The Bitter Medicine of Monetary Unification

The upheaval that the devaluation of the Cuban peso (CUP) and the elimination of the convertible peso (CUC) are causing on production costs is hardly unexpected, nor are their effects on

• wholesale prices,
• the value of the basket of essential foods,
• self-employed workers,
• rising electricity rates and prices at farmers’ markets, and
• all sorts of transactions in informal markets.

It should not be surprising—although it certainly merits analysis—that the financial realities of state-owned enterprises, cooperatives, private enterprises, and households are changing radically. We are talking about a devaluation of 24 times the official exchange rate and around 10 times the average exchange rate in the economy^[1], one of the largest devaluations in the history of multiple exchange rates in Latin America.

For a long time, economists explained that although currency unification would constitute an immediate financial shock, for the most part its multiple benefits would materialize gradually in the medium and long terms. We never hid the fact that it would be bitter medicine for the productive system to swallow, but it had to be done. It is impossible to develop an economy with two national currencies and multiple exchange rates.

Nearly three full decades have gone by with currency distortions, economic miscalculations, and overvaluing or undervaluing of production costs, wages, financial returns and risks, financial debts and assets. The value of many good economic decisions was minimized and the costs of many bad decisions and postponed reforms were hidden. Not everything we did before 2021 was miscalculated, but a large part was.

Currency unification implies a financial shock that produces changes in relative prices at a speed much greater than the average response capacity of the productive system. For a time, economic units are caught in the middle—much of what they have been doing no longer makes economic sense. But they cannot yet understand the steps they must take, and when they do begin to understand, they lack the means to react to the extent needed. Economic policies must work concurrently on two fundamental aspects to lessen the short-term impact of the financial shock: 1) minimizing uncertainty, and 2) increasing the reaction capacity of economic units.

On these two fronts there are many things that the initial design of the s0-called Monetary Ordering has already incorporated, and many others could be added. A permanent dialogue among the economic authorities and state enterprises, agriculturists, private entrepreneurs, foreign investors, and local governments will be a fundamental information source to correct and negotiate the unforeseen. To increase the response capacity, several structural reforms must be undertaken. To that end, recommendations have been made by economists such as  Pedro Monreal, Ileana Díaz, Mauricio de Miranda, Carmelo Mesa-Lago, Omar Everleny, Oscar Fernández Juan Triana and Ricardo Torres, among others.

It is important to emphasize that the success of the monetary reform is not guaranteed simply because the unification of the currencies and the official exchange rates eliminates distortions. Economic policy cannot relax and wait for the medium- and long-term benefits to materialize. Also, it cannot be content with publicizing some of the current short-term benefits, such as more people seeking formal jobs or reduction in household consumption. Those are good signs, and they are the first examples of what can be achieved by changing economic incentives, but they are a far cry from the structural changes and improved efficiencies the Monetary Ordering could achieve, demonstrating that the risk of devaluing the currency 10 times in a single day was worth taking.

Nor should the government promise and try to force through benefits that are unattainable in the short term, especially when it comes to increasing the purchasing power of wages and pensions. Counterfactual projections are always highly speculative, but it could be said that in a hypothetical scenario without a pandemic and without an 11% drop in GDP, perhaps some increase in real wages and pensions could have been achieved through the redistribution of wealth and income and a change in the public spending structure. This was the monetary reform plan on paper, but we already know that the reality of 2020 and 2021 is very different.

I understand that the technical economic team managed to politically “sell” the Monetary Ordering by combining the devaluation of the exchange rate with increases in salaries and pensions. However, to pretend that this nominal increase in income will translate into real improvements in the current context is unrealistic; it generates false hopes and promotes perverse incentives in regulators and politicians. In a recent panel at the Association for the Study of the Cuban Economy (ASCE), I presented an estimate that points to a probable drop of around 15% in the real average salary in the state sector in 2021. In the current complex economic and financial situation, this should be celebrated as a great achievement.^[2]

To be clear, I believe it was wise to combine both economic policy actions, particularly now, in the 2021 scenario. The nominal increase in salaries and pensions makes it possible to protect a large group of households from the social costs of devaluation. But it is one thing to present the increase in wages and pensions as a protection, and another to present it as an increase in real income in the midst of a tremendous adjustment in the exchange rate and relative prices and in an economy that has seen one of its main sources of external income reduced to practically zero due to the global drop in tourism.

At this same ASCE panel I presented an inflation projection that places the most likely rate for this year around 500%. About 300% of inflation is attributable to the pass-through effect, that is, the impact of the exchange rate’s devaluation on prices. The other 200% is explained mainly by excess demand: the increase in wages over productivity. It is important to note that in this scenario, the government's efforts at administrative intervention to control the pass-through effect is already apparent, taking into account the caps the Ministry of Finance has placed on wholesale prices for enterprises and the maintenance of subsidies. In this 500% inflation scenario, the assumption is that with these regulations the government could bring the pass-through to the average value observed in developing economies according to World Bank estimates.^[3] In fact, without considering the effect of these Ministry of Finance regulations, inflation would exceed 900% and real wages would fall by 50%.

According to these calculations, both the official objective of keeping prices to an average increase of only 1.4 times, and the objective of increasing the purchasing power of wages and pensions seem unattainable this year. Encouraging regulators and politicians to suppress inflation beyond what is possible will do more harm than good and may lead to destroying the very mechanisms we need for recovery. We need to recall again the failure of the Ten Million Ton Harvest in 1970 and the weakening that resulted from concentrating efforts on an unattainable goal.

In a more decentralized economy, with more economic actors and more open and competitive markets, most of the corrections in relative prices could be entrusted to the interactions and counterbalances of the productive system. But given the monopolistic and closed structure in which the Cuban monetary adjustment is occurring, negotiation and the systematic correction of price controls is the only way to partially compensate for the rigidity and inefficiency inherent in centralized pricing. We recognize the need to regulate, through administrative measures, the prices of state-owned enterprises and other markets where monopolistic structures prevail, but it is a mistake to impose prices where markets can fulfill this function without state intervention.

The success of the Monetary Ordering cannot be measured using 2021 indicators. The exchange rate and prices have moved in a better direction, but this has happened very quickly and in a complex context. More time is needed to achieve the new equilibria and for the economy to react to the new signals and incentives. Complementary structural reforms could strengthen these reactions and shorten the timeline.

[1] Taking into consideration that the population and the private sector had previously operated at the rate of 24 pesos per dollar, and that in 2021 the parallel market reflects a rate of 50 pesos per dollar

[2] See ASCE panel with Ricardo Torres and Carmelo Mesa-Lago on February 16, 2021

[3] World Bank: “Special Topic. Exchange Rate Pass-Through and Inflation Trends in Developing Countries” Global Economic Prospects, June 2014.