Photo: Sadiel Mederos.

Do Cuba’s MSMEs Inflate the Dollar?

28 / julio / 2023

The value of the US dollar continues to increase on Cuba’s informal market. In June, it passed 200 pesos and in July, it continued to increase alongside the Euro and the magnetic MLC. A new argument is beginning to emerge to explain the trend at bureaus de change, linked to MSME’s demand for foreign currency to import goods. 

The operation of bringing containers full of products from different places, selling them on the national market in Cuban pesos, and then using these pesos to buy dollars and be able to restock, thereby closing the economic cycle seems to be reaching alarming levels on the illicit market for foreign currency. 

Once again, MSMEs are at the heart of the controversy. Just a few weeks ago, social media was flooded with discussions, articles and comments with different views on their economic contribution, relationships with the Government, their importance for political change and their relationship with out-of-control inflation that is stifling the country.

Right now, MSMEs appear to be responsible for speeding up the devaluation of the Cuban peso, a highly-sensitive issue for the everyday life of Cubans, with significant consequences for the way markets and domestic finances work.

The vast majority of economists have tried to argue in favor of MSMEs’ economic importance in the past, trying to explain the root causes of inflation and to draw people’s attention to the diversity of this sector. But faced with this new accusation, it’s hard for economic analysis to prove them innocent. However, there are a series of extenuating circumstances that need to be considered to be completely fair with this sentence.

Foreign imbalances and the “dirty” economy

Bringing in imported containers to sell products on the domestic market is a normal and necessary part of any economy. Import operations involve a currency exchange, unless the domestic market is completely dollarized. This isn’t the case in Cuba, where the economy is only partially dollarized. 

The implications of these operations on the exchange rate depend on many factors, most of which are linked to foreign and domestic economic imbalances.

Imports, and foreign currency purchases involved, don’t have to devalue the exchange rate if the balance of payments is healthy; in other words, if you have enough foreign currency coming in by means of exports, remittances, or international funds. 

Everyone knows that Cuba’s balance of payment has been imbalanced since before the COVID-19 pandemic. Exports have been consistently dropping since 2014 because of the ripple effect of the Venezuelan crisis, harsher US sanctions, the pandemic itself and because there aren’t reforms to organize a sustainable framework for the country to participate in international trade based on the competitiveness of its industries and not political alliances. 

Amidst the currenct balance of payment crisis, which led to a 50% drop in exports, the Cuban State stopped paying its international debt, yet again. Cuban businesses and banks have steadily been losing the trust of foreign suppliers and creditors. 

Private MSMEs were born amidst this landscape and the Government allowed them to begin to take part in foreign trade operations; which is a crucial step to transform the State’s out-of-date and incompent monopoly system. 

The private sector has been able to do this despite not having ample experience, without formal access to funds and foreign currency, with all of the restrictions imposed by the US Government’s sanctions, and without the support of a direct payment system via banks. Despite this, MSMEs have been able to organize themselves, have opened up alternative channels and have taken on risks to make sure international goods can reach the domestic market, thereby (partially) easing chronic shortages on the national market.

Out of all the ingredients that make up this unusual landscape in which MSMEs import goods, we need to emphasise their lack of access to foreign currency on the formal market. 

When state-led businesses import, they receive foreign currency from the State’s centralized resource allocation system. Foreign currency on the formal market comes from exports of nickel, sugar and other raw materials, tourism, exports of medical services and international funding. All of these revenues have dropped significantly. The formal market in foreign currency has been operating with a greater imbalance. 

Foreign currency obtained by the private sector via the formal market is financially irrelevant compared to the value of their imports. As a result, a significant part of demand for foreign currency on the formal market has been unloaded, and moved towards the illicit market. The containers that were once paid for with dollars from the formal market are now being sought on the “parallel, underground and dirty” economy.

