Since the Cadeca rate is currently fixed by the authorities, they have the power to change it without delay, but fear of economic disruption and social costs is holding it back. However, a survey of the relative effects of abrupt and gradual unification on competitiveness, foreign exchange flows and relative incomes suggests that greater urgency would be preferable.
As the experiment with direct supplies to tourism indicates, policymakers recognise that exchange rate unification would involve an appreciation of the currently undervalued Cuban peso relative to the convertible peso, from the current Cadeca rate of CUP24:CUC1 to somewhere between CUP11:CUC1 and CUP5:CUC1. If we assume that the chosen rate was CUP10:CUC1, what would the implications of a sudden change be, relative to the current policy of gradual adjustment?
Impact on currency flows
Concern about a possible foreign exchange crisis is misplaced. In the standard textbook account of currency markets, the impact of an exchange rate change on foreign exchange flows is determined by demand and supply. In general, an increase in the value of a currency is expected to reduce exports (that is, the demand for the currency will decline) and increase imports (the supply of the currency to the exchange market will rise). The result is that net foreign exchange inflows will fall; moreover, in anticipation of this trend, there could be a flight from the peso, causing a foreign exchange crisis. But in Cuba’s case, the determinants of demand and supply are atypical, making such an outcome extremely unlikely.
There are two main peculiarities of the Cuban exchange market. First, the Cadeca rate only applies to the household and micro-enterprise sectors, and is limited to the domestic economy. Second, within the domestic economy, the markets for basic (state subsidised) and non-basic (non-subsidised) goods remain separated, and administered prices for basic goods remain well below market prices. In the case of non-basic goods, market prices dominate – both in the hard currency (TRD) stores, which mainly sell imported products at international prices plus a retail mark-up, and in the ‘free’ agricultural markets, which sell goods produced within Cuba at CUP prices that are accepted as interchangeable with CUCs at CUP24:CUC1. In the latter, prices are broadly in line with (although slightly cheaper than) international prices at the Cadeca rate of exchange; and as such, they remain largely prohibitive for CUP-income households.
Demand for a given currency is determined mainly by the demand for the goods and services produced in the economy. In Cuba’s case, though, the restricted use of the Cuban peso and separation of markets within the economy means that the demand for CUPs in Cuba’s Cadeca exchange market does not come from Cuba’s international trade. Instead, it comes from Cubans with CUCs who want to exchange them for CUPs in order to purchase basic goods and services from the state at administered (way below market) prices. The amount of CUPs that will be bought for this purpose is therefore inelastic: for as long as the CUP prices remain below CUC prices, a rise in the value of the CUP will have no effect on the amount bought.
Indeed, for some relatively low-income CUC-income Cuban households, there may even be an effect similar to the exceptional case of the upward-sloping demand curve of the ‘Giffen good’: as the rise in the price of the CUP reduces their real income, they may shift consumption habits towards the cheaper market, which is the CUP one. That is, they might even buy more CUPs than before, rather than fewer, by looking for bargains in the CUP markets rather than extravagantly shopping in CUC stores.
On the supply side, CUPs are sold on the Cadeca market by CUP-earners who wish to buy goods and services that are only available in CUCs. These households can only spend the part of income left over after they have already bought their essential goods and services in CUPs. This surplus disposable income does not vary if the exchange rate changes. That is, the supply of CUPs to the Cadeca market is also inelastic.
The lower the elasticities of demand and supply of any currency are, the weaker the impact of an exchange rate appreciation on net flows of foreign exchange. Indeed, the ‘Marshall-Lerner condition’ observes that, if the sum of the demand and supply elasticities for a currency is less than one, an appreciation of the currency, which is assumed under normal conditions to cause a decline in net foreign exchange inflows, will not occur. In Cuba’s case, because both CUP- and CUC-income households require a fixed amount of CUPs to make their basic purchases, the impact on net foreign exchange flows will be slight. Exchange rate appreciation would therefore cause little if any fall in demand for CUPs, and have only a relatively weak impact on supply. This condition will apply for as long as state subsidies keep the prices of basic CUP goods below the market level.
There is therefore little risk of any currency crisis sparked by Cuban peso revaluation. Indeed, because it is common knowledge that the Cuban peso is undervalued and that adjustment will eventually come, attempting to maintain the current rate is more likely to cause instability. In 2008, unfounded rumours that the government was about to devalue the CUC against the CUP from CUP24:CUC1 to CUP8:CUC1 resulted in massive sales of CUCs, and the 'clearing out' of stocks of CUPs held by the Cadeca exchange houses. As people consider that the moment of adjustment is coming closer, there is a risk of similar speculative incidents, and also of hoarding of Cuban pesos, which damages growth and adds to the difficulty of adjustment.
