflation and exchange rate has not existed since 2008. It also means that inflation on its own does not determine the value of the Ghana Cedi but rather, at any given time, inflation forms a part of the factors that determine the exchange rate of the Ghana Cedi.

    In the long-run, a country’s current account or balance of payments, terms of trade, government’s fiscal position i.e. surplus or deficit, confidence and political stability play a role in determining a price (exchange rate) for the country’s currency

    Ghana’s trade deficit stood at $452.40 million in June 2016. This implies that our imports were valued $452.40 more than our exports. A country’s balance of payment on current account plus balance of payments on financial account should equate to zero.

    This is because a country that receives net capital inflows should run a matching current account deficit while a country that generates a net capital outflow must run a corresponding current account surplus. The financial account reflects inflows and outflows of capital while the current account mainly shows inflow and outflow of goods and services.

    A country’s exchange rate ensures the balancing of the financial account and current account and in the case of Ghana, the country needs more foreign currency to pay for the goods and services imported into the country implying a lesser demand for the Ghana Cedi. Such a situation will exert a downward pressure on the value of the currency.

    This is linked to terms of trade which is defined as the ratio of a country’s exports to imports. Higher export prices result in higher revenues for the country which is why the fiscal position of many oil-exporting countries worsen when the price of crude oil drops leading to depreciation of the currency.

    The table below shows that Ghana’s balance of payment holds predictive content for the path of the exchange rate i.e. the trade deficit causes a depreciation of the cedi. It is important to note that although this relationship is long run, it does play a role in the short run determination of the exchange rate.

     

    Pairwise Granger Causality Tests

    Sample 2008-2016

    Lags 2

    Null hypothesis F-statistic Probability
    Trade deficit does not granger cause exchange rate 34.1886

     

    0.1201

     

    Exchange rate does not granger cause trade deficit 2.53656 0.4058

     

    Ghana is a stable country politically so it is unlikely this factor plays any role in determining the current value or price of the cedi. That said, the country has been running a fiscal deficit for some years now. Statistical tests as conducted in this article shows that the fiscal deficit on its own does not cause movements in the exchange rate but it, in tandem with other factors play a role in determining a price for the Ghana Cedi.

    However, a higher fiscal deficit together with low economic growth as witnessed in Ghana during the period under discussion is likely to affect investor confidence. Specifically, investors will worry as to how the country will service the deficit in a low growth environment.

    So, we have seen that apart from the balance of payments (trade surplus or deficit), no other single factor determines the exchange rate of the Ghana cedi. Thus, at any given time, several factors act in together to determine the value of the Ghana cedi. Therefore, the current value of the Ghana cedi is being determined by a long run factor i.e. the trade deficit.

    In policy terms, the central bank should aim for a sharp reduction in the benchmark interest rate, while attempts by government to increase revenue collection will make a significant dent in the fiscal deficit. The reduction in taxes will also influence inflation as inflation in Ghana is caused primarily by tax and expenditure policies more than money supply. These, together with the government’s 1 district, 1 factory policy will improve the country’s current account.

    When all these factors come into play, Ghanaians will see a significant appreciation in the value of the Ghana Cedi against a basket of major trading currencies.

    *exchange rate data used is the price of a unit of Ghana Cedi expressed in US Dollars.

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