The informal economy is an encumbrance to economic development in any country and public policies need to try and stop and reverse it. But before throwing regulations, inspectors, police officers and discourse at the issue, we must be objective and transparent when explaining why it exists and take action to address this first. 

The parallel economy can’t be studied without the shortcomings of the 2021 currency reform and foreign and domestic imbalances. The State is extremely responsible for this because of its unbalanced budget, hundreds of nonviable businesses and its unwillingness to expand structural reform.

Restructuring foreign trade with greater participation of the private sector, even when it was a decision made in a moment of desperation and without any other choice, is a reform that should continue. This is because it favors competition and diversifies and expands access channels to the international market. It’s a display of everything initiatives and private businesses can do, even in an adverse situation.

There are lots of issues that still need to be regulated and organized though. It would be very helpful if the Biden Administration implemented the changes that have been suggested to US sanctions, to promote the Cuban private sector. The Cuban Government needs to implement the Macroeconomic Stability Program. Greater competition, less barriers at the beginning and a greater formalization will have an impact on low profit margins.

Domestic imbalances and the inflation/devaluation cycle

The main domestic imbalance in Cuba’s economy is the difference between revenue and expenditure in the State budget. Since 2015, the fiscal deficit has always been over 5% of the GDP (experts recommend a deficit under 3%). In 2017 and 2018, it was higher than 8% of GDP, in 2020 it reached 17.7%, and in 2021 and 2022 it is still above 11%. 

This excess in State expenditure is mostly financed by the Central Bank issuing more money (monetization), which goes hand-in-hand with an excessive increase in money liquidity. More money in circulation with less national production has two results. First of all, excessive demand in the country pushes domestic prices to increase further. Secondly, it increases imports, the demand for foreign currency and devalues the exchange rate. 

The first result is quite well-known, but the second effect is ignored a lot of the time and helps to explain what has been happening with MSMEs and exchange rates on the Cuba’s informal market.

More Cuban pesos circulating artificially increases the buying power for containers of imported goods. Once MSMEs sell their goods in pesos, and go out to look for foreign currency back, that’s when the reality check comes for Cuba’s financial system: there aren’t sufficient dollars in the economy to satisfy this demand for imported goods. 

How is this gap filled? The dollar becomes more expensive and things are put in order again. Nominal values are adjusted to the real values that correspond to the real economic situation, household incomes and the balance of payment. The parallel exchange rate tells us every day just how poor the country is in terms of dollars.

Out-of-control inflation feeds a constant cycle of interdependence with exchange rate devaluation. The devaluation of the peso increases the price of imported goods and supplies, which is passed on to retail prices to the final consumer. Meanwhile, higher inflation motivates MSMEs to continue bringing in containers to sell on the national market, thereby taking advantage of high prices. Greater imports mean more demand for foreign currency and a greater devaluation. And the cycle goes on…

Constant and high inflation has been cancelling the real devaluation of national currency that occurred right at the beginning of currency reform in 2021, which reduced the potential positive effects on exports and replacing imports. 

In other words, when domestic prices increase (inflation) at a higher rate than exchange rates on the illicit market (devaluation), MSMEs aren’t motivated to produce, export and substitute imports, but rather to flood the domestic market with imported goods instead. The price they sell products for in pesos is going up higher than costs to import it in foreign currency. Rampant inflation allows MSMEs to make a profit in pesos on the domestic market, which they then use to go out and buy foreign currency “at any price”, thereby inflating the value of the dollar.

How do you break this cycle? Following the root causes of inflation. 

In the last session of the National Assembly, lawmakers recognized that the solution to inflation comes from production and reducing the fiscal deficit. They said that economic measures are more sustainable than administrative ones. But then statements came from political leaders that instilled fear in any business owner that wants to take a bet on producing in the Cuban economy. On the other hand, the Ministries of Agriculture and Economy and Planning didn’t identify any substantial plans to drive production. The way things are looking right now, there’s still a long way to go for the exchange rate on the illicit market.

This article was translated into English from the original in Spanish.

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