Implicit Exchange rate versus real exchange rate

January 14, 2004

In a comment today I mentioned a graph with both the exchange rate and the so called “implicit” exchange rate on it and said that it was available to anyone that wanted it. I sent it to a few people and they asked lots of questions, thus I decided to post it here and explain it as best as I can.


The graph is shown above. The greenish line is the actual exchange rate from January 1997 until sometime after exchange controls were imposed a year ago. The blue line is what results from dividing the monetary liquidity as defined by the Venezuelan Central Bank (coinage, bills, and deposits both retail and wholesale, close to M1 + M2 in the US) by the “total” international reserves. Thus in some sense you can think of this as the “implicit” exchange rate in the sense that if every Bolivar in public hands were to be converted into US dollars, that would be the price at which such a conversion would take place. Thus, if the greenish line is above the blue line it means that all of the bolivars in circulation, deposits etcetera are 100% backed by the international reserves. If the greenish line is below, then there is no full backing and part of the money in circulation in some form is based on trust. The explanation gets complicated here, because there is also the FIEM, the “Fondo para la Estabilizacion Macroenomica”. This fund, created in 1997 was a savings plan of oil income held at the Central Bank. Some people began talking about “total” reserves which included international reserves plus the money held in the FIEM. The blue line is actually adding both of them. The problem with that nomenclature is that when money is taken out of the FIEM it does go into the international reserves, but it also generates the bolivars, while when it is still in the FIEM has not generated any bolivars. Thus, there is in addition a pink line, which is subtracting the FIEM from the “total reserves”, to reflect the fact that the FIEM has not generated any of the liquidity available.


Now, since 1997, one can see a period in which there was full backing of the bolivar by the international reserves, i.e. there were more dollars in the international reserves than money in circulation or deposits in local currency, at the real exchange rate. (There was less trust in the currency). Then, beginning in 1998 the implicit rate went up as liquidity went up, but reserves did not. Thus the backing was only partial, from 75% to 100%.  (This means there was more trust, due mostly to the savings in the FIEM). For a while 2000-2002 the parity was actually quite good, there were roughly equal number of dollars than the bolivars in circulation at the real exchange rate. Suddenly in 2002, you can see that the pink line goes up, while the other one stayed below until February of 2002. Essentially, liquidity was increasing, pressuring the currency, but the Government kept the exchange rate fairly constant within the “band system” until it was forced to liberate the exchange rate in February 2002. Since that time, most of the time the implicit rate (pink line) has stayed below the real exchange rate (blue line) as the currency went from Bs. 600 to the official rate (today) of Bs. 1600 or the parallel rate of Bs. 3000. This means that most of this time there has been full backing of the currency (There is less trust).


One very interesting aspect of this plot is that it may tell us something about the sudden creation of bolivars, as Chavez is requesting now from the Central Bank. The blue line and the pink line got closer because the Government was taking money out of the FIEM. This means in practice moving dollars into the international reserves AND creating the corresponding bolivars at the same time. (The money from the FIEM belonged to a) the Central Government, b) PDVSA and c) the regional Governments). As money was taken out rapidly from the FIEM, the bolivars were given to their owners that used it, increasing liquidity which went to buy dollars, pressuring the exchange rate. In December 2001 the FIEM had US$ 7.1 billion, which went down to US$ 3.3 billion in December 2002 and is now down to US$700 million. Thus, only in 2002, US$ 3.8 billion was converted into bolivars and it definitely had a strong impact on the exchange rate. To me this shows the effect of those “new” bolivars in the system. Of course, inflation which had been held down near 10% began moving up at the same time, exceeding 30% in 2002. Sorry for the long explanation, hope it is clear.

One Response to “Implicit Exchange rate versus real exchange rate”

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