What Happens When Cuba Devalues Its Peso?

What Happens When Cuba Devalues Its Peso?
Jose Gabilondo - Talking Head, Professor of Law, Florida International
University
Posted: 09/15/2015 7:10 pm EDT Updated: 09/15/2015 7:59 pm EDT

For the Cuban economy to keep making progress on the Lineamientos
adopted in 2011 by the 6th Communist Party Congress and to make good on
the island's vast potential, its leaders must address some vexing
challenges, including reforming its complex monetary system. Two
problems stand out that will almost certainly result in a devaluation of
the national peso.

First, Cuba uses two different currencies -- the national peso (CUP) and
the convertible peso (CUC), a rough proxy for the U.S. dollar. Unlike
the currencies of many countries, neither the CUP nor the CUC trades off
the island.

Second, the island has different CUC:CUP exchange rates for different
parts of the economy. Most people, nonstate businesses, and tourists
exchange pesos at a local market rate of 1 CUC to 25 CUP. However, the
state keeps its intra-governmental accounts at the accounting rate of 1
CUC to 1 CUP. Unlike the market rate of 1:25, the 1:1 ratio is a policy
rate, set and enforced by government fiat. It is a holdover from an
earlier period in which the peso was pegged more closely to the dollar.
In the past, the government has also experimented with other policy
rates in different settings.

The Cuban government has announced that it is phasing out the CUC and
affirming the CUP as a single currency. In a July 15, 2015 speech,
Marino Murillo (Vice President of the Council of Ministers) explained
that these reforms were necessary to rehabilitate the price system. This
is a big deal because an effective price mechanism -- one that adjusts
prices based on supply and demand -- is a trademark feature of
capitalist economies.

Whether Cuba implements this monetary reform all at a once -- a Big Bang
approach -- or whether it is phased in slowly, what it will involve is a
de facto devaluation of the 1 CUP to 1 CUC rate because the new rate
will recognize the market reality that it takes more than 1 national
peso to buy 1 convertible peso.

How much more? That remains to be seen, but the number will be somewhere
between the government's 1:1 policy rate and the market's 1:25 rate. In
2013, the government experimented with a 1 CUC:10 CUP rate for some
state businesses, leading some to wonder if maybe 1:10 will be the
exchange rate used to devalue the national peso.

Because the subject is technical and arcane, exchange rate and monetary
policy remains the province of smart experts. I'm not one of them, but,
having studied it for a while, I want to share a way of thinking about
the problem because it's important.

Assume that the rate used for the devaluation is 1 CUC = 10 CUP. How
would such a devaluation impact Cuban state firms? Consider a
pre-devaluation balance sheet with 10 pesos in assets and 10 in
liabilities. Since the policy rate treats one national peso the same as
one convertible peso, there is no need to pick a denomination.

Firms whose assets and liabilities are denominated entirely in either
CUP or CUC are unaffected in terms of their solvency. What about state
firms whose balance sheets contain both CUP and CUC items? At present,
it's impossible to determine whether such a firm is profitable or not
because intra-governmental accounting distorts the picture.

The critical factor is how much of the balance sheet is CUC. A firm will
be in one of three financial positions: (i) CUC assets will equal CUC
liabilities; (ii) CUC liabilities will exceed CUC assets; or (iii) CUC
assets will exceed CUC liabilities.

This balance sheet is matched because its CUC assets (5) equal its CUC
liabilities (5). When these CUC items are converted to CUP, the firm's
assets still equal the liabilities.

A firm with more CUC liabilities (5) than CUC assets (2) has a currency
mismatch (descalce cambiario). When the CUC items convert to CUP, the
post-valuation liabilities count for much more than before. The
devaluation reveals the insolvency that was hidden under the previous
policy rate.

The converse is the firm with more CUC assets (8) than CUC liabilities
(5). This is also a currency mismatch, but it is a favorable one. When
the CUC items are converted to CUP, the assets exceed the liabilities by
28, this time revealing a surplus that was hidden by the previous policy
rate.

Granted, this explanation does not do justice to the problem. My goal is
to get this idea out to see what others think.

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