Falling Out of a Coca Tree

Is Bolivia about to have a currency crisis?

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Bolivia is back in the news this week, but not for good reasons: a group of army brigades led by disgraced general Juan José Zuñiga surrounded the presidential palace yesterday and demanded that the President, Luis Arce, resign. In another instance of completely farsical 2020s coup d’etat attempts, Zuñiga was then fired by the government, and his replacement as top general simply ordered the golpista troops to stand down - which they did.

The political situation in Bolivia has been unstable for the past five years, with a combination of mass protests against still-controversial election fraud claims and coordinated action by the military and the police resulting in the ouster of leftist then-President Evo Morales. His replacement was right wing backbencher senator, Jeanine Añez, who left office after Morales’s MAS party returned to power in 2021 (by electing Arce), and Añez was imprisoned for anti-constitutional actions. President Arce is a relative moderate compared to Morales even if the he maintained his predecessor’s policies, and the two have clashed over the past three years mainly due to conflicting ambitions over party and national leadership - which has occasionally devolved into violent confrontations between supporters of the two. Arce and Morales have both blamed each other for the coup attempt (despite Zuñiga also being a stalwart Morales opponent involved in the 2019 pressure campaign to oust him), and lots of people have bafflingly blamed the CIA, but I think this is all just a (not very well thought out) power grab at a time of great internal divisions among the left.

Since this isn’t a political science blog and honestly I don’t have much to say about the situation, this will be the end of the politics talk. However, the economic stituation is especially interesting here, and I’ve been looking at it to some extent for a bit, even if it doesn’t have much bearing on the political situation.

You exist in the context of all that came before you

A few years back, it was fairly common to hear that Bolivia was an economic miracle: the country achieved rapid economic growth, drastic declines in poverty, and retained low levels of income and wealth inequality while having sustained increases in government investment and public services spending. So why am I talking about it like it’s about to implode? Good ole’ fashioned exchange rates.

The long and short of it is that, since 2010, Bolivia has had its official exchange rate pegged at 6.96 Bolivianos. The reasons for this are quite complicated to parse, but the TL;DR is that in 2002 Bolivia had a massive economic recession as a product of a generalized economic slowdown in the late 1990s, political tensions after an extremely closely contested election, one of which was Evo Morales, and it was ultimately settled by Congress; a massive outflow of bank deposits due to fears around Morales’s possible election, and economic issues in regional financial centers such as Argentina, Brazil, and Uruguay. This led to a lack of external credit and a fiscal crisis, which was solved by imposing an income tax and a variety of other such austerity measures, which culminated in a political crisis, after which Morales was elected. At roughly the same time and for unrelated reasons, global commodity prices (especially for food, natural gas, and minerals, which are Bolivia’s major exports) increased drastically due to greater demand by China (and other emerging economies like India), which solved the country’s fiscal issues since Morales nationalized the oil and gas sector in 2006.

The Bolivian government utilized these resources from abnormally elevated natural gas revenues to drastically expand government investment and public services, but the country started running massive deficits after global commodity prices declined in the late 2010s. Similarly, the government had started subsidizing fuels, heating, and electricity during the commodities boom, which was a sustainable policy when global commodity prices were high enough to sustain the relevant level of spending, but was not when prices fell. Plus, the lower prices faced by Bolivia’s exports negatively impacted currency inflows, coupled with the fact that the exchange rate peg resulted in rapid appreciation of the Boliviano (the real exchange rate index fell by 32% between 2010 and 2015, and didn’t recover from those levels), meant that that international reserves fell from a peak of USD 15.1 billion in 2014 (around 40% of GDP) to just USD 709 million in 2022.

The Boliviano, it seems, is up for some serious pain in 2024. Most economics forecasters have predicted that Bolivia will abandon the peg sometime this year, mainly because of the expected decrease in reserves and the cumulative impact of inflation. Reserves, however, recovered to 2.2 billion in 2023 and 3.2 billion by April 2024. So, end of story right? Bolivia is not going to have a balance of payments crisis if its international reserves are growing. Right?

Wrong. The country has already imposed import controls and has no access to international capital markets, making it difficult to ration currency use any further - at the same time as Bolivians start demanding foreign currency as an asset and savings vehicle in anticipation of a devaluation. In addition, the trade balance shows little sign of improving: global commodity prices are not really increasing so far in 2024, and it’s not especially clear why oil, gas, or mineral prices should go up much more than they have. Bolivia has been benefitted by a recent increase in global soybean prices after serious flooding in Southern Brazil, but that’s about it in general trends. However, two major factors are hindering Bolivia’s exports: abrupt currency depreciation in most of its main trading partners over the second quarter of 2024, and the worst timed combination of recessions and slowdowns imaginable.

