Ghana at the crossroads – cedi depreciation, the price for inflation

Ghana is facing a severe economic downturn that has impacted a large section of the population, with the poor being the worst hit.

The current economic crisis is arguably the worst to hit the nation in the last 30 years.

To face this plethora of economic battles all at once is quite unusual for the Ghanaian economy.

The price of fuel at the pumps has more than doubled since 2022 and impacted transportation costs. Prices of several essential items and services have also increased by about 300 per cent.

As most would agree, the path to the current economic predicament was set before COVID-19 happened.

However, the journey has only been hastened by some global economic factors, as well as ill-advised decisions over the last decade that consistently increased government expenditure without necessarily increasing revenues.

The impact of the Russian-Ukraine war on the price of crude oil on the international market has contributed to the exchange rate volatility and the high rate of inflation.

While inflation and the Cedi’s depreciation may not be inherently bad, the structure of Ghana’s economy does not allow businesses to make the most of them.

In some economies like China, inflation and domestic currency devaluation are used as tools to stimulate economic growth.

Exchange rate

The exchange rate represents the price of a currency against other major international trading currencies i.e., the price of the Cedi in US Dollars, Pounds, Euro, etc. for the purpose of conversion.

There are primarily two types of exchange rate regimes, pegged and floating.

Under the pegged regime, the value of the currency is determined by a central authority, usually the central bank, and is tied to a foreign currency.

This regime ensures stability in the value of the currency and protects it from market fluctuations.

It, however, requires constant maintenance of adequate foreign reserves to ensure a sufficient supply of forex in the economy.

The floating regime, however, allows market forces, i.e., demand and supply, to determine the value of the currency.

This is the most popular exchange regime that has been adopted by many advanced economies. Floating exchange rate regimes do not necessarily require monetary authorities to maintain prescribed volumes of foreign reserves to be effective.

In this case, any deficit or surplus in the Balance of Payment is automatically corrected. Nonetheless, it encourages speculation that may cause fluctuations in the forex market.

Ghana practices a managed floating exchange rate regime which is between the pegged and the floating regimes.

Under this regime, the central bank intervenes or participates in the purchase and or sale of forex as a way of managing exchange rate stability.

The ability of the central bank to effectively play this role is largely dependent on the volume and availability of its foreign reserves.

Exchange rate movements are influenced by various economic factors including inflation, interest rates and government debt.

In a managed floating exchange regime such as Ghana’s, the current account balance has a major impact on the direction of exchange rates, and it directly affects Bank of Ghana’s (BoG) ability to interfere in the forex market.

The current account balance summarises trading activities between a country and its trading partners and reflects settlement for goods, services, interest and dividends.

A current account deficit as often recorded by Ghana (Refer to Figure 1 below) implies the country spends more on foreign transactions than it earns.

Continuous current account deficits deplete foreign reserves and expose the country to exchange rate shocks. Government, therefore, needs to borrow to shore up these reserves.

Typically, such borrowing must be cheap and near concessionary and must be accompanied by revenue mobilisation structures capable of generating the needed funding required to retire this debt.

In situations where a country’s ability to borrow is limited, like Ghana’s current situation, because of its inability to access the international capital markets, then the central bank’s ability to interfere is diminished, and local currency depreciation is inevitable.

Exchange rate depreciation has a negative impact on the Ghanaian economy.

Role of imports and exports

However, in export-driven economies, local currency depreciation is desirable as it makes exports cheap and competitive.

Imports become expensive and less competitive in the local market. As a result, the depreciation of the local currency in such export-driven economies improves economic activities, reduces unemployment and enhances economic growth.

However, in an import-dependent economy like Ghana’s, exchange fluctuations increase the cost of both foreign and locally produced goods and services.

This partly explains the largely positive relationship between the depreciation of the Cedi and the continuous surge in inflation over the last year as depicted below.

Inflation

Inflation is the most obvious economic indicator and affects everyone.

It measures the general increases in prices of goods and services over time. There are generally three kinds of inflation i.e. demand-pull, cost-push and built-in inflation, with demand-pull and cost-push being the most popular.

Demand-pull is caused by growth in spending power without a corresponding growth in the supply of goods and services.

Cost-push, however, is caused by any increase in the cost of producing and delivering goods or services to the consumer.

Cost-push inflation is usually not desired as it increases the cost of living without improving incomes.

Ghana’s inflation over the past year has been largely cost-push inflation, even though it may have started as demand-pull inflation. At the peak of COVID-19 in 2020, several governments implemented measures to reduce the spread of the virus.

These measures, however, constrained production and caused supply chain challenges as well as limited consumption.  According to the World Bank, this resulted in the contraction of the global economy by some 3.1 per cent.

Within the period, Ghana’s gross domestic product (GDP) grew by a paltry 0.4 per cent.

To remedy the decline, the BoG applied some monetary policy tools to improve liquidity and to revitalise economic activities to pre-Covid levels. Inflationary pressures slowly built up, pushing the inflation rate from 7.8 per cent in March 2020 to 12.6 per cent at the close of the year 2021.

In the first quarter of 2022, the delayed response by the BoG to tighten up monetary policy to deal with the excess liquidity in the economy induced demand-pull inflation and the depreciation of the Cedi against all major trading currencies.

This coincided with the Russia-Ukraine war and its impact on the price and the global supply of crude oil, causing prices to substantially rise.

The effect on fuel prices locally was aggravated by the depreciation of the Cedi. As a result, transportation costs increased and inflation spiraled out of control.

By November 2022, the Cedi’s value had plummeted to the lowest in the year and by the close of the year, inflation had surged to 54.1 per cent.

Every government works to keep a stable economy and that is achieved by maintaining an optimal inflation level necessary to generate economic activity and facilitate economic growth.

In periods of depression, economies employ inflation to encourage spending and incentivise firms to increase production and propel economic growth while reducing unemployment. In economies operating at optimal capacity, the impact of inflation on productivity is limited and usually results in an increase in the cost of living, which makes it less desirable. Exchange rate and inflation are major headaches for economic managers.

However, striking the right balance for both produces the desired levels of economic growth and promotes confidence and certainty in investors’ minds.