My friends over at the Association for the Study of the Cuban Economy blog have posted a new essay by Luis R. Luis, an international economist specializing in international finance who has long been involved in international finance and investments as an officer of international organizations, commercial banks and investment management companies. Luis is a member of ASCE since its foundation. He holds a PhD degree in economics from the University of Notre Dame and has lectured at universities in the US, Europe and South America.
Luis' essay, "Inflation in Cuba 2010-2021" considers the trajectories of inflation in the shadow of the unification of the national currency in late 2020 and early 2021 and the attendant devaluation of the peso in response to a decade of fiscal politics that made that devaluation unavoidable..
The Cuban economy has experienced moderate inflation in recent years. The only recent official statistic is the household consumption deflator in the national income accounts of the Oficina Nacional de Estadística e Información which shows an average increase of 3.1% per year in 2010-2019 (ONEI 2016, 2020). The United Nations Economic Commission for Latin America (CEPAL 2021) places Cuban consumer prices down -0.3% in 2020 though this deflation does not mesh with observation of rising foodstuff and other essential good prices in private markets in the island. CEPAL reported 2019 inflation at a decreasing -1.3% while the ONEI consumption deflator shows a 1.9% increase. Price controls, subsidies for basic goods and services and a fixed dual exchange rate underlie moderate inflation but also distort available statistics. Price deflators also do not fully reflect prices in free markets for agricultural products and other consumption items. Shortages of these essential items in state stores have recently contributed to drive inflation upwards in private markets.
The devaluation of the Cuban peso by 2300 % in January 2021 is altering the path of consumer prices. Additionally, price movements will be impacted by a sizable government budget deficit largely financed by monetary expansion in 2020 and 2021 and a weakening peso in the parallel currency market. In this note I look at recent trends for consumer prices and its relation to foreign prices and domestic costs. In the absence of consumer price indices I also assess the short-term impact on inflation of the currency devaluation.
He concludes:
Cuba experienced moderate inflation during 2010-2020 assisted by subsidies, price controls, stabilization policy in 2011-2013 and especially an overvalued currency. Decades long overvaluation of the peso led to high prices of non-tradable goods versus tradable goods creating huge distortions in relative prices and anti-export bias. The massive devaluation of the peso in January 2021 goes far in correcting the imbalance in relative prices with non-tradable good prices falling initially as much as 87% against tradable prices. In the absence of consumer price indices short-term (one-quarter) inflation is gaged under alternative scenarios at 270% to 470% depending on assumptions about the openness of the economy, the role of CUPs and CUCs in foreign exchange transactions and the use of tradable goods in production. This high initial expansion of prices is igniting inflationary expectations in the population, not eased by projected fiscal expansion of at least 18% of GDP in 2021 and a sharp dollar shortage.
The analysis makes fascinating reading. The entire essay may be accessed HERE. It is reposted below.
Inflation in Cuba 2010-2021
Luis R. LuisINFLATION IN CUBA 2010-2021*
Luis R. Luis
The Cuban economy has experienced moderate inflation in recent years. The only recent official statistic is the household consumption deflator in the national income accounts of the Oficina Nacional de Estadística e Información which shows an average increase of 3.1% per year in 2010-2019 (ONEI 2016, 2020). The United Nations Economic Commission for Latin America (CEPAL 2021) places Cuban consumer prices down -0.3% in 2020 though this deflation does not mesh with observation of rising foodstuff and other essential good prices in private markets in the island. CEPAL reported 2019 inflation at a decreasing -1.3% while the ONEI consumption deflator shows a 1.9% increase. Price controls, subsidies for basic goods and services and a fixed dual exchange rate underlie moderate inflation but also distort available statistics. Price deflators also do not fully reflect prices in free markets for agricultural products and other consumption items. Shortages of these essential items in state stores have recently contributed to drive inflation upwards in private markets.
The devaluation of the Cuban peso by 2300 % in January 2021 is altering the path of consumer prices. Additionally, price movements will be impacted by a sizable government budget deficit largely financed by monetary expansion in 2020 and 2021 and a weakening peso in the parallel currency market. In this note I look at recent trends for consumer prices and its relation to foreign prices and domestic costs. In the absence of consumer price indices I also assess the short-term impact on inflation of the currency devaluation.
