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Exchange-rate pass-through. Some observations on the Colombian case

In the last days in Colombia, the main topic in the news is inflation and the rise in the price of food. Note that the current inflation is a worldwide phenomenon that has been attributed to both supply and demand shocks.

However, in Colombia many people are talking about the exchange-rate pass-through effect, a relationship between inflation and exchange rate where the depreciation of the domestic currency brings about the rise of prices.

 

A brief context of the Colombian economy

As a developing country, Colombia depends on the importation of capital goods and intermediate goods. For instance, Colombia imports most of the fertilizers used in agriculture.  You can see it in the increasing ratio import/production of phosphate and Nitrogen fertilizers (the latter is the most consumed by the country).

Figure 1. Ratio import/production of phosphate and Nitrogen fertilizers

Figure made by the author with data from Atlas Big (https://www.atlasbig.com/en)

 

In 1991, Colombia’s political leaders adopted a set of reforms known as “economic openness” (aperture económica), where the country curtailed tariffs and made much more room for market assignation (privatizations).

Years later, in the 2000s a set of free trade agreements (FTAs) were proposed and signed to boost the international exchange of goods and services with several countries, from developing to developed ones.

On the one hand, Colombia got an FTA with Canada (entered into force in 2011), The United States (entered into force in 2012),  the European Union (entered into force in 2013), Israel, and Korea,  on the other hand, with regional partners such as Mexico, Cuba, Costa Rica, Chile, and Venezuela (click here).

Taking a look at the trade balance, we can observe that Colombia held a deficit (imports larger than exports) in the last years.

Figure 2. Colombia external sector

Figure realized with data of Banco de la República.

The rise in the deficit of the Colombian goods trade balance catches the eye because it came up once entered into force the FTAs with Canada, the United States, and European Union. That is to say, Colombia becomes a net importer country after the agreements.

Keep in mind that the deficit in the Colombian trade balance means more external debt, while the deficit in the Current Account means that the country cannot fund its own investments and has to draw upon external capital. As we can see, the trend has been the growth of these two deficits. 

 

The central bank and Inflation control

In 1991 a constitutional reform came about and since then the central bank of Colombia (Banco de la República) has been formally independent of the central government and its main objective has been to curb inflation.

As we can see in the figure below, the opening-up reforms matched with the reduction in inflation measured by the Consumer Price Index.  In order to reduce inflation, the central bank has set up a range of inflation targets throughout the timeline from 1993 to 2021. Thus, we can see that both the openness and the central bank’s inflation targets have reduced the inflation trend, the former through competition of imports and the latter through monetary policy.

Figure 3. Actual inflation and inflation target

Figure made by the author with data from Banco de la República.

However, as inflation has speeded up in the last months, drawing away the inflation target set by the central bank, the idea of exchange rate pass-through has gained traction in the public debate. In other words, it is believed that Colombia is importing inflation thanks to the depreciation of the exchange rate (caused by lack of foreign exchange) and its dependency on imports of capital goods and intermediate goods.

The mechanism works as follows. When the domestic currency (Colombian peso) depreciates against the American dollar (the most used foreign exchange), all the intermediate goods and capital goods become more expensive and the costs to produce internally rise, then, inflation comes about.

If we take into account the Producer Price Index as a metric of inflation, the exchange rate pass-through is highly likely in a developing economy like Colombia. The scatter plot below shows the positive relationship between the nominal exchange rate percentage changes and the Producer Price Index percentage changes, yearly from 2000 to 2017. The R² is 0.48, relatively high.

 

Figure 4.  Yearly Producer Price Index and nominal devaluation 2000-2017

Figure made by the author with data from Banco de la República

The following scatter plot, made with monthly data from Jun 2011 and September 2018, also shows a positive relationship between the aggregates.  However, this time we have more data but the R² drops from 0.48 (previous figure ) to 0.33, but still there is a relationship that indicates that the movement of the exchange rate has something to do with inflation changes.

 

Figure 5. Monthly Producer Price Index and nominal depreciation Jun 2011- Sept 2018

Figure made by the author with data from Banco de la República.

On the other hand, if the same exercises are made with the consumer price index (including food), the relationship is less strong and not statistically significant. The yearly relationship delivered an R²=0.06 while the monthly one was R²=0.13 (I have not added the figures). In other words, it seems that the nominal exchange rate does not have much to do with the prices the consumers found in the markets.

However, if we take the Consumer Price Index data disposable in ECLAC (Economic Commission for Latin America and the Caribbean) and depreciation of Colombian peso data from Penn World Table for the period 1971-2017 the regression turns out to have an R²=0.29.

Figure 6. Consumer Price Index and Nominal depreciation

Figure made by the author with data from CEPAL (Consumer Price Index) and Penn World Table (Depreciation)

However, the relationship is stronger if the data is split and analyzed from 1980 to 2017, a time that covers the years when the openness took place.

 

Figure 7. Consumer Price Index and Nominal depreciation

Figure made by the author with data from CEPAL (Consumer Price Index) and Penn World Table (Nominal Depreciation)

This last regression shows a certain relationship between the nominal exchange rate and the domestic prices that consumers found in the Colombian domestic market.

The exchange rate pass-through is stronger when inflation is measured through the Producer Price Index than the Consumer Price Index, suggesting that the producer does not transfer the total costs to the consumers, maybe due to the competitive forces that restrain the producers.

Of course, the pandemic has brought about issues in the worldwide real economy related to the world supply chain disruptions (cost inflation). A document of the Colombian central bank explains this point by referring to the widening gap between the FOB and CIF prices (click here), so it is not only an exclusive Colombian issue as I remarked at the beginning of this post. Nevertheless,  these correlations suggest the possibility of the existence of the exchange rate pass-through in Colombia and its contribution (modest or not) to the increase in the general prices.

 

Some remarks

Colombian free-market policies have not only intensified the dependency of the country on international trade, but it also has not brought about a surplus in trade balance but deficits, therefore lack of foreign currency, depreciation of the national currency, and fuel for inflation speed-up. 

It is well known that correlation does not mean causation, however, I think it is important to show some data on the topic. 

The argument brought to light here also can be considered by MMTers who advocate for expansionist policies. Bill Mitchell exposes that deficits in trade balance and the Current Account are not necessarily bad if investment steps up (click here), however, it has not been the case in Colombia (click here). But investment behavior deserves another post.

Maybe Colombia needs more than a heterodox monetary policy to achieve sustained growth, it requires another economic model that defies the free-market policies and boosts its investment and industrialization.

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