Q. How does the foreign exchange earnings system in Trinidad & Tobago work?
Like any country, Trinidad & Tobago earns foreign exchange from a variety of sources — from remittances sent from overseas, from investments we as a nation (private and public sectors) have made abroad, from tourism and other services we export, from foreigners who invest in our country (FDI) for example, but mostly our foreign exchange earnings come from our (net) exports of LNG and other energy related products such as gasoline and diesel, and petrochemicals such as ammonia and methanol.
As Charts 1 and 2 show, in 2018, 86% of our total exports came from the energy sector. This was the highest level of export concentration on energy since 2011, and shows that instead of becoming more diversified, our economy has become more energy dependent. Why did this happen? At a time when we know our energy production levels are well below historic highs, it’s not a question of a roaring energy sector becoming relatively larger and stronger than the non-energy sector. No, that’s not the case. The reason, which I will discuss in more detail later, is that the overvalued TTD, and other harmful policies, have steadily eroded the non-energy sector, such that the energy-sector has become relatively larger.
How exactly does T&T earn the vast majority of its foreign currency from the energy sector?
- The energy companies such as BG and BPTT earn foreign currency by selling their energy products for foreign currency (USD). They sell some of the foreign currency they earn to the local banks in exchange for TTD to pay their local bills, salaries, etc. This is one way in which foreign currency enters the financial system in T&T.
- The energy companies also pay some of their taxes to the Government in foreign currency. The Government then uses this foreign currency in a number of ways: to pay its USD denominated obligations such as debt servicing, to pay its bills to foreign suppliers of goods and services, and the Government sells some of its foreign currency to the Central Bank in return for TTD, again to service its local currency obligations. This is the most important way in which the Central Bank receives the foreign currency it holds as Official Foreign Reserves, in order to sell to the public, largely to pay for the nation’s imports.
So in essence, earnings of foreign exchange from the larger and mostly foreign owned energy sector companies is the most important way in which our country receives the majority of its foreign exchange, and we have become even more dependent on them for this purpose, based on successive administrations’ shortsighted policies.
The non-energy sector also contributes to exports, at 14% of total exports in 2018, but it is not clear where these foreign currency earnings go. Some would be sold to the banks or other (informal) buyers in exchange for TTD, some would sit in USD accounts in T&T, and maybe some would be held abroad. It is hard to imagine a scenario where an exporter in T&T would sell all their foreign currency earnings for TTD, given the difficulty in sourcing foreign exchange. I would imagine therefore that this source of foreign exchange into the wider system would be rather insignificant.
Q: What’s the underlying reason for the foreign currency crunch?
As discussed earlier, 86% of export earnings in 2018 came from the energy sector at USD8.85 billion. Total exports for 2018 had reached USD10.3 billion, up 9.2% over 2017. But this still remains well below 2013 levels, for example.
As Chart 3 shows, our total export revenue declined from 2014 to 2016, mostly driven by the decline in energy exports (based on the drop in oil prices in 2014, but also lower production volumes), but non-energy exports also fell by 59% in 2018 compared to 2013.
These declines in exports from 2014 led to lower levels of foreign exchange being earned by exporters (both energy and non-energy), and therefore, less foreign exchange would have been sold to the banks by the energy sector players and by the non-energy sector exporters. It would also suggest that the amount of foreign exchange being earned by the Government, as seen in Chart 4 (and hence the Central Bank) via the energy sector, would have also declined from Fiscal Year 2014/15, severely affecting the Central Bank’s ability (and perhaps willingness) to inject foreign currency into the banking system.
If we look at Chart 5 however, the story it tells is quite interesting. Recall that the Central Bank gets the bulk of its foreign currency from the Government, who earned it from the taxes paid by the energy sector companies. And recall that the Central Bank then uses this foreign currency to supply the local financial system, via USD injections to the commercial banks, so that the commercial banks can then sell it to their clients who have foreign currency obligations to satisfy.
