Cuba: Exchange Rates Drop, but Domestic Prices Increase

One of the most serious problems with the Cuban economy is that it doesn’t have this ability to replace imports, especially in most industries.

By Mauricio De Miranda (La Joven Cuba)

HAVANA TIMES – We have seen a very interesting, yet inexplicable, phenomenon recently. After a sharp increase of the US dollar (USD) on Cuba’s informal market – which strengthened after the Government started selling limited amounts of this currency, jumping up five times the official rate -, it reached a maximum of 200 Cuban pesos (CUP) per USD, and then hastily dropped, reaching 165 CUP in the case of USD cash and the euro (EUR), and to 166.5 in the case of the dollar in bank deposits (MLC).

Prices of most consumer goods also shot up, especially of food, as the USD increased in value; but when it dropped, not only did the price of consumer goods not also drop, they also continued to increase in many cases.

Correlation between exchange rates and domestic prices

An exchange rate is just the exchange relationship that exists between two currencies, or in other words, the price of one country’s currency expressed in units of another country’s currency. This lets you fix relative prices of goods and services produced in one country and compare them with others in another country.

This is how a domestic market is connected to the global market, not only with foreign currency markets, but also through international trade, financial markets, and foreign investments. It’s precisely for this reason that an exchange rate needs to be based on the economy, that’s to say, it needs to reflect conditions with suitable relative prices.

The relationship between exchange rates and domestic prices normally comes from international trade. This is why prices of imported goods and services become more expensive when a national currency reduces in value, and this also goes for raw materials, supplies and machinery that need to be imported for national production. Thus, this increase in the price of supplies is transferred to the cost of production and, finally, to the product that is manufactured with them.

In an economy that is able to replace imports with national production, a devaluation of national currency can be an incentive for national producers to sell their products instead if they can make them cheaper than the foreign competition, although they also need to meet quality standards that satisfy demand.

Nevertheless, one of the most serious problems with the Cuban economy is that it doesn’t have this ability to replace imports, especially in most industries, where – according to the latest Statistical Yearbook, published by Cuba’s Office of Statistics and Information (ONEI) -, the physical volume of production was only 54.8% of what it was in 1989.

Imported supplies are also needed for agriculture, which needs fertilizers, tractors, improved seeds, fuel, irrigation systems, to only mention a few.

The serious crisis that affects domestic productive sectors has forced the country to import basic foods and industrial goods, even though the country’s complicated credit situation – which has become worse by its failure to make debt repayments, and financial restrictions imposed by US economic policy -, limit the State’s ability to guarantee these foreign purchases, which is becoming more and more limited by their ability to bring in revenue in foreign currency with exports.

Meanwhile, exports have plummeted in Cuba, because of the demise of the sugar industry and the decline or standstill of the country’s other few export sectors. According to ONEI figures, goods exported reached 5.87 billion USD in 2011, but a decade later, in 2021, this only stood at 1.966 billion USD, shrinking by 66.5%.

This decrease in foreign revenue has also hit the services sector, which is currently our leading sector in the international market. Services, including tourism and professional services abroad, went from 11.449 to 6.053 million USD, if we take the official exchange rate of 24 CUP per 1 USD into account. This represents a 47.1% decrease.

These limited foreign currency funds lead to the need to reduce imports, which have shrunk from 13.952 to 8.431 million USD in the years taken as an example above, representing a 39.6% decrease.

This reduction of imports of basic goods – consumer, intermediary and capital -, as well as a drop in domestic production, creates a supply deficit which translates into higher prices, in normal situations.

Higher prices despite exchange rate dropping

The recent drop in exchange rate value, reflects, in the short-term, the moment prices have gone up so high that consumers aren’t able – or willing – to pay this price for what they are buying, in this case, foreign currency. However, I don’t believe this will persist for long, because the weaker purchasing power of national currency has deeper structural causes that are essentially linked to Cuba’s limited integration on the international market.

On the other hand, when shortages prevail in a market, like they do in Cuba, it’s very unlikely that goods imported at a higher price have their prices adjusted when exchange rates are lower, because products purchased abroad for a higher price may remain in stock. There is normally a delay in this adjustment.

Devaluation of the Cuban peso isn’t the only thing that influences inflation in Cuba, although there is a direct relationship between the value of foreign currency and the price of a product sold on the domestic market, in the case of many imported goods sold on the informal market.

