Struggling Lek keeps prices high as economy dwindles

In times of economic crisis, lower prices are a common phenomena that helps customers’ pockets. Deflation, rather then inflation, is the issue economists need to deal with in an economic slowdown. Yet, when Europe and globe-wide prices are dropping as the global economy shrinks, prices in the Albanian economy are far from showing similar effects, indeed an opposite trend is notable, a testimony that things might be worse off than expected.
Inflation for the first 4 months of 2009 was 1.9%, below the floor target of 2% set by Bank of Albania, yet data from the same source revealed that prices in Europe, Albania’s main trading partner, have suffered a drop of 5% during the same period. Albania imports 90% of its consumer goods and theoretically a price effect should reflect itself. What is happening?
First, the Lek is losing its war in the currency exchange ground. The Albanian currency has lost 7% and 10% in front of its main counterparts, the Euro and the USD respectively. That in itself is enough to offset the supposed effects of global prices making the Lek the main culprit in this economic anomalousness. Indeed, consumers are paying more in 2009, despite a clear decrease in incomes.
Second, the budget deficit scored an annual increase of 4.8% during the first quarter of 2009, despite a decrease in production and import prices, and a general shrinkage in trade volume. In what is becoming an absurd situation, the government’s investment frenzy in the first four months of 2009 is artificially keeping costs higher then the market would reflect otherwise. Perhaps, because it is an election year, the government has borrowed to higher levels regardless of the costs, interest rates, and market need for liquidity, and even more so, regardless of revenues which are bound to diminish as the economy shrinks. The problem becomes two fold: the government borrowing is affecting the market single handed in terms of interest rates and costs and, on the other hand, is sucking the necessary monetary sources which could otherwise be used by the private sector to revitalize businesses and the economy. Higher public borrowing increases demand for liquidity artificially. Artificially increased demand can only be curved down through higher interest rates (higher borrowing costs). However, since the borrowing appetite for Lek shows no signs of slowing down, demand and interest rates are bound to increase simultaneously and the offset mechanism nullifies itself. And the Lek keeps weakening.
Third, demand for foreign currency remains high. The Albanian economy is very much Euro dependent with a good part of its transactions done in Euros and with EU countries being its main trading partners. At the end of 2008, taking into consideration the threatening effect of the global economic crisis and dangerous fluctuations in the currency exchange rates, Bank of Albania (BoA) lowered the base interest rate by 5% for the first time in years, in order to encourage borrowing in Lek rather than in foreign currencies. This way, a targeted decrease in foreign currency demand would have minimized risks from fluctuations in the currency exchange rates. However, the system turned to be more resilient than thought. Inherited borrowing in foreign currencies was too much to allow BoA’s mechanisms to be effective. As a result, with incomes decreasing and the Lek weakening, costs of inherited loans increased and demand remained. Additionally, as we already mentioned, a transition of the private sector toward loans in Lek was made impossible because the governmental borrowing increased the costs artificially.
Fourth, banks themselves have tightened standards for loans and increased interest rates. There may be various reasons to their behavior, such as pessimistic expectations for the upcoming quarters and the aim to curve government’s borrowing levels. Despite the reasons, costs remain high.
As a result, BoA announced last week that it will continue to keep its base interest rate unchanged, unlike its European counterparts. It justified its decision on the basis that the current situation in exchange rates would destabilize the market further if base interest was lowered. It also warned the government to keep spending within parameters.
There are no signs of the Lek picking up ground anytime soon. It will surely win some points during summer as holidaying immigrants supply the market with foreign currency. But the effect will remain seasonal and unless there is a more cautious approach in governmental spending policy, the future of the Lek and of the Albanian economy will simply deteriorate.