“The value of a currency is, ultimately, what someone will give you for it — whether in food, fuel, assets, or labour. And that’s always and everywhere a subjective decision.” - James Surowiecki

Every day millions of local transactions are conducted with the Bermuda dollar. Most people go about their daily lives without an afterthought of conducting business with our colourful currency. The fact that little concern is noted suggests there is implicit confidence in the Bermuda dollar.

The Bermuda dollar and the US dollar are used interchangeably in most forms of commercial life in Bermuda because the Bermuda dollar is pegged to the US dollar. A fixed exchange rate regime is one in which the government or central bank ties the official exchange rate to another currency to maintain another currency’s value, normally in a narrow band. Fixed exchange rate regimes offer greater certainty for exporters and importers and tend to assist governments in maintaining lower inflation. They do, however, limit flexibility and the natural economic rebalancing that may arise when countries of varying inflation rates diverge in prices. This is where the calculation of a real exchange rate offers information of relative values.

Real exchange rates

The real effective exchange rate (REER) is essentially the weighted average of a country’s currency relative to an index or basket of other major currencies adjusted for the effects of inflation. Real exchange rates are usually calculated for all goods and services in an economy rather than for a single one. This can be accomplished simply by using a measure of aggregate prices (such as the consumer price index or gross domestic product deflator) for the domestic and the foreign country in place of the prices for a particular good or service.

Using this principle, the real exchange rate is equal to the nominal exchange rate times the domestic aggregate price level divided by the foreign aggregate price level. Since Bermuda’s main trading partner is the US and the currency is pegged to the US dollar, we have chosen to compare Bermuda to the US.

Using a simple approach of comparing relative levels of inflation, as measured by the Consumer Price Indices, since 1972 we note, by this measure at least, the Bermuda dollar is about 17 per cent overvalued versus the US dollar. This is depicted graphically in the accompanying chart.

Basically, this model illustrates that since the inflation rate in Bermuda has been higher than the inflation rate in the US, all other factors considered equal, the purchasing power of the Bermuda dollar will be less, relative to the US dollar. Or, to say it a different way, higher inflation in Bermuda than in the US lets one buy less per dollar than in the US.

It is worth noting that valuing currencies is a relative game that involves much more detailed analysis than this simple model but it does offer some guidance as to the Bermuda dollar’s relative value versus the US dollar. Changes in terms of trade and differences in fiscal policy, tariffs, and even the levels of financial sophistication can also help explain REER differentials across countries.

Implications and Outcomes of the REER and the Peg

As noted above, based on a simple REER analysis, if the Bermuda dollar was floated versus the US dollar then it may be worth about 17 per cent less, considering all other factors equal. Maintaining the peg has led to some less noticeable consequences and implications. Here are a few implications of the real-exchange rate differential and the peg for Bermuda:

1. Loss of competitiveness. A floating currency often offers an offset for inflation differentials. By looking at the REER, economists can determine which countries have lost their competitiveness to other countries. In many aspects Bermuda has lost some competitiveness versus the world due to its high cost. It is probably most noticeable in the labour market where a comparable worker costs much more than that of a worker abroad. The immediate outcome of this has been more offshoring and outsourcing. Of course, if productivity is much higher in one nation versus another then higher cost or wages are warranted but in many cases and for many jobs that have been outsourced there was no or very little productivity advantage of being in Bermuda. Some jobs simply don’t offer much scope for productivity enhancement and so their location will be determined ultimately by cost. A weakening currency would offset relatively higher wages.

2. You may not be as rich as you think. If our cursory analysis of the Bermuda dollar is correct it would imply that there may be greater risk than perceived for Bermuda dollar assets. Any currency devaluation or adjustment to the peg would seem to put at risk assets like real estate to be devalued lower vis-a-vis the US dollar. Currently, with the peg, sales of Bermuda dollar assets are freely converted into US dollars after foreign currency purchase charges at a one-to-one rate. Currency risk tends to increase discount rates or the cost of capital used to make investments and lowers asset values. If REER was used to value economic factors, such as GDP per capita for example, they would be less than otherwise reported.

3. Do you like Janet Yellen? Since Bermuda’s currency is not floating and pegged to the US we are essentially outsourcing any function of a central bank. We are, in essence, held to the vagaries of the US dollar and its relative movements globally. If you are a fan of the US dollar and its value, then a pegged Bermuda dollar is great. If you question the value of the dollar then you may be concerned tying your own currency to one of dubious value. Bermuda also, by proxy, is subject to the Federal Reserve’s monetary policy decisions.

Should we float or devalue?

No. Devaluation or a floating rate are really not an option. To quote Robert Stewart from A Guide to the Economy of Bermuda (2003): “[Bermuda] does not manufacture or grow anything of any significance. It does not have a financially independent industrial or agricultural base like Argentina, where devaluation is an option, though a painful one. In actual practice devaluation is not an option for Bermuda … no one would be willing to hold a floating Bermuda dollar. It would become just a worthless piece of paper. If Bermuda were unable to earn foreign currency, then the standard of living would fall dramatically, as would salaries and wages and the real value of real estate. The Bermuda Government would be compelled to make huge budget cuts. Seeking to maintain the Bermuda dollar without a tie to major currency would not work.”

Because of the potentially negative consequences of floating the Bermuda dollar, it is important that we continue to maintain a solid balance of payments, or current-account surplus. Bermuda is currently backed by sufficient foreign exchange, mainly in US dollars, earned by Bermuda from international business and tourism.

If, at some point, Bermuda failed to generate adequate levels of foreign income from outside trade, the Bermuda dollar would risk becoming a worthless currency. Jamaica is one example of a country in which as series of devaluations has caused its standard of living to erode because the country does not earn sufficient foreign currency to pay for its imports from abroad.

In Bermuda our current-account surplus, or profit, stood at $224 million for the third quarter of 2015, offers a nice cushion. The future value of the Bermuda dollar hinges on this positive balance of trade and, at least in real terms, a stable inflationary environment.

Nathan Kowalski CPA, CA, CFA, CIM is the chief financial officer of Anchor Investment Management Ltd and can be reached at nkowalski@anchor.bm

Disclaimer: This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by the author to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. Readers should consult their financial advisers prior to any investment decision. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.