The global economy is witnessing an unprecedented motion in the value of the euro, as its exchange rate has reached levels not seen since the early years of its existence as Europe’s common currency. After a prolonged depreciation in the euro’s value, the euro/dollar exchange rate has almost reached parity.
It happened faster than expected, and the movement of the exchange rate between these two currencies has been non linear. The euro’s fall below parity against the dollar, however, merely reflects a widening gap in the interest rates between the two shores of the Atlantic. While the Federal Reserve has implemented aggressive interest rate hikes to curb inflation, the European Central Bank continues to opt for a more cautious monetary policy approach.
As a result, a significant interest rate difference between the Euro-Zone and the US, which has sparked larger capital inflows to the US and massive purchase of the dollars, as the dollar has become more attractive to investors.
The latest reforms are not enough
In a global context, however, let’s not forget that the Moroccan dirham is pegged to an anchor basket of these two currencies that reflect the relative weight of our trading partners. In 2015, Bank Al-Maghrib (BAM), Morocco’s central bank, and the Moroccan Ministry of Economy and Finance updated“ the Dirham’s basket weighting to reflect the current structure of foreign trade of our country.”
Under the updated basket, the Moroccan currency’s basket weighting is “set at 60% for the Euro and 40% for the US dollar,” notes the website of the finance ministry. But this range limits the ability of Bank Al-Maghrib to maintain the dirham around a predetermined central value.
The range has only been widened twice, in January 2018 and then in March 2020. In January, 2018, after years of a (+-) 0.3% range around the reference price, the dirham exchange rate began to evolve to a wider band of (+-)2.5%. The outbreak of the COVID-19 pandemic in March 2020 then prompted Moroccan monetary authorities to further widen the fluctuation range of the nominal effective exchange rate, thus increasing to (+-) 5% around a central value.
Despite this progressive process concerning the exchange rate’s flexibility, the fluctuations of the dirham bring out a basket effect that continues to dominate the liquidity effect of market drivers. The basket effect comes from the impact of the fluctuation of the euro/dollar exchange rate on the dirham, and the difference between this impact and the evolution of the reference price of the dirham is equal to the market effect.
While the dirham would appreciate against the dollar and depreciate relative to the euro when the euro/dollar exchange rate appreciates, it would depreciate against the dollar and appreciate against the euro, when the euro/dollar depreciates.
The Moroccan exchange rate regime thus allows the current appreciation of the dollar/euro to appreciate the dollar/dirham and depreciate the euro/dirham rates. Nevertheless, these fluctuating values of the dirham occur at the expense of Morocco’s foreign exchange reserves, which remain the primary buffer against external shocks.
Making the Dirham more resilient to external shocks
Given the dirham’s vulnerability to the relative values of the euro and dollar, switching Morocco’s monetary policy towards adopting a targeted inflation rate, announced by Bank Al-Maghrib, could lead to a stronger market effect. Such a monetary policy framework can be implemented with a floating, or at least, a more flexible, exchange rate.
However, this transition would amplify the exchange passthrough to inflation, defined as the degree to which Morocco’s domestic prices react to a fluctuating value of the dirham, and induce persistent supply shocks, namely cost-push shocks. Nevertheless, more market discipline would follow and the exchange rate, rather than international reserves, would serve as the main shock buffer.
The redesign of Morocco’s monetary policy framework becomes even more critical in the face of the increase of oil prices. Morocco has long benefited from a negative correlation between oil prices and the US Dollar. The resulting compensatory effect made it possible to mitigate, albeit partially, the increase in the energy bill paid in dollars.
But this compensatory effect has faded in recent months due to the rise in the value of the dollar against the dirham, combined with a staggering increase in the cost of energy inputs. Taken together, these two outcomes have amplified the inflationary pressures that households are experiencing, negatively affecting the Moroccan economy.
Under such conditions, Bank Al-Maghrib will need to provide more support to the dirham at the detriment of foreign exchange reserves. However, current fixed-exchange rate behavior fails to support the Moroccan economy. By strengthening the foreign value of the Moroccan currency, the country maintains the same level of inefficient domestic absorption, which in turn leads to supporting harmful consumption of energy and the bad habit of using imported goods.
Moroccan households currently face a volatile exchange rate and energy shocks. And rather than consuming our foreign reserves to maintain the same rate of energy utilization, an awareness of our consumption habits is probably more suitable. The fact is that pegging the dirham requires selling central bank’s reserves whenever there is an exchange rate pressure that generates costs associated with the continued use of foreign reserves as an external shocks absorber.
On the whole, the support that Bank Al-Maghrib provides to the dirham helps maintain relatively high levels of an unfavorable and unproductive use of energy and raw materials. If these imported inputs are expensive and hinder economic growth, Moroccans need to be informed.
Greater flexibility of the dirham and the resulting depreciation of its exchange rate would reduce domestic energy consumption, whereas a fixed exchange rate simply fails to readjust our consumption habits.
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