Will inflation rise with the elimination of dual currency?

Cuba will have to assume the complex process of the currency unification without the help of international financial institutions, with very limited international reserves and at a time of low economic growth. Though the increase of the fiscal deficit has not been announced, it would seem inevitable in the short term to mitigate the impacts of the currency unification. The most probable forecast for after “zero day” is an increase of inflation. What would remain to be done is to assess its magnitude, permanence in time and distribution among the different markets and sectors.

There are high probabilities that, starting 2015, the first steps will be taken to eliminate the dual exchange rate and currency in Cuba. The appointment of Marino Murillo as the new economy and planning minister could have had, among one of its reasons, giving him the responsibility of directly looking after this complex process, which requires an effective economic policy designed to manage the impacts, as well as a great effort in the operational organisation.

The country has been functioning for 20 years with the simultaneous circulation of several currencies and with multiple exchange rates. Initially the circulation of the Cuban peso and the U.S. dollar predominated, and at present the Cuban peso and the convertible peso. The latter currency is destined to disappear on the road to the currency unification in order to re-establish the peso as the only national currency. Meanwhile, the distance must be resolved between the official exchange rate used for enterprise and state budget transactions and the exchange rate in force for the operations of the families and tourists, which is currently 24 times.

The dismantling of the dual currency and the system of multiple exchange rates is not simple. It implies changing the way in which the enterprises, families and government have become accustomed to assigning resources and decision making. It also involves a change of perspective toward the economic problems that have prevailed during all these years and, to a great extent, have remained hidden or foggy because of the currency and exchange distortions.

The devaluation of the official exchange rate, pegged at one Cuban peso for one U.S. dollar, constitutes the indispensable action to unchain the processes that will lead to the currency unification. The devaluation will be transferred to the markets and commercial and financial variables through diverse channels. The economic policy that accompanies the devaluation will define which of these transfer mechanisms will have the greatest preponderance or even which will be annulled.

Such decisions have been reconciling for several years in the Central Bank, the Economy and Planning Ministry and the Finances and Prices Ministry, together with other involved government entities. It seems an agreement has already been reached and the so much announced and awaited currency reform will soon start up.

One of the principal channels through which the devaluation will be transferred to the entire economy is inflation. The multiple exchange rates and the official overvaluation of the Cuban peso have maintained a distortion of the relative prices of goods and services, the calculation of production costs, enterprises’ measurement of profitability and competitiveness, real wages and the State budget. Actually, the devaluation of the exchange rate is only a means to finally correct all these distortions, which prevent a better use of the economy’s productive capacities.

Therefore, for the devaluation to meet its objective, it must affect the relative prices. The success of the economic policy is that prices and wages be put right after the devaluation, but avoiding the creation of an inflationary spiral, that is, to avoid falling into a vicious circle where the price increases generate more price increases in an uncontrollable manner in time. In other words, inflation should not be avoided, but rather managed.

The economic policy must not annul the effects of the devaluation, but rather guide them toward the markets where the most distortions exist, mitigating the impacts there where less capacity for immediate reaction is identified and where the greatest social costs are previewed.

It would be desirable that the devaluation have real effects on the economy and not just nominal. But technically, we economists would say that a devaluation of the nominal exchange rate would not only be desirable but also that of the real exchange rate. For example, it would be expected that the state enterprises that demonstrate their financial unsustainability in the new currency scenario will go bankrupt, that the State Budget and Economic Plan change their structure of expenditures and subsidies, and that no bureaucratic limits exist so that the enterprises favoured by the devaluation increase the real wage of their workers.

Up to now, there is very little information about the economic policy that will accompany the process of eliminating the dual currency. Only some regulations that will come into force on “day zero” have been published, that is, when the economy starts working with the Cuban peso as the only currency. Let’s analyse these regulations and their possible impact on inflation.

Changes for wage policy

Cuban pubic workers are not compensated annually for the cost of inflation in their real wages; there is no indexing procedure for wages or for pensions. The public enterprises and entities do not have the autonomy to modify the wages paid to their employees. Through bureaucratic procedures, associated to the central economic plan, every year the government has been regulating that the state wages not increase more than productivity.

This has been a decisive factor in the control of inflation since the 1990s, but it has been impossible to transfer to a scheme of guaranteeing currency stability in a context of more flexible wages. What could be called an “intermediate goal” of the Cuban currency policy (the adjusting of state wages to productivity) has functioned very well to guarantee a low inflation, but has not left a space for wages to serve as an incentive for productivity, rather it has unchained a vicious circle of low productivity and low wages.

The economic policy does not plan to change this intermediate goal for the time being, it will continue basing itself on this goal as one of the principal means to conserve the currency balances. What apparently will happen with the announced reform of the state enterprises is a relaxing in the way in which this goal is controlled once the enterprises can decide with greater autonomy their wage levels.

