Peg Under Pressure in Maran
The Republic of Maran pegs its currency to the US dollar at 5.0. The current account deficit is 7% of GDP, and foreign reserves have fallen from $40bn to $22bn in twelve months. Domestic inflation is 9%, compared with 3% in the United States, and unit labour costs are rising by 11%. The government has short-term external debt of $18bn due within a year. The black-market exchange rate is 6.2 per dollar. Exports are 60% unprocessed commodities; imports are mainly fuel, machinery, and medicines. The finance minister proposes either a devaluation to 6.0 or an internal adjustment through spending cuts and wage restraint. The central bank governor warns that many firms have unhedged dollar debt and that energy prices are administered. Trade unions oppose wage cuts, and households already spend 45% of income on food and fuel.
1. Explain why the fixed exchange rate is under pressure, using the data on competitiveness, reserves, and expectations.
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The peg at 5.0 is under pressure because the central bank must sell dollars whenever private demand for foreign currency exceeds supply. A current account deficit of 7% of GDP means more foreign currency is demanded for imports than earned from exports. Inflation of 9% versus 3% implies domestic costs rise about 6 percentage points faster, so at a fixed nominal rate the real exchange rate appreciates and competitiveness worsens. Reserves falling from $40bn to $22bn show intervention is finite; $18bn of short-term external debt adds rollover risk. The black-market rate of 6.2 signals expected depreciation. If investors anticipate devaluation, capital outflow accelerates, forcing higher interest rates or capital controls. The peg provides a nominal anchor, but it conflicts with internal balance.
2. Evaluate whether Maran should devalue to 6.0 or use internal adjustment.
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Devaluation to 6.0 raises import prices and lowers export prices in foreign currency. The current account may improve only if the Marshall-Lerner condition holds and after a J-curve lag. With 60% commodity exports and inelastic imports of fuel and medicines, the trade balance may worsen initially and inflation rise via pass-through. Unhedged dollar debt becomes harder to service. Internal adjustment through spending cuts and wage restraint avoids a nominal shock but is slow, contractionary, and may cause debt deflation. Judgement: devaluation is not a complete policy. It should be combined with fiscal consolidation, debt restructuring, and a credible monetary framework. If reserves are adequate and the shock is temporary, gradual adjustment may be preferable; if reserves are near exhaustion, a one-off devaluation with support for vulnerable households is more realistic.