Tunisia dinar drop shows momentum for reform

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Weakness of Tunisia's dinar is undermining the purchasing power of its citizens and evoking memories of the country's economic crisis after its 2011 revolution. But this time, the dinar's depreciation may point to a stronger financial future.

For the past four months, the central bank has permitted a slide of the dinar against both the euro and the U.S. dollar, ending a period of several months in which the bank intervened to keep the currency steady or even rising.

The depreciation carries economic and political risks as the country gears up for parliamentary elections in October and presidential polls in November - votes which it hopes will complete a sometimes violent transition to democracy.

But a cheaper currency could in the long run have big benefits for Tunisia, creating jobs by stimulating export industries, and making it more economical for foreign investors to put money into the country.

Slim Feriani, executive chairman at London-based Advance Emerging Capital, said the central bank seemed to have become more willing in recent months to let the dinar drop in response to Tunisia's trade deficit and low foreign exchange reserves.

He said the depreciation was moderate and controlled, and should be seen in the context of pragmatic economic policies being pushed by a technocratic cabinet appointed in January, such as cuts in petrol and food subsides.

"There is light at the end of the tunnel" for the economy, said Feriani, a Tunisian whose company invests in emerging and frontier markets around the world.

Many North African central banks have been reluctant to let their currencies depreciate since the Arab Spring revolts of 2011, fearing capital flight and inflation that could worsen social tensions. If Tunisia's controlled depreciation succeeds in boosting its economy, other countries could follow its lead.

Tunisia's central bank intervened heavily to support the dinar in the wake of the revolution by selling hard currency, though it was only able to slow the drop, not halt it.

The intervention drained the country's foreign currency reserves, which sank to just 10.39 billion dinars ($6.08 billion at current exchange rates) or 93 days of import cover in late April, down from 102 days a year earlier. Central bank governor Chadli Ayari described the drop in reserves as "dangerous".

The drop appears to have triggered the decision to reduce intervention and allow a controlled fall of the dinar. The process began in early April, taking the dinar down from 2.17 against the euro to its current 2.30. Against the dollar, the dinar fell to 1.71 from around 1.57.

Central bank officials declined to comment publicly on exchange rate policy, citing the sensitivity of the issue.

But the depreciation coincides with reforms to the foreign exchange market that were discussed with the International Monetary Fund, which agreed in June 2013 to lend Tunisia $1.74 billion under a two-year program.

In March, authorities introduced an electronic trading platform and created a system of market-making banks as ways to permit exchange rates to move more flexibly in response to supply and demand, rather than being dominated by central bank transactions.

In a letter to the IMF in late April, the central bank pledged to take another step towards a more flexible market before the end of this year by introducing weekly auctions of hard currency.

It said its intervention now accounted for only about 30 percent of trade in the foreign exchange market, compared to 50 percent just two months earlier.

In place of intervention, the central bank appears to be relying much more on interest rate levels to prevent any excessive dinar depreciation; in June it raised its key rate to 4.75 percent from 4.5 percent, the second hike in six months.

The shift in currency policy has won public approval from the IMF, which in July issued a statement urging Tunisian authorities "to continue rebuilding foreign exchange reserves, including through further exchange rate flexibility".

It is not clear how far the dinar's slide will extend. In its late April statement, the central bank said it thought the dinar was overvalued by around 7 percent; that implies it should stabilize at roughly 2.39 against the euro.

On the other hand, it may be difficult for the currency to find a floor as long as Tunisia continues running a big deficit in trade in goods and services, which the IMF projects at $3.1 billion or 6.7 percent of gross domestic product this year.

For many ordinary Tunisians, the depreciation is unwelcome, cutting the hard currency value of their savings and fuelling inflation, which edged up to 5.7 percent in June.

"Citizens are paying the price for the drop of the Tunisian dinar. The dinar has no value now with the high prices," said Wassila ben Saleh, a 40-year-old employee of a transport company in Tunis. She added that some types of perfume had disappeared from shops as currency depreciation raised import costs.

Moez Abidi, an economist and former board member of the central bank, said the dinar's slide was potentially "catastrophic" and that authorities needed to do more to support the currency by reducing imports of luxuries such as cars, and by acting against smuggling.

However, there are signs that the depreciation is already helping to rebuild Tunisia's foreign currency reserves, which had rebounded to 12.09 billion dinars or 108 days of imports by the end of July, according to the central bank's website.

At least part of the recovery is due to foreign aid - Algeria deposited $100 million with the Tunisian central bank in May - but some private money may also be returning to the country. The stock market is up 5 percent since the end of April.

Tunisia may be well placed to benefit from a newly competitive exchange rate if a gradual economic recovery in Europe gathers pace and creates demand for its exports.

Tunisia's policy shift is likely to be closely watched by other North African states which are also struggling with big external deficits and need to attract more foreign investment, but have so far not dared to let their currencies depreciate.

Egypt, for example, has largely kept its pound steady over the past year, spending billions of dollars of foreign aid to do so. Morocco has blocked significant depreciation of its dirham, though the IMF has been urging it to free up its exchange rates.

Jason Tuvey, Middle East economist at Capital Economics in London, said Tunisia's depreciation of the dinar could in some ways be seen as a sign of confidence rather than economic failure, as the country was addressing a key policy issue.

"Other countries in the region such as Egypt could eventually make the same decision," he said, adding that Egyptian authorities might move on the currency after parliamentary elections that are expected at the end of 2014.

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