Recall that after 2013, export revenues declined significantly (Chart 3), falling 53% between 2013 and 2016. Note from Chart 5 that foreign currency injections from the Central Bank rose slightly in 2014 as a proportion of energy exports, jumped in 2015 to 30%, (coinciding with the general election) but then declined steadily to about 17% in 2018. This tells us that as a proportion of energy exports (the denominator, which increased in 2017 and 2018, alongside fiscal revenue from the energy sector), the Central Bank and the energy companies both sold significantly less to the banks. In 2018, total export earnings grew 9.2% y/y; yet, total foreign exchange sales from the public contracted 16% y/y. This could at least partially explain the tightness in the availability of foreign exchange at the banks.
When we look at the total foreign exchange sales coming to the banks in Chart 6 — from Central Bank and from the ‘public’ (mostly the energy companies) — which is then available for the banks to sell to the general public — we see that the volume of foreign currency coming to the banks has been on a downward trend since October 2015, with slight increases since early 2018 (on a 12 month cumulative rolling basis). Note that sales of foreign exchange from Central Bank to the banks, however, have continued to decline. Again, this would contribute to the tightness being experienced in accessing foreign exchange from the Banks.
Q: Is it that we are spending too much and earning too little?
In my opinion, it would appear that this is the case, and it is a chronic / structural problem. As Chart 7 shows, the non-energy fiscal deficit (the size of the fiscal deficit if there was no energy revenue) peaked in FY2013/14 at over TTD26 billion, and has largely retreated since then, but jumped in the current fiscal year’s budget, to TTD17 billion. This shows how dependent the Government is on the energy sector to finance its spending, and that this dependence has INCREASED by about TTD5 billion in the current fiscal year.
Beyond our fiscal dependence on the energy sector as depicted in Chart 7, we are also heavily dependent on the energy sector to finance our import bill as Charts 8 and 9 show. Non-energy exports financed less and less of our total import bill since 2013, when they covered close to 40%, but in 2018 this dropped to 22% at USD1.45 billion, indicating a clear downward trend, with 2018 being the lowest on record since 2011.
Furthermore, we earned less from non-energy exports in 2018, at USD1.45 billion, than we spent on fuel imports at USD1.75 billion (which is largely to run Petrotrin). This raises another question — would the closure of the Petrotrin refinery mean that we are better off from a foreign exchange standpoint? Was Petrotrin a net user or net earner of foreign exchange?
The Ministry of Finance is projecting 60% y/y growth in oil revenues for this year at TTD9.52 billion. Production has only met its target one month so far this fiscal year as Chart 10 shows. This has serious implications for fiscal revenue, and it seems to me that the fiscal deficit target is unlikely to be met, and the non-energy fiscal deficit is likely to be even wider than projected.
Q: Is the Central Bank not managing its injections properly?
Managing the injections? Relative to what objective? Has the Central Bank stated what its objective is regarding the exchange rate or otherwise? What is the Central Bank’s monetary policy goal?
As depicted in Chart 6 and Chart 11, Central Bank injections have been on an overall downward trend since October 2015.
In Jan-July 2019, Central Bank has injected on average USD115.7 million monthly — about 16% below the average for the Jan-July period for the prior 10 years. Yet, for commercial bank’s purchases from the public, the figure is on par with the average for the prior 10 years. So yes, this would suggest that the Central Bank has reined in its injections, but we are not sure why and what they are trying to accomplish.
Q: Is it that the TT dollar is overvalued?
According to the IMF, in 2017 the TTD was as much as 42% overvalued. Another indicator that the TTD is overvalued, is the existence of a black market where USD are sold for more than the official rate (6.80 roughly), at about TTD7.00 — TTD8.00 / USD.
Based on the current relationship T&T has with the IMF, annual (at least) visits by the IMF team to conduct the Article IV review and produce the accompanying Staff Report, are the norm / expectation. The last visit was around mid-2018, so another visit would be (over)due now. It is not clear whether this visit will occur later this year, but it has not occurred yet for 2019. I consider the IMF’s Article IV staff report to be one of, if not THE most important macroeconomic analyses that should be available for any country, not just T&T. If an IMF staff visit is not organized for this year, it could signal this Government is not supportive of transparent and objective assessment and reporting on the macroeconomic conditions in T&T.
