Inflation in Cuba and the Economy’s Potential Recovery (Part 1)
Often, people don’t know what they have until they no longer have it. From 2000 to 2019, the official inflation rate in Cuban pesos was approximate 1.3%. Although the official Consumer Price Index (CPI) underestimated inflation to some degree, there was an extended period of monetary stability in the mid-1990s. This meant that for more than two decades, state-owned companies, self-employed workers, cooperatives, companies with foreign investment, farmers, and families operated in Cuba with very low inflation.
Nonetheless, there was considerable dissatisfaction with the economy given the low purchasing power of wages, the dual currency system, and continuing scarcity in consumer markets, among other issues. Now, very high inflation rates have added to the list of economic woes that have worsened in recent years amid a more complicated economic context and the coronavirus pandemic.
Cuba’s National Office of Statistics and Information (ONEI) began publishing a monthly CPI last year, which represents a step forward; previously, only the annual CPI was published, with several quarters’ delay. The ONEI had calculated an inflation rate of 18.5% for 2020. In 2021, accumulated inflation stood at 69.5% through November,[i] the highest since the economic crisis that began in 1991 as a result of the collapse of the Soviet Union (known as the Special Period).
Current official inflation data is based on an outdated CPI from the year 2010; it used the structure of average family expenses from ten years prior when calculating today’s average prices. This base only considered an 18% weighting of the non-state market,[ii] which did not capture how much the private sector had expanded over the last decade nor did it adjust for the current crisis, which has forced people to resort to the informal market to acquire basic goods and services of all kinds. This explains why even higher inflation is being considerably underestimated currently in official statistics.
Using Phillips curve methodology to consider the effect of the peso devaluation, the scarcity of products, and the increase in wages, inflation can be estimated at around 500%,[iii] which coincides with anecdotal information indicating that, on average, the prices of most products rose between four and eight times in 2021. With these estimates, Cuba currently has the second-highest inflation in the region after Venezuela.
Inflation and Monetary Reform
The low levels of inflation in the Cuban economy since the second half of the 1990s had three fundamental determinants:
- The fixed exchange rate between the Cuban peso and the CUC (Cuban convertible peso) over time meant that the pass-through effect[iv] towards the final consumer prices was offset by not adjusting exchange rates.
- The decision to freeze pensions and nominal wages in the state sector during the crisis of the 1990s, and to make very few upward adjustments in subsequent years, with some exceptions (2005 and 2006: +16%; 2014 and 2015: +20%). From 1990 to 2019, the average nominal salary in the state sector grew at an annual rate of 5.3%. Thus, the increase in consumer demand from the income of workers in the state sector was kept at bay.
- The fiscal deficit was reduced and maintained at low levels, although it had been growing since 2015. From 2000 to 2019, the fiscal deficit as a proportion of GDP stood at 4.2%. This allowed greater stability in the growth of the money supply, which is highly dependent on fiscal imbalances due to the use of Cuba’s monetization (until 2014, when public bonds began to be used).[v]
These three fundamental determinants of low inflation in previous decades changed radically in 2021 as part of the monetary reform and the complicated domestic and international circumstances. The official exchange rate was devalued 24 times and the informal exchange ratio devalued three-fold, which increased the cost in pesos of imported goods and, subsequently, the cost of final consumer prices. Salaries in the state sector increased five times on average, as did pensions, thus expanding the nominal value of the demand for goods and services. The fiscal deficit has been close to 20% of GDP, necessitating the printing of more currency in order to finance the deficit.
Within the so-called monetary system, the government has had some control over the pass-through effect that occurs from the devaluation of the official exchange rate to consumer prices, since this transmission occurs through producers, wholesale companies, and state-owned retail companies, on which the government can place certain limits.
But the parallel exchange rate has also been depreciating, at over 80 pesos per banking dollar (freely convertible currency, or MLC) and over 90 pesos per euro[vi]), and this occurs through the growing non-state markets over which the government has no direct control. This explains in part why 2021 inflation was left out of the official estimates when the monetary reform was designed.
Dollarization using MLC, institutionalized by the Central Bank since mid-2019, also helps to understand the higher inflation rate, because consumer prices are more sensitive to fluctuations in the exchange rate. In other words, not only do the costs of imported inputs increase when currency is devalued, which producers then transmit to the final prices of goods and services; because of this dollarization, a more direct effect occurs. Some goods are sold in Cuba in dollars (MLC); once the currency depreciates, the value of these goods in pesos immediately increases for consumers.
Inflation reduces the purchasing power of savings, salaries, and pensions. In 2021, state wages and pensions were nominally increased as part of the currency reform, partially hedging against inflation. However, salary increases were not officially presented as a protection. The monetary reform was erroneously presented as a way to improve the purchasing power of wages, leading to false expectations in the midst of an economic crisis.
The objectives of the monetary reform have been distorted, and cannot be objectively evaluated by the 2021 results and indicators. It was to be expected that the monetary reform would be a “bitter pill”[vii] for the economy. Implementing the reform during a recession, a balance of payments crisis, and with borders closed to tourism meant that Cuba’s financial disruptions combined and multiplied with the effects of other destabilizing and inflationary shocks. Implementing the reforms in this complex context also delayed potential benefits.
However, Cuba is neither the first nor the only country to apply an exchange rate devaluation to attempt to unify a multiple currency system during a crisis. Internationally, this has been the rule rather than the exception. A comprehensive study by Kiguel and O'Connell in 1995[viii] examines the difficulties experienced by economies that previously had dual exchange rates in the 1960s and the 1980s.
One of the study’s conclusions is precisely that, in many cases, the decision to unify the foreign exchange market occurred during a crisis; examples are Venezuela (1989), Mexico (1987), Argentina (1989), and the former socialist economies. More recently, devaluations and reforms of Latin American exchange rate regimes towards more flexible systems also occurred amid crises: for example, Mexico (1994), Colombia (1999), and Argentina (2001).
Monetary reforms and exchange rate adjustments are implemented to increase financial transparency, for prices to better reflect the economic reality, and so that better decisions can be made based on better information and incentives. This should lead to more exports and national production, the closure of financially unviable state enterprises, and more efficient investments, decisions that imply resource savings and fewer subsidies.
But all of this takes time to manifest and requires other reforms and policies so that the benefits can be enhanced in the medium and long terms. It is a mistake to think of monetary reform as a way to redistribute wealth and obtain immediate results.
The official calculations, which resulted in a possible increase in the real value of salaries and pensions, did not take into account the economic context of 2021 nor the diversity of relationships in the economy. Simply put, it was simply a poor accounting calculation. Economic analysis is one thing, and accounting is another.
The design of the reforms focused too much on accounting, which led to skewed expectations regarding their short-term impacts on wages and pensions. Using a simple Phillips curve model, it was possible, as early as 2021, to anticipate that the official inflation projections would not be met.[ix]