The reform of the state enterprises implies that they will be able to decide on their wage system and increase the wage levels according to their financial capacities. They will be allowed to destine part of the 50 per cent of the profits at the end of the year to give workers money incentives. If this announcement were to be fully achieved and other obstacles not placed through the central plan, the state enterprises would be in a more favourable position to respond to the opportunities created by the devaluation of the exchange rate and the currency unification.

In addition, wage increases have been previewed for the employees in the Mariel Special Development Zone and for the workers linked to foreign companies. For the non-entrepreneurial state sector the generalised wage increases have been ruled out, beyond the recent increase carried out in the health sector, with which it could become the group of workers most vulnerable to the social costs of the currency unification.

Relaxing of the mechanisms for the formation of prices

Three resolutions (19, 20 and 21) of the Finances and Prices Ministry (MFP) were published in March of this year in the No. 12 extraordinary Gaceta Oficial. The resolutions are designed to regulate the formation of prices and the accounting practices in the Cuban economy once the convertible peso (CUC) is eliminated and the Cuban peso is established as the single currency for the economic transactions in the enterprise sector.

Resolution 19 refers to the accounting regulations that the business system must apply after the devaluation of the official exchange rate and the elimination of the CUC. Resolution 20 regulates wholesale prices, service rates and the commercial margin rates of the state enterprises. Resolution 21, on the other hand, refers to retail prices and the rates for the services of the state enterprises in relation to the population. It has not been said when the resolutions will come into force, they refer to “day zero” without mentioning the moment in which the currency substitution will take place.

Specifically, Resolution 20 leads to a relaxation of the mechanisms for the formation of prices and tariffs in the Cuban enterprise system, but which will be controlled and/or audited by a group of authorities like the MFP and the Higher Organisations of Business Leadership (OSDE), among others.

The resolution proposes two methods for the formation of prices: a) by correlation or b) by the method of expenditures. The method of correlation will have priority, that is, as long as it is possible, the authorities indicate that the state enterprises must apply the first method, which in fact is the one that grants greater authority to the enterprise.

According to the method of correlation, the enterprises will define their prices using as reference the prices of products and services equivalent in the domestic or foreign market. Resolution 20 exactly specifies that: “When the method of correlation is used a ceiling price is not established for prices. A permanent monitoring system must be maintained on the acceptance of prices by the market and if necessary, reductions or increases are carried out…. The method correlation, in addition to guaranteeing competitiveness, must maintain the balance between supply and demand.”

The enterprises that use the method of correlation only need to draw up an internal procedure (in the very enterprise), approved by the MFP or another authority, but will have autonomy to change prices according to the economic situation.

Meanwhile, the second method (method of expenditures) will be used in the formation of wholesale prices, for example, if the product that is sold does not have equivalents in the domestic or international market, or when they are imported products, among other cases.
What the method of expenditures proposes is to add to the total costs a profit rate or a commercial margin approved by the MFP, according to the producing or commercialising enterprise. The MFP underlines that the approved wholesale prices must guarantee the total recovery of the enterprises’ costs. The prices as well as the commercial margin rates approved by the method of expenditures have a maximum character. That is, the enterprises can decide on price discounts.

Resolution 21 extends the same principles and methods for the formation of retail prices, for the liberated markets as well as for the regulated one (ration card). It says that “the retail process do not receive subsidies from the State Budget.” It adds that only some mass consumer products and services will be exceptionally subsidised. This declaration in the text of resolution 21 contradicts recent government announcements about the intention of not affecting the retail prices after the devaluation, since the only way to achieve this would be by increasing the subsidies.

In short, one perceives in the new resolution the spirit of relaxing the prices to connect them more to the economic facts, which would be creating a more favourable context to observe the real impacts of the unification of the exchange rate and currencies.

Implications in the State Budget

With the devaluation of the official exchange rate of the Cuban peso the financial results of the enterprises, banks and other organisations will be mutated. The balance between assets and liabilities of the enterprises will change when multiplied by a different exchange rate. The ones who lose out would be the financial balances that present debts in convertible pesos and hard currency higher than their assets in those currencies. The institutions that have a different situation to the latter in their balances will be favoured by the measure.

The devaluation will create traumas in the financial situation of the enterprises, but designed to promoting more transparent countable balances and that reflect more precisely the economic facts. This would be one of the most difficult balances to be achieved by the economic policy. On the one hand, it is necessary for the devaluation to have an impact (that it be a real and not just nominal devaluation), that it changes the financial situation of the enterprises and that it leads to a better allotment of resources. But, on the other, neither can it be an unmanageable shock for the enterprises, in a manner that it causes a collapse of the economic activity.