Bolivia’s main trading partners are, in order, India (I don’t get this one), Brazil, Argentina, Colombia, Japan, Peru, China, South Korea, Ecuador, and other nations such as Chile. India and South Korea are, to my knowledge, doing fine so far, so I’ll rule them out. But (as I’ve written before) China is undergoing a signficant economic slowdown as a byproduct of persistently weak demand and persistent overcapacity at the exact same time that appetite for foreign investment is drying up and Western nations are economically decoupling from the country. Japan is perhaps doing better economically, but the yen has depreciated by around 30% since the start of the year, which is not ideal from Bolivia’s perspective (however, it is actually good for Japan). Brazil will experience a modest economic slowdown this year as a product of adverse weather conditions negatively impacting the agroindustrial sector, as well as hard-to-parse changes in transfers to households, VAT rates, and investment incentives. Argentina is currently in the middle of a severe recession, and while the peso is gaining value, the country’s own production of oil and gas is booming after multiple years of investment in new deposits came to fruition, meaning that the largest item in its imports from Bolivia is decreasing in quantity.

Colombia, Chile, and Peru were all in recession or had near-zero growth in 2023 (as a result of extremely tight monetary policy, surging inflation, and climate and other exogenous factors such as miner strikes), so they are faced for an acceleration of growth this year. But they also have seen extremely large currency depreciations, alongside Brazil, Japan, and (to a much lesser extent) South Korea and India - for example, the Brazilian real has fallen from around 4.9 to the dollar to over 5.40 by late June. The reason why all of these countries are having large depreciations in years with declining inflation and without external disruptions is that the Federal Reserve has strongly signalled it will not cut rates until November or December, which means that all the very aggressive cuts that developing economy Central Banks have been implementing (Brazil’s SELIC rate fell from 13.75% a year ago to 10.5% this year, and Chile has gone even further, cutting the policy rate from 11.25% in July 2023 to 5.75% this month) made financial inflows suddenly way less attractive. The Fed's reluctance to cut rates also strengthened the US dollar globally, which both weakened global commodity prices and emerging market currencies (except the Chinese RMB, which is being propped up by the PBoC not cutting rates, which is leaving the Chinese economy in the middle of a deflationary spiral).

This all has puts eneormous pressure on the Bolivian currency over the past three months: lower prices for its main exports, plus all of its main buyers are in economic trouble (China, Argentina), depreciating their currencies significantly (Colombia, Chile, Peru, Japan), or both (Brazil).

Do we all float down here?

This is a fairly familiar story, similar to that of Argentina in 2018, Russia in 2022, or the UK also in 2022, or cryptocurrency in 2022 as well. The main issue at hand is the oft-misunderstood topic, at least for Americans, of exchange rate policy and management¹.

Countries with non-reserve currencies (so every country except the US and Eurozone) normally choose between two options: a fixed (or pegged) exchange rate, and a floating exchange rate (also called a float). These are the two extreme examples, since other mix-and-match approaches exist: a crawling peg (where the currency depreciates by a predetermined amount), dirty floats (where the central bank stabilizes the currency at some “arbitrary” level), or currency bands (where the central bank floats the currency between a certain floor and ceiling, and intervenes in currency markets if it breaches either of those bounds). To maintain a fixed exchange rate, central banks have to respond to external shocks or increases in demand for foreign currency by increasing or decreasing its reserves. Meanwhile, with a float, countries face adverse shocks by depreciating or appreciating the currency, without corresponding changes in reserves.

Why would a country choose either? When talking about foreign currency flows we generally think about trade, but the balance of payments generally has three parts:

• the current account, which contains goods and services trade, alongside wages paid to and from foreign workers, interest payments, and remittances.

• the financial account (sometimes called the capital account), which contains investment into and out of the country, both in assets and direct investment.

• the capital account (sometimes included in the financial account), which has a lot of really strange items like debt forgiveness, intellectual property transfers, or weird things like sales of athletes between sports clubs.

What impacts the level of reserves under a fixed exchange rate is the overall balance of payments - so, for example, a trade deficit, but also interest payments to foreign banks, or a sudden outflow of foreign investment in the country. The exchange rate impacts all of these by affecting the dollar value of the investments - a very high real exchange rate means the currency has “too much” value, so investing is too expensive. Another factor that affects the balance of payments is the national interest rate, which is ruled by something called interest rate parity: the domestic rate must be set at a level equal to the global interest rate plus expected currency depreciation plus the risk premium (i.e. a sign of how unstable or volatile a country is). The logic here is fairly simple: if a country’s interest rate is too low, foreign capital will leave the country, and the currency will have to depreciate more to make up the difference. Meanwhile, if it’s too high, then too much capital will flood into the country, raising the exchange rate.

