We have not­ed pre­vi­ous­ly that con­tin­u­ous fis­cal deficits fu­el the de­mand for for­eign ex­change (forex), there­by de­plet­ing T&T’s for­eign ex­change re­serves. The new ad­min­is­tra­tion’s ini­tial com­ments sug­gest that there is lit­tle ap­petite for spend­ing cuts on the scale re­quired to lim­it the fis­cal deficit and no ap­petite for tax in­creas­es. The prime min­is­ter’s scathing re­but­tal of the prop­er­ty tax demon­strates this in­tent.

T&T is a small coun­try with a cor­re­spond­ing­ly small pop­u­la­tion and can­not be self-suf­fi­cient. It must trade with the rest of the world to buy what cit­i­zens re­quire to sur­vive.

Im­port­ed prod­ucts are ubiq­ui­tous as we im­port every­thing: food, fu­el, cars, trucks, spare parts, fer­tilis­er, pa­per, pens, soft­ware, in­ter­net ser­vices, tele­vi­sions, movies, ca­ble of­fer­ings, and even for­eign per­form­ers. The coun­try ob­tains forex to pay for these im­ports by ex­port­ing.

T&T is an open econ­o­my, as in­ter­na­tion­al trade (im­ports and ex­ports) ac­counts for a sig­nif­i­cant per­cent­age of the econ­o­my. In 2023, the to­tal val­ue of goods ex­port­ed and im­port­ed ac­count­ed for ap­prox­i­mate­ly 62.86 per cent of the Gross Do­mes­tic Prod­uct (GDP).

Trade in ser­vices con­tributed about 12.14 per cent to the GDP dur­ing the same pe­ri­od. Com­bin­ing these fig­ures, in­ter­na­tion­al trade (goods and ser­vices) con­sti­tut­ed rough­ly 75 per cent of T&T’s GDP in 2023.

This high trade-to-GDP ra­tio un­der­scores the coun­try’s open­ness to glob­al mar­kets and high­lights the crit­i­cal im­por­tance of trade to its eco­nom­ic struc­ture.

In an open econ­o­my, the ex­change rate, the num­ber of TT dol­lars re­quired to buy a unit of a for­eign cur­ren­cy, is prob­a­bly the most im­por­tant eco­nom­ic vari­able as it un­der­pins every area of eco­nom­ic ac­tiv­i­ty.

The­o­ret­i­cal­ly, many vari­ables can in­flu­ence a coun­try’s ex­change rate. These in­clude com­mod­i­ty prices (es­pe­cial­ly oil and gas in T&T’s case), pro­duc­tiv­i­ty changes, in­fla­tion, in­ter­est rates, cap­i­tal flows/for­eign in­vest­ment, cen­tral bank poli­cies, and po­lit­i­cal and eco­nom­ic sta­bil­i­ty.

In the T&T, nat­ur­al gas, its en­er­gy de­riv­a­tives and crude oil gen­er­ate ap­prox­i­mate­ly 80 per cent of the coun­try’s for­eign ex­change earn­ings. There­fore, changes in en­er­gy ex­port prices or vol­umes have a dom­i­nant im­pact on the ex­change rate in an open (free) mar­ket.

In eco­nom­ic jar­gon, a change in the terms of trade (the ra­tio of ex­port prices to im­port prices) can sig­nif­i­cant­ly im­pact the ex­change rate. If ex­ports be­come more com­pet­i­tive (high­er pro­duc­tion with the same in­put) or prices rise, then the cur­ren­cy should ap­pre­ci­ate. Con­verse­ly, when vol­umes fall or prices de­cline (the terms of trade de­cline), the ex­change rate should de­pre­ci­ate.

T&T has os­cil­lat­ed through many pe­ri­ods when ex­port vol­umes and prices have risen and then de­clined. The­o­ret­i­cal­ly, the ex­change rate should have ap­pre­ci­at­ed dur­ing those pe­ri­ods and de­pre­ci­at­ed when ex­port vol­umes or prices fell.

