Serbia, That the depreciation of the domestic currency could improve the competitive position of the economy is a wrong claim

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That the depreciation of the domestic currency could improve the competitive position of the economy is a wrong claim that ignores reality, states Ivan Nikolić in his analysis in the latest issue of Macroeconomic Analysis and Trends (MAT).

“As of December 6, the National Bank of Serbia net bought 525 million euros (purchased 2,885 million euros and sold 2,360 million euros). But the objection related to a more “realistic” exchange rate of the dinar still finds a place in the public speeches of some “academic” economists, it is taken out of context and maliciously interpreted,” Nikolić points out.

He says that in the last three decades, MAT has emphasized countless times that maintaining the relative stability of the dinar against the euro as a reference foreign currency, within the regime of a managed floating exchange rate, is the optimal strategy for Serbia.

In this way, price stability, business certainty, security for the domestic financial system and foreign investors are achieved, while at the same time maintaining the independence of monetary policy and the ability to adapt to strong external shocks.

Economist Milan Kovačević also agrees with the view that it is necessary to maintain the stability of the exchange rate.

“If the euro were to become more expensive now, those who export would receive more dinars, and those who import would have to pay more. One suits some, the other suits others. However, what is very important – if the euro would cost 150 dinars, then it would harm our overall economy because we would have to export many more raspberries in order to import phones”, says Kovačević in an interview with Biznis.rs.

He adds that a jump in the euro due to inflation would cause even greater inflation, because everything from imports would become more expensive by that amount.

“Secondly, people who have foreign exchange savings would have more dinars, so they would raise domestic prices. The only argument that some have is that we would then export more, but that is not true because for that purpose there should be export capacities that we do not have. If the exchange rate were to change, then both the economy and the citizens who are indebted in euros would fail,” Kovačević points out.

The influence of the exchange rate on the formation of prices

In his analysis “Who benefits from exchange rate depreciation?” published in the latest issue of Macroeconomic Analysis and Trends (MAT), economist Ivan Nikolić assesses that in every open economy the exchange rate plays an important role in the formation of consumer prices.

“The exchange rate has a direct effect on the prices of imported goods, regardless of whether they are durable products for mass consumption or intermediate products and energy products, which generate production costs, i.e. producer prices,” explains Nikolić.

The exchange rate also affects prices indirectly, through the demand for domestic goods.

“When the real exchange rate depreciates, domestic goods become relatively cheaper compared to foreign goods – the demand for domestic goods increases, which has an inflationary effect, and vice versa. As this is not a one-time process, the volatility of the exchange rate and its transmission to other prices also creates negative inflationary expectations. Their accumulation, which goes hand-in-hand with the loss of trust in policy makers, creates a spiral of exchange rate growth and inflation,” Nikolić believes.

Higher inflation provokes a reaction from the monetary authorities, a tightening of monetary conditions and an increase in the reference interest rate. This potentially increases the return on investments in domestic currency, that is, the inflow of foreign (portfolio) investments. The conversion of foreign currency into domestic currency has the opposite effect, in the direction of strengthening the domestic currency.

“On top of that, the exchange rate is a euphemism for the financial risk of citizens and the economy. A change in the exchange rate directly changes their external liquidity and solvency. Whether the exchange rate will change, as part of a package of structural changes that the economy is going through, and what the effect of those changes will be, is therefore also determined by the degree of external indebtedness and the competitiveness of the economy itself. The rise in import prices is crowding out foreign competition. This gives domestic producers an opportunity to raise prices. In that case, more favorable conditions on the market naturally lead domestic producers to abuses”, explains the author.

In Serbia, in the first ten months of 2022, the balance in the exchange of energy products participated in the total deficit of foreign trade exchange with 44 percent (last year, in the same period, with 28.2 percent). More than 30 percent of the increase in the total value of goods imports in this period is due to energy imports.

“In the conditions of a dramatic increase in energy prices, the depreciation of the exchange rate would only further burden production costs, investment and consumer confidence, which would result in a stronger slowdown in economic activity,” concludes economist Ivan Nikolić, Biznis writes.

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