Impact on competitiveness and dynamism
In the state sector, currency unification would not only improve competitiveness at a stroke by reducing the official value of the CUC, but it would also make meaningful enterprise autonomy possible, improving the responsiveness of enterprises to global market conditions and enabling the integration of the domestic and external economies. Autonomy would allow profitable companies engaged in exporting or import substitution to generate a surplus, and then use it to purchase more inputs and reinvest to expand capacity. Even companies operating entirely within the domestic economy would be able, for the first time, to source foreign inputs and weigh up the potential profitability of international expansion. Loss-making enterprises that failed to improve efficiency would face bankruptcy or take-over by more profitable competitors. The impact on overall productivity would be strongly positive.
Bankruptcy and redundancy, which are unfamiliar in Cuba, will become more common as the economy restructures. The government has drawn up new laws and procedures for the liquidation of companies, and is currently consulting on a new labour code, presumably in preparation for the changes ahead. Restructuring will inevitably sacrifice security in favour of dynamism.
In the non-state sector, the sudden appreciation of the Cuban peso would mean a reduced state subsidy. It would also remove many of the opportunities for generating profits simply by illegally diverting supplies from subsidised peso markets to sell in free markets. That is, entrepreneurial effort will be diverted from unproductive to productive activity.
The adjustment cost would be greatest for those operators whose business model had been most dependent on the exchange rate subsidy. Small businesses selling in CUC markets, in which the productivity per worker is only sufficient to pay CUC1 a day – which is enough for subsistence at the current exchange rate – would now need to generate around CUC20. Either earnings would need to rise, or the business would have to close. There would be upward pressure on prices in these markets, as wage costs rose, although these pressures would be mitigated by the forces of international competition. For example, a paladar (private restaurant) can only raise prices if its tourist customers would be willing to pay.
The only other way for non-state enterprises to restore real earnings would be to increase productivity. Exchange rate unification would immediately benefit efficient state enterprises, while the inefficient ones would lose their subsidies. In the non-state sector, enterprises that have been able to generate relatively easy profits because the existing Cadeca rate provides them with a hidden subsidy would be hardest hit. The longer the delay in making the adjustment, the more people will have become dependent on this unsustainable sector, and therefore the harder will be the social cost.
Impact on prices and incomes: winners and losers
There will be winners and losers from any change to the dual currency system. The impact of revaluation of the CUP relative to the CUC on prices will be mixed, with some prices rising and others falling. For example, fixed CUP prices would be unchanged, although their cost in CUC terms will increase because of the CUP’s appreciation. Imported goods that are currently sold in CUCs would not change in CUC terms, but in CUP terms their prices will be lower than before. And in the free CUP markets, prices would tend to fall, to the extent that they are influenced by competition from imported goods. On the whole, if inflation is measured in CUP terms, the effect of CUP appreciation would be to reduce the price level.
For CUP-income households, the impact would range from neutral to positive. For those with the lowest level of income, whose entire income is spent on basic goods at fixed prices, an exchange rate appreciation would have no effect on the cost of living, but for CUP-income households with income to spare, exchange rate appreciation would reduce the cost of living. That is, it would bring an immediate improvement in real income and living standards. The greatest percentage improvement in real incomes will be for those on higher CUP incomes. This will enhance the effectiveness of wage incentives.
For CUC households, exchange rate appreciation will result in a rise in the cost of living, that is, a fall in real incomes, as the prices of CUP purchases in CUC terms will rise by the amount of the appreciation. In effect, the revaluation will diminish the labour market distortion that has been caused by the undervaluation of the CUP. This will reduce income inequality, because Cuba’s highest-income households are those with CUC incomes. However, households who have become dependent on jobs in the (informal or legal) non-state sectors that pay very low CUC-denominated-wages would suffer real hardship.
Rapid adjustment would, on balance, reduce the cost of living as measured in Cuban pesos. The impact on relative incomes would favour those earning CUP incomes, who would be better off in absolute and relative terms, finally starting to restore living standards and reversing the distortion that has favoured those with CUCs for the past two decades.
While this would generally have a positive effect on restoring work incentives, the adjustment would require provisions to protect those who have been earning very low CUC-denominated wages. The number of people in this category will continue to grow as long as the exchange rate adjustment is postponed, so the greater the delay in making the change, the larger will be the problem of poverty resulting from it. The restoration of a single set of prices will make it necessary, as well as possible, to establish a meaningful minimum wage for the non-state sector, in line with the minimum wage in the state sector.
