1. Bifm Economic Review 2nd Quarter 2005
Economic Review
Summary of different countries and the trade weights
used. Chart 1 shows the evolution of one of
crawling band mechanism for the Pula, in
which the Pula exchange rate will adjust in
Economic the possible REER measures in recent years,
using trade weights that reflect
line with expected inflation differentials
between Botswana and its major trading
Developments (approximately) Botswana’s entire trade
patterns, including diamonds1. It is clear that
partners, the Government has indicated that
it will not permit the real value of the Pula
Dr Keith Jefferis, after being relatively stable, on average,
through the 1990s, the REER appreciated
to deviate from a competitive, equilibrium
value in future. This should, in principle, rule
Chairman of sharply from mid-2002 onwards. If the
relatively stable value of the REER during the
out any need for further devaluations.
Furthermore, the adoption of a gradually
Bifm Investment 1990s is taken as an approximate equilibrium
value, then by January 2004, the Pula was
widening band (between the Bank of
Botswana’s buy and sell rates) will
Committee about 12% overvalued, in real terms. The
devaluation of February 2004 reversed part
progressively allow market forces to
determine the value of the Pula, hence
T
of the real appreciation, but this was eroded introducing an element of floating into the
by subsequent price and exchange rate exchange rate mechanism. This will, over
movements, with the result that the Pula time, enable monetary policy to become
was again 12% overvalued by April 2005. more effective in countering Botswana’s
The May 2005 devaluation takes the REER relatively high inflation as, until now, the
he major economic event of the second
back close to its long-term value, although fixed exchange rate has limited the
quarter of 2005 was the devaluation of the
of course an important issue going forward effectiveness of monetary policy.
Pula by 12 percent on May 29, and the
will be the extent to which the
introduction of a new mechanism for The announcement of the crawling band
competitiveness gains resulting from the
determining the Pula exchange rate. While mechanism gave few details about how it
devaluation can be sustained, given that
catching most people by surprise, there were will work in practice. Hence we do not yet
inflation is likely to rise.
good reasons for the move, and in the long know key details, such as what the rate of
term it should be positive for the economy. While it is the devaluation that has received crawl will be, and how it will be implemented
In the short term, however, there will be attention – understandably in terms of its – for instance, how frequently will the
negative consequences, including higher short-term impact – the change in the exchange rate against the basket be adjusted
inflation, and economic confidence has exchange rate mechanism is more important – daily, weekly, monthly, or at some other
undoubtedly taken a knock, which will take than the devaluation in terms of long-term interval? On the basis of historical inflation
some time to recover. impact on the economy. By adopting a continue...
As the Ministry of Finance and Development
Planning pointed out, the devaluation was
prompted by concern about Botswana’s
international competitiveness. Although there
are no detailed official figures on measures
of overall competitiveness, a useful starting
point is the Real Effective Exchange Rate
(REER). The real exchange rate adjusts the
actual (nominal) exchange rate for differences
in inflation between Botswana and its trading
partners; a (relatively) higher inflation rate in
Botswana, or an appreciating nominal
exchange rate, will cause competitiveness to
decline. The REER is simply the trade-weighted
average of bilateral real exchange rates with
Botswana’s major trading partners.
1.
This REER measure uses weights of 50% SA rand and 50% SDR (IMF Special Drawing Right, which is itself a basket
Various different REER measures are possible, including US dollar (45%), euro (29%), yen (15%) and pound (11%)). These proportions are intended to reflect trade
depending on the choice of price indices in patterns, not pula currency basket weights.

2. 2 Economic Review
differentials between Botswana and trading spending, and there will no doubt be pressure in international perspective, noting that
partners, a rate of crawl in the region of from some quarters for wage rises. Also floating exchange rate currencies can often
perhaps 2-3% a year might be expected. If important is the impact on economic move by much greater amounts – the
so, the individual adjustments against the confidence in and about Botswana. In the rand/dollar and euro/dollar rates being prime
basket will be relatively small, and certainly long-term, the devaluation and the new examples. Even on a trade weighted basis,
too small for speculative activity based on exchange rate policy should help to boost the rand depreciated by 6% between April
predicting the crawl adjustments to be confidence, as it will be supportive of growth. and June this year. The prospect of greater
worthwhile. That is why, in most countries In the short-term, however, the impact on nominal and real exchange rate stability for
that have adopted crawling bands or pegs, confidence has been extremely negative, for the pula going forward should provide some
the rate of crawl and frequency of adjustment a variety of reasons: not only was the compensation for the shock of the
is publicly disclosed. Nor do we know how devaluation sudden and unexpected (as it devaluation.
quickly the band will be widened, and hence had to be), it was also relatively large. Perhaps
Inflation and Interest Rates
how quickly the fixed Pula peg will be most damagingly for Botswana’s reputation
loosened, although it will be obvious to amongst foreign investors was the fact that Inflation has been generally falling since
market participants when this parameter is the devaluation came only two days before January, when it reached 8.0%, although
changed. the maturity of the P750m BW001 showing a disappointing increase from 6.2%
government bond, in which foreign investors in April to 6.3% in May, prior to the
Given the likely slow rate of crawl, and a had significant holdings. Their returns from devaluation. The May increase resulted mainly
slow widening of the band, the main investing in Botswana were, therefore, much from a hefty rise in the cost of new vehicles,
influence on Pula exchange rates against reduced and, while it could be argued that and resulted in inflation remaining just above
other currencies in the short term will continue the interest rate on the bond was high the top edge of the Bank of Botswana’s 3%-
to be cross exchange rate movements of the precisely to compensate for risk, including 6% inflation objective range for 2005.