Tradable and Non-Tradable Good Prices in 2010-2019
It is important to understand the mechanism for connecting international prices to prices in the domestic economy. This will help explain past trends and gage the impact of the massive devaluation of the peso in January 2021. Cuba had a fixed exchange rate for the CUP and CUC against the dollar for decades. This means that the exchange rate does not affect prices directly. To be sure overvaluation of the currency distorted prices. At the same time a complex system of subsidies for state firms and consumers masked inflation driven by internal demand and constrains on supply. Aside from the huge impact of the devaluation, the elimination of some subsidies is now altering prices.
A way to describe consumer prices, PC, and its relationship to international prices, PI, is to use a basic relation:
PC = (ePI)αPN(1-α) (1)
PT and PN are domestic prices of tradable and non-tradable goods and PT = ePI.. The exchange rate in domestic currency per dollar is e and α is the share of tradable goods in the consumer price index. Tradable goods and services are those that are exported or imported and their close domestically produced substitutes. When the exchange rate is fixed tradable good prices will reflect directly the change in international prices. A devaluation on the other hand will also cause domestic prices to vary in proportion to the movement in the exchange rate. In actual experience the relation between PC, PI and e will not be instantaneous and will take place over time so that a devaluation, for example, will impact prices over several months or longer. The existence of two currencies and two exchange rates prior to January 2021 is also a peculiar aspect of the Cuban monetary system. It means that up to the end of 2020 e is a composite of the exchange rates for the two currencies.
CHART 1
Source: Derived from ONEI, Cuentas Nacionales, Anuario Estadístico de Cuba.
Chart 1 shows price deflators for household consumption, government consumption and imports of goods and services. In the absence of detailed transaction data, the import deflator is used as a reasonable proxy for the price of tradable goods while government consumption represents the price of non-tradable goods. These correspond to EpI and PN in relation (1). The graph plots a volatile series of the deflator for tradable goods resulting from large fluctuations in the price of imported petroleum products which peaked in 2011-2013 and suffered a steep decline in 2014 recovering somewhat in 2017-2019. Household consumption prices averaged a 3.1% yearly rise during 2010-2019 with a sharp jolt at the beginning of the decade. Household Consumption prices rose 11.1% in 2011 and 5.6% in 2012 easing thereafter after a successful fiscal stabilization program and the fall in oil prices. Note that the household deflator overshoots the government consumption deflator in 2010-2014 when tradable goods are on a rising pattern and vice versa after 2014 when import prices decline. This supports the use of the import and government consumption deflators as proxies for the prices of tradable and non-tradable goods.
It is easy to calculate α, the share of tradable goods in the household consumption deflator, from the series in Chart 1 and relation (1). From (1) we have that α = (lnPc – lnPN)/(lnPT – lnPN) where ln is the natural logarithm. The average α for 2010-2019 is 0.197 and 0.199 for 2014-2019. Tradable goods are thus one-fifth of the household consumption deflator. On a first look this might appear reasonable as non-tradable services such as education, health, internal security, distribution and others are a large part of the Cuban economy. The exclusion of export prices in the proxy index for tradeable good prices does not introduce a substantial bias. The main exports, tourism, professional services and nickel, are segmented from the rest of the economy and do not compete directly with domestic products. Yet the smooth path of consumer prices is still remarkable in view of the volatility of import prices. The answer lies in the severe overvaluation of non-tradable versus tradable goods as a result of the fixed exchange rate. This means that α is substantially understated by the high relative price of non-tradable goods. As an example, α ranged between .43 and .59 in a well-known study covering five developing economies or two- to three-times the Cuban share of tradeable goods in the consumption price index (Burstein, Eichenbaum and Rebelo 2005).
Wages and Consumption
Labor income is the most important component of national income and bears a close relation to domestic prices. Wages of state workers and affiliated company employees rose at an average annual rate of about 8% in 2011-2019, twice the rise in the deflator for government consumption. This suggests a roughly 50% share of labor costs in non-tradable good prices. As may be expected patterns of state wages mesh with the government consumption deflator (Table 1). Not so with consumer prices as measured by the household deflator.
TABLE 1
Chart 2 shows the index of real wages as against an index of real consumption for 2010-2019. Real wages are the average salary of workers in the state sector deflated by the household consumption index in Chart 1. Household consumption at constant 1997 prices is taken directly from the ONEI national income accounts.
CHART 2
Source: Derived from ONEI 2016, 2020.