Evidently, the devaluation is associated to financial stress and costs on the enterprise sector, but also generates benefits. All the national production of the buying and selling sectors will see a relative improvement in their competitiveness in the face of imported goods and services. Exporters will see their profits and competitiveness increase.

For these benefits to materialise, the state enterprises must have greater autonomy. That is why it is favourable for the reform of the state enterprises to advance in unison with the currency reform. The state enterprises, which will be the ones that will feel the most impact of the devaluation, require easy margins to respond to the new environment and react to take advantage of the opportunities that the changes in the relative prices generate.

The devaluation of the Cuban peso, indeed, will generate costs and benefits; the contrast is that the majority of the costs are certain and immediate, while the benefits appear as opportunities and will take time to completely materialise.

This is why it is of key importance that the monetary reform be accompanied by the economic policy, particularly the fiscal policy. A group of compensatory measures for the enterprises that receive the immediate costs of the devaluation must be thought of, but with potentials to take advantage of the new exchange opportunities.

The economic policy must adapt its instruments to mitigate this temporary gap between costs and benefits of the devaluation: the subsidies, taxes, the credit policy and the allotment of resources through the economic plan must define measures of support for the exporters and all the enterprises with potentials to take advantage of the devaluation. This will mean tension in the fiscal balance on the side of expenditures, which must be compensated for with a renewed tax policy that attracts a percentage of the extraordinary incomes received by the enterprises that benefit from the devaluation.

The country will have to assume this complex process of currency unification without the help of international financial institutions, with very limited international reserves and at a time of low economic growth. However, the “ideal moment” cannot continue being waited for to undertake it, the group of structural reforms need the currency reform.

Effects on inflation

According to data from the National Office of Statistics and Information (ONEI), the average inflation rate from 2000 to 2013 stood at 1.5 per cent. While these official estimates can be underestimating in several percentage points the real inflation, it is very probable that the annual average inflation is more than one digit point, that is, that it is the same or higher than 10 per cent.

The low inflation records in Cuba have had four very clear decisive factors: 1) the fixed exchange rates, 2) the control of all the wage levels of the state sector through the Plan, 3) the centralised setting of a high percentage of the economy’s prices and 4) the low fiscal deficit.

After what we have been assessing in this article, one can see that the announcement of policies and the published regulations would be showing that these four factors will undergo changes. The devaluation of the exchange rate, the increase of wages and the relaxing of the mechanisms for the formation of prices are actions that the government itself has already recognised as necessary. The increase of the fiscal deficit has not been announced, but it would seem inevitable in the short term to mitigate the impacts of the currency unification.

As a consequence, the most probable forecast that could be given for after “day zero” is an increase in inflation. What would remain to assess would be the magnitude, the permanence in time and the distribution among the different markets and sectors of this growth in inflation.

The direct inflationary effect on the population will depend on what happens with the retail prices. The government has said that no one will be affected by the currency unification. During the last session of the National Assembly, Marino Murillo said that, as a result of the currency reform “there will not be a price increase in the network of shops of the retail market….”

For there to indeed not have an increase in the retail prices, it will be necessary to increase enormously the subsidies after the devaluation. This will put pressure on a greater increase in the fiscal deficit, which is also already expected to grow to mitigate other short-term impacts of the devaluation. An excessive increase of the fiscal deficit would be the scenario less favourable to avoid an inflationary spiral, since the amount of money in circulation would increase in a disproportionate manner.

In short, a short-term inflation seems inevitable and necessary to achieve real effects in the economy. The sustainability of the fiscal deficit and the productive response to the opportunities that the currency unification opens will both determine the possibilities of conserving the stability of prices in the medium term.

In conclusion

Two risks stand out in the imminent Cuban currency reform. First, a mid-term productive response of the state enterprises is crucial for the benefits of the unification to be greater than their costs. This causes a logical uncertainty, since there are many doubts about the flexibility and capacity for reaction of the state enterprises, especially in an economy that continues being very centralised and where bureaucracy has gained too much force.

In the second place, there is the risk that the economic authorities, in their effort to mitigate the impacts of the devaluation and to control inflation, end up by annulling the principal real effects of this measure. A nominal currency reform instead of a real currency reform is possible, but not desirable. If the currency unification does not produce a change in the financial situation of the enterprises, if it does not stimulate exports, if it does not have an effect on the real wages and, in general, does not improve the efficiency in the allotment of resources in the economy, all these years of planning the currency reform, the operative deployment that will take place on “day zero” and the currency uncertainty the measure has caused will have been in vain.

Some regulations have been published for “day zero” that point to a currency reform that will correctly be carried out parallel to a transformation of the mechanisms for the formation of prices, wages and the management system of the state enterprises. However, this does not guarantee that the mentioned risks have been overcome. There are still many aspects of the design of the currency reform and its implementation we don’t know about. (2014)

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