Why is the exchange rate increasing in Republic D?

The increase in the exchange rate in relation to the US dollar in the Dominican Republic since the end of 2023 has been a matter of concern for a large part of the population. This is mainly due to the pronounced exchange rate devaluation that the country experienced in the past, as happened during the banking crises in 1990 and 2003. Another element that potentially adds to the general nervousness is that the exchange rate in relation to the US currency is approaching RD$60.00 per US$1, something that has not been seen in the country since the peak of February 2004. Banking crisis. However, it is important to highlight that the macroeconomic fundamentals of the Dominican economy are solid. We are not facing an environment of crisis and macroeconomic imbalance like 20 years ago.

There are many factors that have influenced the increase in the exchange rate that are part of the economic cycle that we are currently experiencing. First, it is normal for the national currency to depreciate slightly in the month of December, as there is greater demand for the US dollar by local businesses to replenish inventories due to the Christmas festivities, and the rate is usually found for the month of January. Within its normal range in normal economic cycles.

Similarly, it is normal for the exchange rate to decline by an average of 2% to 3% annually in a small open economy like the Dominican Republic with a free-floating regime. Furthermore, the international context in which we live is putting pressure on the exchange rate in the short term with higher interest rates.

Many economists and finance experts believe that a world without restrictions on capital mobility across borders is responsible for short-term fluctuations in exchange rates resulting in adjustments in investment portfolios. Simply put, money follows where interest rates are highest (causing fluctuations in the demand and supply of dollars). These adjustments in the investment portfolio determine the effects that dominate the determination of the short-term exchange rate. Therefore, the scenario of high interest rates generally causes exchange rate appreciation in the immediate future, and low interest rates leads to depreciation (Meerschwan 1984). In the international scenario we are experiencing due to the flow of capital from emerging markets to advanced economies due to higher interest rates, exchange rate fluctuations in the short term are normal, and the Dominican economy is no exception. Rule.

The economic literature tells us that the real exchange rate is determined by the risk premium as well as the discovered real interest parity position. According to (Céspedes, Chang and Velasco 2004), the risk premium depends on debt level, exchange rate and GDP. The risk premium is an increasing function of the increasing ratio between external debt and GDP. This friction in international capital markets is necessary to guarantee the stability of the external debt/GDP ratio. According to (Cespedes, Chang and Velasco 2004) other elements affecting the risk premium are the trade balance. As a result, they link the risk premium negatively to exports and positively to imports, so that a weakening of the current account increases the risk premium.

As we can see from the perspective of these authors, the elements that influence the risk premium of the Dominican economy are relatively stable. For example, according to data provided by the Directorate General of Public Debt, the external debt/GDP ratio increased from 38.9% of GDP in 2020 to 32.2% of GDP in November 2023. Regarding the current account of the balance of payments, according to the Central Bank of the Dominican Republic (BCRD), in 2022, the deficit in the current account of the balance of payments was 5.5% of GDP. For this reason, the country’s risk premium is stable, and that is why the risk rating agency Standard & Poor’s recently highlighted the stable management of Dominican debt at the beginning of the year and affirmed its credit rating as stable (BB). . Therefore, there is no danger of capital flight from the country which would jeopardize the exchange rate.

The monetary policy conducted by the BCRD has been timely in managing interest rates in line with inflationary pressures, so the recent increase in the exchange rate is not due to inadequate management of monetary policy. According to (Taylor 2001), there is little evidence that implementing systemic responses to exchange rate movements would improve macroeconomic performance, even in an open economy like the Dominican one. Taylor attributes this to two main factors: first, within a simple framework monetary policy responds to the indirect effect of exchange rate movements through output and inflation control. Second, the appropriate response to the type of movements should depend on the cause that is causing said movement. Therefore, taking into account the various shocks impacting the economy, reacting without considering the cause may be counterproductive. For this reason, given the cyclical context of exchange rate appreciation, a simple intervention in the exchange market, as announced by the BCRD, amounting to US$200 million, would be more than enough to calm market concerns. And, this will not cause any shock in the future, as the net international reserves are projected to reach US$ 15,457.7 million by December 2023, equivalent to 5.6 months of imports.

Finally, when exchange rates fluctuate many citizens are forced to think about dollarization. However, dollarization makes an economy more sensitive to external shocks and warns of instability. For example, in countries that issue their own currencies, a shock causes the exchange rate to depreciate, leading to changes in relative prices that boost domestic production and exports. But in a dollarized economy, since the exchange rate does not exist, it no longer acts as a shock absorber; External shocks have an impact on economic activities. In conclusion, the Dominican Republic is not experiencing a widespread economic hell like other countries in the region, and is the envy of the continent in stability in economic and political systems; Worrying about the exchange rate is a mirage.

Reference:

Meersschwan, D. (1984). Note on exchange rate determination. Harvard Business School.

Cespedes, L, Chang, R, Velasco, A. (2004). Balance sheet and exchange rate policy. American Economic Review, Volume 94 (September), pp. 1183-93.

Taylor, J. (2001). The role of exchange rates in monetary policy rules. American Economic Review, Volume 91 (May), pp. 263-67.

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