Real wages impact price levels through two channels. In the first place it is an important component of costs in domestic production especially services. Most of these services are provided by the state and its enterprises. The second channel is the role of wages in overall demand. Wages are a part of disposable income and thus affect personal consumption. Yet the Cuban rationing system and price subsidies distort the relationship. During 2010-2014 real salaries declined while household consumption showed steady advance. Since 2018 we have the opposite case particularly in 2019 when real salaries rose by 11% while real consumption declined 1.3%. This means there is excess demand as incomes expand and is reflected in higher free market prices for products compared to prices in state stores.
Short-Term Impact of the Devaluation on Consumer Prices
The devaluation of the peso at the beginning of 2021 was a shock to the price system although it was not unexpected. The devaluation was announced many months in advance, and the government introduced in late 2020 a long list of measures regarding controlled prices, salaries, pensions, cautious reforms of the farm distribution system and expanded the occupational categories for the self-employed (Mesa-Lago, 2021). The sheer size of the devaluation of the peso from an official rate of US$1 = CUP 1 to US$1 = CUP 24 is having a large impact on consumer prices. The CUC was steady against the dollar as it is exchanged for CUPs at the same rate as the new dollar/CUP rate. This means products priced in CUC were not directly hit by the CUP devaluation but will adjust through domestic price mechanisms. How much consumer price inflation can Cuba expect from the CUP devaluation?
A precise answer to the question is difficult, and Cuba is not yet publishing consumer price indices. However, calculations for the initial impact of the devaluation can be based on accounting relation (1). This relation can be widened to include the two currencies in Cuba at the time of the devaluation and to account for the distribution margin in retail goods. The retail price of tradable goods PrT can be written:
PrT = θ(epPI)β(kecPI)1-β (2)
In (2) ep and ec are the exchange rates for the CUP and CUC, β is the share of CUPs in foreign exchange transactions and θ is the distribution margin of retail goods which is a non-tradable service. The constant k=24 is the internal rate of exchange between the two currencies so CUC1 = CUP24.
Likewise, we can establish a relation accounting for the retail price of non-tradable goods PrN:
PrN = θwγPrTή (3)
This relates the retail price of non-tradeable goods to unit labor costs, w, the price of tradeable goods and the distribution margin. The parameters γ, ή and θ are the elasticity of non-tradable good prices to unit labor costs, the share of tradable goods used in the production of non-tradable goods and the distribution margin in retail prices. Relations (2) and (3) describe the links of prices to the exchange rate, foreign prices and labor costs and are accounting relations not mechanisms for market price determination. As is well known, there is in Cuba an important element of price controls determined by the state that affects prices (Monreal 2021 and Falcon 2021).
From relations (1), (2) and (3) I obtain estimates of the initial impact of the devaluation on consumer prices which can be taken as a one-quarter projection. The parameters of the three relations are obtained from the Cuban national income accounts and correspond to proportions in price indices described above for tradable goods, non-tradable goods and wages . Assumptions about the use of CUPs and CUCs in foreign transactions are derived from ONEI data on consumption in private businesses and monetary time series. Foreign prices are non-fuel dollar commodity prices at the quarterly rate forecast in IMF (2021) or 4.0%. The share of tradable goods used in production of non-tradable goods, ή, are tentative assumptions. I use two alternatives for this value, 10% and 20% which compare to the share of imports in GDP that has oscillated between those two values in 2013-2018.
TABLE 2
Table 2 presents four scenarios for the short-term impact of devaluation on consumer inflation PC, and prices of tradable and non-tradable goods PT and PN. Besides the peso devaluation a key input is the rise in unit labor costs in 2021. I use the announced rise of the minimum wage by a multiple of 5.25 as a proxy for unit labor costs. This is somewhat greater than the increase in state sector wages but less than in state enterprises as indicated by (Mesa-Lago, 2021). The calculations as mentioned above use IMF projection of 2021 commodity dollar inflation. I assume no change in the distribution margin. However, current scarcity of many essential foodstuffs and market segmentation suggests that there is some increase in retail margins which is difficult to quantify.