Q: What will bring the market into equilibrium?
To bring it into equilibrium, the Central Bank would have to allow some market determination of the exchange rate, which existed in the past and was abolished years ago under the previous administration. The current Minister of Finance had mentioned in previous Budgets that the auction system for the injections would be reintroduced, but this has not yet come to pass. In the mid-year fiscal budget review, the Minister referred to “this Government’s policy decision to defend our exchange rate”, which signals to me that there is currently no intention to allow for market determination.
Q: Are people hoarding?
“Hoarding’ can be a misleading term. As far as I understand it, people buy and hold onto USD for a period of time, when possible, for a number of reasons. There is the traditional motive of “flight to quality” where people try to buy and hold USD if they feel there is uncertainty and therefore risk of loss associated with having exposure to / holding another currency (in this case TTD), in an effort to reduce the risk they are subjected to. Then there is the speculative motive, where people try to buy at the official price and profit by selling on the black market at a higher price, and / or after there has been a TTD devaluation. But some people buy and hold in order to ensure that they have access to sufficient USD as and when they need it, to pay suppliers, pay for school fees / medical bills / retirement, etc. later on.
You will see from Chart 12 that the quantum of foreign currency deposits has remained fairly stable since 2014 at around 23% of total deposits, at over USD3 billion. I would not consider this evidence of undue / unreasonable ‘hoarding’, especially given (1) policy uncertainty, (2) the mounting possibility of devaluation as reserves decline steadily, and (3) longstanding tightness in the foreign exchange market.
One other thing that we need to discuss here as well, is the scandalous and grossly unacceptable Errors and Omissions item in the Balance of Payments, which stood at an eye-watering USD2.6 billion in 2018, according the CBTT May 2019 Monetary Policy Report. This means that USD2.6 billion LEFT Trinidad and Tobago, and the authorities are unable to account for it.
Q: How is policy helping or hindering investment and earnings potential?
By maintaining an overvalued currency, the Government is essentially subsidizing imports and penalizing or taxing exports. This would make locally made goods less competitive relative to the imported substitutes and could damage the local manufacturing sector. This would then hinder further investment into the manufacturing sector, whether local or FDI.
As you can see from Charts 13, 14 and 15, the manufacturing sector has shrunk / declined in size relative to the rest of the rest of the economy, and is smaller now than it was in 2012, and capacity utilization is consistently in the 60–70% range. I would argue that manufacturers with excess capacity, who are unable to export their surplus output because of the overvalued TTD, would generally be hesitant to invest further in their plant / equipment.
Furthermore, if you look at the data on Foreign Direct Investment you will see that in addition to having the most overvalued currency in the hemisphere, T&T is the ONLY country in the entire region of Latin America and the Caribbean that has had NEGATIVE Foreign Direct Investment flows for the past THREE consecutive years. This is an indication of an unwillingness to invest in our country and to take out whatever we can. This is FEAR.
Q: Why is the government so adamant that there’s not a problem with foreign exchange, or rather, the exchange rate, when there clearly is?
I am not sure. Because they can get away with it? Because they think people will believe them? Because if they admit that there is a problem, they would then be asked “how are you going to address it?” and maybe they don’t want to or can’t answer that question? Your guess is as good as mine.
What is important to note is that with the black market reportedly trading at TTD7.00 — TTD8.00 / USD1.00, there is infinite demand for USD at the official rate of TTD6.78/USD1 providing an opportunity for arbitrage for those that have access to USD at the official rate, and reinforcing the need to allow the exchange rate to adjust.
Q: How do we earn more foreign exchange, especially given falling hydrocarbon earnings?
We should be exporting a wider range of goods and services, like we used to, but instead we have become more dependent on the energy sector for USD earnings, because of the overvalued exchange rate and the shrinking manufacturing sector.
We should also be asking: how can we spend less on imports? Do you know who or what are the major drivers of imports? It used to be crude oil, to feed Petrotrin. I would assume that refined products will take the place of crude oil. How serious are we about switching to renewable energy to reduce our need for imported fuel?