This all comes together in something called Mundell’s Trilemma: a country can’t be open for foreign capital, set its exchange rate to other currencies, and set its own interest rates all simultaneously. This is because you can’t really decide on the quantity and price of foreign capital: if you peg the exchange rate and set interest, then foreign capital will decide whether it’s attracted to your country or not. If you set the exchange rate and let global capital invest in the country, then you have to abide by interest parity. And if you want to control how much foreign money pores into your economy and the interest rate, then the currency will fluctuate because of interest parity as well. For example, Argentina wants to have independent monetary policy and independent currency market policy, so it has ironclad capital controls. And Hong Kong, a major financial center, traditionally cared more about FX stabilization than interest rates, so it has to play by the Fed’s rules, often with disastrous consequences.

Why would a country choose to peg its exchange rate instead of floating it? In traditional economic models, the domestic economy has sticky prices/wages (i.e. recessions result in higher unemployment, not deflation), interest rate parity holds in most circumstances, and foreign and domestic financial assets are perfectly replaceable with each other. This means that, under a fixed exchange rate, the economy cannot use monetary policy to resolve a recession, since any changes in interest rates will be eliminated by loss of reserves. Meanwhile, under a floating rate, fiscal policy is totally ineffective for boosting aggregate demand, because higher demand would mean higher interest rates, and thus would result in more capital inflows and a lower exchange rate that suppresses aggregate demand via exports.

Of course, this is completely unrealistic, and doesn’t really explain much anything. The reason why this framework is not especially useful to talk about anything is that the link between aggregate demand and interest rates is very muddled, leading to very weird effects - most countries with currency floats apply effective fiscal stimulus. One issue is that most countries take some intermediate approach, which is hard to evaluate this way (even countries that claim to float actually generally peg their exchange rates to some degree), plus it’s not really true that countries can meaningfully control capital flows anymore, and there’s the fact that it might not even be true that currency floats reduce financial freedom with globalized capital flows.

The bulk of the issue comes from the fact that a devaluation is not necessarily stimulative for the economy, which is a massive debate on its own, but generally a devaluation increases exports and decreases imports, which can reduce aggregate demand based on how income from international trade is distributed and how the people who receive that income spend it. But a devaluation can also stimulate the economy by reducing consumption of imports and increasing the share of production-related imports, which raises domestic output. And in countries like Bolivia, which mostly export natural resources, there can be a significant delay between the moment of a devaluation and the moment in which production can increase, which renders it non-stimulative for most intents and purposes. There doesn’t seem to be a clear empirical answer to this question, but it seems that adopting a currency peg might be negative for growth in low income countries, and an intermediate regime might be optimal.

So why do countries peg (partially or fully) their exchange rates? Firstly, because global commodity prices are very volatile, which could affect prices in countries that export commodities consumed by their populations (oil and gas, food staples, etc.). However, not many countries that partially peg their exchange rates to counteract movements in commodities. The real reason that (at least emerging markets) peg their exchange rates has to do with shoring up Central Bank credibility: a central bank that can control interest and exchange rates may one to use one of the two to stabilize inflation expectations. Since inflationary economies have some degree of price dollarization, and relinquishing control of interest rates is usually considered unwise, an exchange rate peg is the superior option. In developing countries, pegs are associated with lower inflation, and lower volatility in economic growth. I think that both of these explain why Bolivia chose to stick with a currency peg: it had one in the 1990s, and inflation was relatively elevated in the early 2000s - plus, given how investing in domestic electricity and heating infrastructure was a priority (Bolivia is also an extremely poor country by global standards), they wanted to cushion the domestic economy from higher global commodity prices (also by subsidizing fuel).

Knocked down a peg

In September of 2022, a number of cryptocurrencies whose value was pegged to the US dollar collapsed suddenly (de-pegged), leading to a sudden loss of value among several ones. Why? It just seems that people started betting against the currencies not having sufficient amounts of assets (dollars, bonds, or other crypto) to maintain the parity between the two currencies. While initally the foundation that controlled the main currency in question was able to contain the damage, news of it having a weaker financial position than anticipated sent the currencies down the toilet.