The calculations indicate consumer inflation ranging from a multiple of 3.7 to 5.7 in the first quarter of 2021, that is, inflation of 270% to 470% (Column PC, in yellow). Scenario I has inflation of about 300% and assumes CUCs account for 6% of transactions in the foreign exchange market. This is household consumption expenditures at cuentapropista businesses in 2019 as reported by ONEI (2020). Scenario II sets CUCs at 16% of all currency transactions or half of my estimated proportion of CUCs in the money supply in 2020. Monetary data imply that the CUC proportion of the money supply (M2A) was 39% in 2017, suggesting that CUC transactions may be higher than indicated in Scenario I. Inflation in Scenario II is lower than in Scenario I as CUC prices are not immediately affected by the devaluation of the CUP. Scenario III has a higher proportion, 20% instead of 10%, of tradable goods as inputs in the non-tradable sector. Scenario IV assumes a more open economy, and tradable goods account for 40% of consumption instead of 20% in Scenarios I, II and III. This is nearer the proportion of tradable goods in relatively closed Latin American economies. In this scenario consumer prices rise 470%. These are all estimates of consumer price inflation between December 2020 and March 2021. Annual estimates place consumer price inflation between 480% and 950% (Vidal, 2021).
While exact consumer inflation is uncertain, surely there is a swift rise in the price of tradable versus non-tradable goods providing a needed incentive to improve allocation of resources and the balance of payments shortfall. The scenarios in Table 2 show a fall of as much as 87% in the relative price of non-tradable goods. Another way to look at this is the lag of non-tradable prices to overall inflation. This means there is a large real devaluation of the currency. The question is whether or not policies will be in place to make use of this opportunity to realign the use of resources to the benefit of the population and the economy. This is a much larger topic than the one addressed in this article.
The price expansion caused by the devaluation will require stabilization policies in place to contain inflationary expectations. These can be seen in private markets as well as in the black market for dollars. The dollar in early May 2021 is quoted at around CUP 55 as against CUP 30 at the end of December 2020. The government estimates a fiscal deficit of 18% of GDP for 2021 which may be exceeded (Rodriguez 2021). The deficit will largely be financed by expansion of the monetary base which will add to inflationary pressures.
Conclusion
Cuba experienced moderate inflation during 2010-2020 assisted by subsidies, price controls, stabilization policy in 2011-2013 and especially an overvalued currency. Decades long overvaluation of the peso led to high prices of non-tradable goods versus tradable goods creating huge distortions in relative prices and anti-export bias. The massive devaluation of the peso in January 2021 goes far in correcting the imbalance in relative prices with non-tradable good prices falling initially as much as 87% against tradable prices. In the absence of consumer price indices short-term (one-quarter) inflation is gaged under alternative scenarios at 270% to 470% depending on assumptions about the openness of the economy, the role of CUPs and CUCs in foreign exchange transactions and the use of tradable goods in production. This high initial expansion of prices is igniting inflationary expectations in the population, not eased by projected fiscal expansion of at least 18% of GDP in 2021 and a sharp dollar shortage.
NOTE
*This article benefitted from comments by Ernesto Hernández-Catá and Lorenzo Pérez.
REFERENCES
Burstein, Eichelbaum and Rebelo (2005), Ariel Burstein, Martin Eichelbaum, and Sergio Rebelo, “Large Devaluations and the Real Exchange Rate,” Journal of Political Economy, April 2005.
CEPAL (2021), Comision Economica para la America Latina, “Balance Preliminar de las Economias de America Latina y el Caribe – 2020,” repositorio.cepal.org.
Falcon, R. et. al., (2021), “Tarea Ordenamiento: nuevas medidas de carácter salarial y actualización sobre precios y tarifas,” cubadebate.cu, 12 marzo 2021.
IMF (2021), International Monetary Fund, World Economic Outlook, April 2021.
Mesa-Lago (2021), “La unificación monetaria y cambiaria en Cuba: normas, efectos, obstáculos y perspectivas,” Documento de Trabajo. 5 de febrero de 2021. Real Instituto Elcano.
Monreal (2021), Pedro Monreal, “Cinco hipótesis sobre los desconcertantes precios agrícolas del ordenamiento,” elestadocomotal.com, abril 12, 2021.
ONEI (2016), Oficina Nacional de Estadística e Información, Anuario Estadístico de Cuba 2015, Edición 2016.
ONEI (2020), Oficina Nacional de Estadística e Información, Anuario Estadístico de Cuba 2019, Edición 2020.
Rodríguez (2021), José Luis Rodríguez, “La economía cubana en 2020 y perspectivas de 2021. Una evaluación preliminar (IV).” Cubaperidistas.cu, febrero 2, 2021.
Vidal (2021), Pavel Vidal, “Cuba’s New Monetary and Exchange System: How are They Progressing?” ASCE Webinar, February 2021.
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