In a free mar­ket, this would have been re­flect­ed by ex­change rate fluc­tu­a­tions.

For ex­am­ple, en­er­gy ex­ports in­creased sharply dur­ing the pe­ri­od 1999-2008 and again dur­ing the pe­ri­od 2011-14. Yet the ex­change rate re­mained rel­a­tive­ly con­stant, hov­er­ing be­tween a nar­row band around the $6.4 to USD 1 mark.

Sim­i­lar­ly, dur­ing the pe­ri­od of eco­nom­ic de­pres­sion from 2015 to 2022, the TT/USD rate ought to have de­clined to re­flect the de­cline in en­er­gy ex­port vol­umes and prices. Whilst there was some shift in the USD/ TT rate from $6.4 to $6.87, the mag­ni­tude of that de­cline does not re­flect the pro­por­tion­ate de­cline in ex­port earn­ings. This is one rea­son why many com­men­ta­tors have ar­gued that the TT dol­lar is over­val­ued rel­a­tive to T&T’s terms of trade.

This fluc­tu­a­tion with­in a nar­row band has been a mat­ter of con­scious gov­ern­ment pol­i­cy to ei­ther de­fend the for­eign ex­change re­serves or “the stan­dard of Liv­ing”. This ap­proach con­flicts with the un­der­ly­ing eco­nom­ic the­o­ry and the in­her­ent au­to­mat­ic sta­bil­i­sa­tion caused by mar­ket-dri­ven ex­change rate changes.

When the terms of trade de­cline, the ex­change rate should de­pre­ci­ate, thus re­duc­ing im­port de­mand be­cause im­ports would have be­come more ex­pen­sive.

This does not hap­pen, be­cause the Cen­tral Bank sets the ex­change rate through the com­mer­cial banks. The con­tra­dic­tion oc­curs be­cause pub­lic pol­i­cy con­flicts with re­al-world out­comes.

Read­ers should note that the ex­change rate is on­ly fixed to the USD, the cur­ren­cy of T&T’s most im­por­tant trad­ing part­ner. Since the USD floats against oth­er cur­ren­cies in­ter­na­tion­al­ly, the T&T ex­change rate for oth­er cur­ren­cies fluc­tu­ates dai­ly.

In good times, not al­low­ing the ex­change rate to ap­pre­ci­ate with the im­prove­ment in the terms of trade is meant to de­fend the for­eign re­serves. If the rate were al­lowed to ap­pre­ci­ate, it is as­sumed that im­port de­mand would ex­pand as im­ports would be cheap­er, thus de­plet­ing the re­serves.

Con­verse­ly, when en­er­gy prices de­cline (the terms of trade de­cline) the ex­change should de­pre­ci­ate (ie, more TT per USD). This de­pre­ci­a­tion is not al­lowed to hap­pen to keep the cost of liv­ing low­er than it would be if the ex­change rate were al­lowed to de­pre­ci­ate.

Keep­ing the ex­change rate fixed rather than al­low­ing it to float with the move­ment in the terms of trade has con­se­quences.

First, the econ­o­my los­es com­pet­i­tive­ness by avoid­ing the ad­just­ment and the in­cen­tive nec­es­sary to find al­ter­na­tive or new ex­ports, ie di­ver­si­fi­ca­tion. Sec­ond, it leaves the de­mand for forex un­al­tered. Third, it en­cour­ages a black mar­ket in times of scarci­ty. Fourth, it en­cour­ages re­liance on ex­ter­nal loans to meet forex de­mand rather than en­cour­ag­ing in­ge­nu­ity to dis­place im­ports.

Next week, we will ex­am­ine how to cal­cu­late an ex­change rate.

Mar­i­ano Browne is the Chief Ex­ec­u­tive Of­fi­cer of the UWI Arthur Lok Jack Glob­al School Of Busi­ness.