For real currencies that are actually valuable, this happens too, and it’s called a balance of payments crisis. A country that has a pegged currency needs enough central bank reserves to defend it as it conducts expansionary fiscal and monetary policy. At some point, the combination of declining reserves and expanding domestic currency stocks means that private creditors have enough money to simply buy out the central bank’s entire reserve stock and force a devaluation, pocketing the gains from the higher exchange rate. However, it isn’t necessary that the government adopt inconsistent fiscal-monetary policies; only that it have reasons both for abandoning the exchange rate, and for maintaining it, and an imperfect capacity to commit to either option.

The lack of clarity on whether the central bank will fold or not can create a business opportunity to attempt to force a devaluation - but this opportunity only arises if the maintaining the peg gets more expensive the less confidence people have in the government’s capacity of fixing the exchange rate. There are two alternative reasons why this happens: first, that people expected in the past that the currency would be depreciated by now, so they set prices, wages, or interest rates at unreasonably high levels (in USD); second, that people expect now that there will be a devaluation in the near future, which usually requires extremely high short-term interest rates to manage. Because maintaining the currency peg for indefinitely long would be really expensive, the government would probably like to devalue at some point, and currency speculators want to get ahead of this by securing more USD-denominated assets, leading to further drops in reserves; this incentivizes a devaluation even more, incentivizing even more speculation, and then the government can face a devaluation even if it has a somewhat adequate level of reserves. There, of course, has to be some weakness or incompatibility to explain this - but the core mechanism is just a self-fulfilling prophecy regarding currency collapse. A relevant mechanism here is that there could be “contagion” between similar currencies: countries that either have close economic ties or observable cultural/political ties (such as similar locations, culture, or policies) might lead to sustained speculative attacks on each other’s currencies after an initial balance of payments crisis creates the impression of vulnerabilities.

Finally, newer models place an emphasis of the impact of the financial channel on output and fiscal accounts: a devaluation may affect the country’s level of output and employment extremely negatively in the short term. This has two major channels: the first is that the currency crisis is a kind of bank run, which causes depositors to lose confidence in the banking system as part of devaluation expectations. Because banks sometimes have a high share of their assets and liabilities denominated in US dollars, a devaluation may quickly spiral into an all-out financial crisis, leading to a complete economic breakdown. Likewise, it is possible that private sector balance sheets themselves have assets and liabilities in US dollars, which directly causes economic breakdown after the depreciation.

Conclusion

Well, is a currency crisis likely or not? It is. Even the more basic models have Bolivia as at risk: the country has extremely elevated government deficits and persistently low interest rates. Additionally, given how many countries in Latin America, as well as important trading partners like Japan, faced devaluations, then it’s no wonder that Bolivia is at risk, both because of trade and because of contagion dynamics.

The question here is, then, what reasons Bolivia might have for depreciating and not depreciating its currency. This is more or less the same as whether the exchange rate devaluation is harmful or not, and who it harms. Firstly, there’s the matter of debt, since around 37% of the total debt held by the Bolivian government is linked to the US dollar (amounting to 30% of GDP), and while the country does not face exorbitant interest payments, an abrupt change in the exchange rate would be harmful to general government finances. This isn’t a concern for the banking system or the private sector, since Bolivia has more or less no access to international financing beyond Chinese loans. At the same time, devaluing the currency would also improve fiscal resources from the oil and gas sector, which would alleviate, and not increase, overall fiscal pressures. However, the government does face interest payments of around USD 110 M these next few years, and starting in 2028 they will have to face 333 M in interest per year for three years, which means a devaluation needs to happen before then, setting the stage for the “delay” part of the equation.

The other question is whether the exchange rate acts as a kind of monetary policy anchor, then a devaluation would be disastrous for inflation expectations. The higher-than-usual pass through rate of the FX rate into consumer and producer prices might make it into a relevant concern, but what truly should raise alarms are reiterated reports of everyday citizens hoarding foreign currency out of concenr over a devaluation - which would result in extremely chaotic effects after a jump in the currency’s ratio to the US dollar.

So Bolivia might suffer a currency crisis, or it might not. However, it would be extremely destructive if it were to happen. So the government should try to avoid it. The odds don’t seem very good: most professional forecasts assume some change to the exchange rate this year (which, to my knowledge, didn’t happen last year) and the combination of significant pressures to devalue and substantial internal political disputes preventing a (painful) normalization of fiscal and monetary policy led to Bolivian debt being downgraded, which also points to an unwillingness to make painful decisions that may eventually accelerate a currency crisis.

1. Time to get one of my pet peeves out of the way, which is that English language textbooks and articles usually define currency appreciation as what everyone else calls depreciation (i.e. a currency losing value versus the dollar), while they call depreciaiton what everyone else calls appreciation (i.e. gaining value versus the dollar).