currencies in the basket, especially the rand/US that of devaluation, the timing was
dollar rate. With the rand apparently on a Prior to the devaluation, inflation was
interpreted – wrongly – as being deliberately
depreciating trend against the dollar, the pula expected to continue falling through the
malicious. Recovering from a damaged
is likely to appreciate against the rand and year, and there was a good chance that it
international reputation and rebuilding
depreciate against the dollar for the remainder would soon have been with the BoB’s desired
confidence will undoubtedly be a slow
of this year. range. The devaluation has changed the
process.
inflation picture entirely, however, even
In the long term, the devaluation should be However, the devaluation is unlikely to have though predicting the inflationary impact of
of benefit to the economy, especially to any negative impact on Botswana’s the devaluation is difficult. Following the
exporting and import-competing sectors. The international credit rating. Both Moody’s and February 2004 devaluation of 7.5%, there
long-standing policy of export-led Standard & Poors have been concerned about were a few months of relatively large monthly
diversification is unlikely to be successful the slow pace of diversification and the price increases, but by July these had tailed
without a competitive exchange rate, and government’s fiscal problems, and the off and the overall impact on prices is
even those who have criticised the devaluation devaluation will help to address both of these estimated at 2%-3%. Assuming a similar
have generally failed to put forward issues. And while the magnitude of the pattern this time around, with the devaluation
alternative strategies for Botswana’s long devaluation was large by the standard of having a relatively small and fast pass-through
term economic development or suggested previous Botswana devaluations (7.5% in to prices, inflation can be expected to rise
how development can succeed with an 2004, and typically 5% or less during the
overvalued exchange rate. Immediate benefits 1980s and early 1990s), it needs to be kept continue...
will be felt by the mining sector, government,
manufacturing, tourism and other export-
oriented services, which together account
for around two-thirds of GDP. More generally,
the devaluation and accompanying exchange
rate policy changes signal a determination
by government to make international
competitiveness the overriding policy aim, in
support of export-led growth.
Short-term effects are more likely to be
negative, however. Inflation will undoubtedly
rise, although hopefully the effect will be
small and fast, as it was following the February
2004 devaluation of 7.5%. Real incomes will
fall, which will affect those sectors of the
economy dependent upon consumer

3. 3 Economic Review
by some 4%-5%. Therefore, a rise in inflation Conditions Index (MCI), which is calculated conditions has been in negative (weak)
to 10%-11% is likely over the next 2-3 as a weighted average of the real effective territory since early 2004, having started its
months, where (due to the annual nature of exchange rate (REER) and the real interest downward trend in mid-2003. It reached a
the inflation calculations) it will remain at rate (RIR). As Chart 3 shows, there has been low point at the end of 2004, but has since
least until the end of the first quarter of a steady rise (tightening) in the MCI recent improved slightly, although overall economic
2006 (see Chart 2). years, due to both an appreciating REER and conditions remain very weak3.
rising real interest rates2. A high or rising
As yet there have been no indications as to MCI will tend to constrain aggregate demand The economic downturn is not particularly
the likely monetary policy response to the and economic growth, and will also restrict surprising, although it is encouraging that it
devaluation; the Bank of Botswana’s mid- inflationary pressures. A lower MCI will tend appears to have bottomed out. As noted
term review of the Monetary Policy to be supportive of growth, but may be above, monetary and exchange rate
Statement, likely to be released in late August, inflationary if excessive aggregate demand conditions have been steadily tightening over
will provide important information in this pressures are stimulated. As the chart shows, a long period – at least prior to the May
regard. At the very least, it is likely that the the devaluation has reduced the MCI devaluation. Fiscal conditions have also been
monetary policy easing that had been considerably, leading to an easing of tight, with the slowdown in government
anticipated in the light of falling inflation monetary conditions, which should boost spending in the 2004/05 and 2005/06 fiscal
earlier in the year will be put on hold until growth prospects. years and lack of a public sector salary
the inflationary impact of the devaluation adjustment in 2005. This has had a negative
has worked itself out. Domestic Economic Conditions impact on certain economic sectors –
There is considerable evidence to suggest especially construction and the
Monetary Conditions Index
that domestic conditions remain weak, retail/wholesale trade sector. The latter will
The combined impact of monetary and although some indication that the slowing be squeezed further by higher costs and the
exchange rate conditions on the economy trend may have bottomed out. As Chart 4 contraction in real incomes resulting from
can be assessed by way of a Monetary shows, our indicator of domestic economic the devaluation. In the short-term it is likely
that domestic demand conditions will remain
weak. While troubling for some activities,
this is, however, a supportive environment
for the devaluation – weak domestic demand
makes it less likely that there will be a large
or long-lasting inflationary impact, and hence
more likely that the objectives of the
devaluation will be achieved.
2.
The weights used in the MCI calculation are 2/3 for the
RIR and 1/3 for the REER where, following convention,
the REER enters as percentage change, and the RIR as
the percentage point change, from the chosen base
period. While the weights should, in principle, be derived
from an empirical analysis of the impact of interest rates
and the exchange rate on economic growth, the
coefficients chosen here are consistent with those
estimated for other small open economies. The absolute
value of the MCI has no economic significance; what is
important is movements over time, and the value at a
particular point in time relative to the chosen base period.
3.
The index presented here represents a first attempt to
produce an indicator of domestic economic conditions
in Botswana. Such an initiative is constrained by the lack
of good quality, timely economic data – broad-based
indicators such as GDP, for instance, are only produced
with a relatively long lag. The indicator here combines
two data series that meet the requirements of quality
and timeliness – the annual growth rates of bank credit
to private businesses and of non-mining electricity
consumption – and which are reasonably representative
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