Other factors that explain inflation on the island are: shortages of basic goods, excessive currency in circulation after wages and pensions were increased as part of the clearly failed currency and exchange rate policy in 2021, as well as using increased funds in circulation to compensate for budget deficits. The productive sector didn’t have an answer to this increase in wages and pensions which, by the way, continues to be far from guaranteeing the population’s basic living needs.

According to ONEI statistics, industrial production in 2021 was less than it was in 2019 in terms of the production of food, drinks, tobacco, textiles, clothing, leather and wooden products, paper and its products, recordings and prints, fertilizers, chemical products, rubber, non-metallic minerals, building materials, machinery, electrical appliances and materials, radios, TV sets and communication devices, medical equipment, eyeglasses, and furniture.

Only the production of metallic products has slightly increased, although it still remains at only 17.7% of what the country was producing in 1989. The Statistical Yearbook doesn’t have updated information for oil products and derivatives and the pharmaceutical and sugar industries. However, according to information from different media sources, the 2020-21 sugar harvest only managed to meet 66% of the 1.2 million ton target (that is to say, 792,000), while the 2021-22 harvest was 431,000 tons, which brings current production levels down to 19th century levels.

In the agricultural sector, production of potatoes, sweet potatoes, malanga, plantains, tomatoes, onions, peppers, rice, corn, beans, tobacco, citrus fruits, fruit and cocoa was lower in 2021 than already reduced levels in 2019. Cuba’s livestock population and number of poultry continues to decline, as does the production of beef and pork, milk and eggs, and numbers and weight of poultry killed is low and at a standstill.

The Government budget balance has gone from a surplus of 0.9% of GDP in 2011 to a deficit of -6.2% in 2019 and to -11.7% in 2021. This reveals a serious financial imbalance in the country, which is being covered financially by printing more money, which is the direct reason the national currency has lost its purchasing power. Money supply grew from 65.028 billion pesos in 2019 to 190.917 billion in 2021 and the currency balance has gone from -5.267 billion pesos to -26.780 million in the same time period.

Monetary and fiscal factors, as well supply shortages, contribute to keeping prices high despite the recent drop in exchange rates. However, uncertainty and expectations are also factors we need to take into consideration.

Uncertainty and expectations

One of the contributions of the neoclassical school of economic thought -which I’m not affiliated with, but I recognize the validity of many of its hypotheses – is the importance of psychological factors and expectations in the way markets work. This is something that History has confirmed, and we see it more clearly in times of economic and financial crises.

At this moment in time, Cuba is not only experiencing a serious economic crisis, but there is also a crisis of confidence and expectations. The migration stampede is the most visible indicator, which not only bleeds the country dry in demographic terms but is also reducing the price of property and assets significantly, as people who have property and want to leave are forced to sell them for a much lower price than they were two or three years ago.

The Cuban Government has failed with its economic policy. It has failed to establish a market in freely convertible currency, in designing and implementing the so-called Tarea Ordenamiento  (economic reforms), in adopting an extremely restrictive Decree-Law about small and medium-sized enterprises, as well as the recent decision to create a formal market in foreign currency without the means to sustain it, which introduces different exchange rates that create new distortions.

Despite the evidence, it hasn’t wanted to try and fix things. The worse thing is that the Government doesn’t seem to be willing to adopt the radical changes the economy needs, nor institutional changes to guarantee the sustainability of these transformations, and it seems to give the impression that it doesn’t know what it can do anymore, apart from throw slogans around and call upon the people for “creative resistance”.

This has led to a greater sense of despair – among most of the population – about the country’s future, while poverty and social inequality continue to grow.

It’s impossible for markets to work properly under these circumstances. The reality is these conditions aren’t propitious for the Cuban peso gaining more value. We are experiencing a volatile moment that depends on subjective factors, as well as other more objective factors that center around the national currency’s purchasing power.

For this reason, the solution lies in abandoning control and centralization practices that continue to stifle business. This would include dropping monopolies of foreign trade and the financial and banking sector; opening up the economy and adopting measures to encourage macro-economic stability that will allow the country to move past current imbalances. Likewise, doing all of this in a political atmosphere that encourages democratic change that allows citizens to become empowered and take the reins of their own fate and for Cuba to become a country they can live in again.

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