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The pass-through of a devaluation to prices

2023-08-20T10:30:15.481Z

Highlights: Argentina was surprised by the devaluation of the so-called "official dollar" (wholesale reference exchange rate) Price went from 287.29 to 349.98 pesos per dollar (an increase of 21.8%). Domestic prices of products that are exported and imported necessarily reflect international prices, the exchange rate, transport costs, and domestic policies that distort those prices. A successful devaluation passed 90% to prices within the following 12 months, and an unsuccessful one did so by 110%. The experiences of other countries lead to the conclusion that in countries with low levels of inflation and dollarization, the pass-through of exchange rate movements is much lower.


The pass-through of a devaluation to prices


Last Monday the country was surprised by the devaluation of the so-called "official dollar" (wholesale reference exchange rate) whose price went from 287.29 to 349.98 pesos per dollar (an increase of 21.8%).

At the same time, the price of the so-called blue dollar went from 490 pesos at the end of June to almost 800 pesos last Wednesday (an increase of 63%).

These increases were quickly reflected in domestic prices raising the rate of inflation. Many people ask why, ignoring the functioning of the economy and Argentina's long experience in this area.

Argentina is a small country with little influence on the determination of international prices, so domestic prices of products that are exported and imported necessarily reflect international prices, the exchange rate, transport costs, and domestic policies that distort those prices (tariffs, export tax and other regulations). These prices necessarily change when the exchange rate changes, completely independently of the wishes of the governments of the day.

In this context, what kind of change are we talking about? Normally most of these products are traded using the official exchange rate, but in continuous processes of devaluation and price increases many products are quoted at "replacement cost", that is, at the projected exchange rate at the time of replenishment, and alternative exchange rates are generally used.

Currently, the products traded using the official exchange rate are: food, medicines, fuels, essential inputs, and some industrial exports. The rest of the products that are traded internationally set their prices using the "replacement cost". That is why, given the recent devaluation, the prices of all these products will rise between 21% and 60%.

On the other hand, the evolution of the prices of products that are not traded internationally depends on the evolution of domestic demand, but in the short term all producers will try to incorporate in their prices the increase in their costs and raise their prices so that their relative price does not deteriorate.

In this context, questions are repeated such as: Why do rents and hairdressers have to rise? They are valid questions, they require a response and the previous paragraph explains it.

The price of rents is generally a percentage of the value of the property, which are usually quoted in dollars. If these dollar prices are not modified, rents will rise. In the same way, the hairdresser sees the increase in his costs (rent, electricity, etc.), but also does not want his net income to deteriorate, so he raises his prices.

In my book Lessons from the Argentine Crisis I stated that in Argentina (and not in the rest of the countries) a successful devaluation passed 90% to prices within the following 12 months, and an unsuccessful one did so by 110%. These numbers were not whimsical or based on theoretical analysis; They were the reflection of the Argentine historical experience.

The May 1975 devaluation initially improved the real exchange rate by 125%, but six months later that improvement fell to just 50%. The subsequent devaluation and unification raised the real exchange rate again by 550%, but twelve months later that improvement fell to 85%.

The situation in February 1989 was even worse; The value of the dollar went from 10 to 600 in six months, raising the real exchange rate, but nine months later the rise in prices had erased much of that improvement. And in November 1990 the devaluation improved the real exchange rate by 63% but twelve months later the situation was worse than before the devaluation.

The only relatively successful devaluation was that of 2001-2002, in which the initial improvement in the real exchange rate was maintained close to 50 per cent; But this was achieved with a recession of more than 11% and with the imposition of taxes on exports that reduced the "true" devaluation.

However, the situation is quite different in other countries. Between April 23 and September 23, 2015, the Brazilian real went from 2.58 to 4.18 (an increase of 62%), but the inflation rate was 6.32%, with a slight increase compared to the previous period.

The experiences of other countries lead us to the conclusion that in countries with low levels of inflation and dollarization, the pass-through of exchange rate movements to prices is much lower than in those countries that are de facto dollarized and have high inflation. The true unit of account in our country is the dollar and economic agents express prices in pesos taking into account the dollar quotation.

That brings us to another question: How do you improve the country's competitiveness if devaluations do not allow us to improve the real exchange rate? The answer is quite clear.

A country is competitive if firms that compete with the outside world (either by exporting or substituting imports) make money, and to do so it is not enough to slightly modify a relative price; It is necessary to improve all the costs that influence the competitiveness of a country.

How can we be competitive if the tax burden of companies that comply with all their obligations is twice that of other countries; if the country risk exceeds 2,000 points and we compete with others whose country risk is less than 100 points; or if regulations make the entire production process more expensive. It's impossible.

This implies that to be competitive the country must attack the problems where they are: lower its tax burden, reduce taxes on labor, lower the financial burden, simplify – or eliminate – most regulations, avoid periodic crises that reduce the productivity of investments and generate social conflict, etc.

If devaluation were the solution to Argentina's problems, we would be the richest country in the world.

Ricardo Arriazu is an economist.

Source: clarin

All news articles on 2023-08-20

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