The other major driver of imports on the whole, is Government spending. If we assume that, like the rest of the Caribbean, 80–90% of what we consume is imported, it means that the government as the largest spender in the economy, the largest employer, is also the largest driver of imports. And the fiscal deficit means we are borrowing to import. Therefore, balancing the fiscal budget is critical to reducing the level of imports and stemming the decline in the level of foreign reserves and import cover.
The overvalued exchange rate is in effect a subsidy to imports, making it more profitable to import than to produce domestically, and making our products less competitive in global markets. Furthermore, the de facto peg to the USD means that the appreciation of the USD itself has caused a further loss of price competitiveness for our goods and services to non-US trade partners.
Both restrictions on the supply of foreign currency and an overvalued currency also represent a risk for foreign direct investment, which is the other source of foreign currency. So, to earn more foreign exchange, we first need clear policy objectives and institutional transparency in reporting progress against these objectives in order to reduce uncertainty and allow for private expectations to be set. The overvalued currency must be addressed, as well as the fiscal deficit and other structural weaknesses. Finally, we must address issues such as corruption, bureaucracy, and crime and violence that make T&T less attractive for investment and doing business.
Q: What is the solution to the current foreign exchange challenge? Is devaluation an option?
An overvalued currency is not sustainable but a devaluation in and of itself is not going to solve the underlying structural challenges that have existed for several years. While devaluation is an ‘option’, it has to be part of a comprehensive reform agenda, because by itself, it will achieve little. It may just serve to make imports more expensive, drive inflation, and by extension, drive renewed overvaluation of the currency, and it would also drive the debt/GDP ratio higher in TTD terms.
In the first place, in order to determine whether a devaluation will help, you would need to determine whether the Marshall-Lerner condition is satisfied — this condition tells you whether a devaluation, and to what extent, would cause an improvement in the balance of trade. Once the Marshall-Lerner condition is satisfied and we know what exchange rate is optimal, then we have only the easy part of the problem solved. We have to implement the necessary reforms to avoid a recurrence of the problem.
As mentioned earlier, fixing the fiscal deficit is probably the single most important supportive reform that would be necessary to accompany a devaluation, in order to avoid the recurrence of an overvalued currency.
Another reform, again as discussed earlier, is having a mechanism where some market determination is captured in determining the exchange rate — such as the auction mechanism in the Central Bank foreign currency injections. Beyond this, I would also suggest that an inflation targeting regime could be looked at, in terms of the Central Bank’s overarching policy regime, which would support greater overall macroeconomic stability, policy predictability and transparency, boost consumer and investor confidence, and stem the flight to quality / excess demand for foreign currency.
Switching to renewable energy generation in the medium-long term will reduce the reliance on imported fuel and the demand for USD — supporting the devaluation and making a recurrence less likely. Fuel imports amounted to USD1.76 billion in 2018, which was 21% greater than the total amount of non-energy exports for the year.
And finally, sweeping and comprehensive ease of doing business reforms which support private sector led growth and job creation, would help to ensure that there is some reasonable level of local manufacturing and therefore import substitution and exports — both of which would boost export earnings and reduce the reliance on imports and foster an environment conducive to attracting foreign investment.
Most importantly, none of this can occur without a clear plan or policy agenda to address these challenges. Currently, the government has not demonstrated they have such a plan, and in fact there is not even an acknowledgement of the problems in the first place, signaling that these problems ought to be (or will be) addressed:
1) there is no clear plan to address the fiscal deficit and rising debt, and as a matter of fact, the Government plans for an even wider fiscal deficit this year than last,
2) there is no clear plan to address the overvalued TTD, foreign exchange tightness, and the scandalous Errors and Omissions item in the Balance of Payments,
3) there is no clear plan to reverse the trend of higher and higher dependence on an energy sector which has passed its peak AND a shrinking non-energy sector.
And to top it all off, there is no information signaling that the IMF will be coming to T&T in 2019 for their usual annual Article IV review / staff visit. So, the important data gathering, reporting and analysis that’s done by the IMF, informing us about the current situation, the challenges, and the suggested policy response, will be ABSENT this year, and who knows about next year, just before an election. How convenient indeed.