The informal foreign exchange market in Cuba

The currency and exchange rate debate has become part of the citizens’ agenda in Cuba. One of the least addressed elements is the collateral consequences of the balance of payments crisis and the delay of the financial system to accommodate the profound changes in consumption patterns and the growing heterogeneity of the national productive fabric. In recent weeks, while there’s an ongoing campaign readying us for the unification of the currency and the exchange rate, national television has incorporated the crimes related to the purchase and sale of foreign currency.

Informal foreign exchange markets (IFEM) are a common phenomenon in the underdeveloped world and are not so new in Cuba. They have experienced great growth in recent years, beginning in the 1990s, precipitated recently from an acceleration of partial re-dollarization, the inconvertibility of national currencies, the phenomenon of what are known as “mules” (persons who import products not readily available on the Island) associated with chronic shortages in large segments of domestic consumer markets, and the opening of a network of foreign exchange stores.

For a long time, the informal exchange rate remained relatively stable, but this changed around the summer of 2019, when for the first time since the replacement of the US dollar by the CUC, the value of the U.S. currency exceeded the convertible peso. However, previously there were signs that indicated an increase in the volume and organization of the IFEM.

The establishment of the 10 percent tax when exchanging dollars created incentives for agents to continue operating in the IFEM. The tax widened the gap between the sale and purchase price of the dollar in the official market, and IFEM operators settled there, offering a more profitable exchange rate for buying and selling foreign currency. Likewise, the partiality of the economic reforms concerning the private sector and the restrictions on domestic supplies contributed to the expansion of transactions in the informal markets for goods and currencies.

As of 2011, the private sector in Cuba has re-opened without adequate material and regulatory conditions. The absence of a wholesale market, scarce access to bank credit, and a tax system that incentivizes tax evasion contributed to the fact that part of the operations of private agents passed through informal channels to achieve them and avoid scrutiny of the authorities.

Added to this are the deficiencies in domestic supply in terms of volume, variety and competitive prices, which constituted an opportunity for merchants (mules) to fill the gap between domestic supply and demand by importing products in an informal manner. In 2018 alone, there were 458,656 Cubans who traveled to recognized shopping destinations. They are: Mexico (169,230), United States (116,437), Guyana (74,209), Panama (51,710), Russia (26,944), and Ecuador (20,126).

This has become an important vehicle for meeting the consumption and investment needs of families and non-state management entities, respectively. Some estimates, such as those made by the consulting firm The Havana Consulting Group, affirm that in 2018 ‘mules’ imported 1.5 billion dollars. Which represents 65 percent of the total consumer goods officially imported by Cuba. However, others report that total imports in this manner totaled $512 million in 2018. That figure rises to 732 million if we take into account the data on re-exports to Cuba ($335.5 million) reported by authorities of the Colon Free Zone. This represents between 22.18 percent and 31.7 percent of the official figure for imports of consumer goods. The volume is large enough to find channels to flow through and continue its reproduction.

Then we can affirm that the IFEM emerges as a counterpart to several fundamental evils of the economic model: the lag of the financial system, together with the monopoly of foreign trade and its reflection in the structure of the supply of consumer goods and capital in the face of a productive panorama that becomes more heterogeneous. The demand for balance denominated in foreign currency is satisfied by two main sources of supply: tourism and informal remittances.

The diversion of part of the tourism income towards the informal sector was due to factors that had nothing to do with the insertion of private actors in accommodation and extra-hotel services (e.g., transportation services, restaurants, tourist tours, etc.), the change in the structure of tourist issuing markets in favor of a greater number of US visitors and the Cuban emigrant community, who, due to their characteristics, provide foreign currency directly to households and family members. According to the Cuba-United States Economic and Commercial Council, U.S. cruise passengers alone spent an estimated $64 million on transportation, excursions, restaurants and souvenirs in the 2016-2018 period. Finally, there’s the limited development of electronic payment methods, as well as the restrictions on financial flows associated with the U.S. sanctions. This implies that tourists handle their domestic transactions in cash.

In turn, a considerable volume of the remittances received by domestic residents travels through informal channels. This is a because the largest community of Cuban emigrants resides in the United States, a country that imposes sanctions that limit remittances while increasing their cost as they flow to Cuba. For this reason, members of the emigrant community residing abroad prefer to send money through safe and less expensive ‘mules’, rather than transferring money through remittance agencies.

However, since the end of last year there has been an unusual increase in demand for foreign exchange in the IFEM. First, due to the creation and expansion of the domestic supply of goods denominated in freely convertible currency (MLC). Second, because the financial system is limited in its ability to offer foreign currency to the population as of the new measures are adopted. Therefore, those consumers without access to foreign exchange turn to the IFEM in order to buy in the MLC stores.

The above factors coincided in time with a worsening of the shortage in the network of stores in Cuban Pesos (CUP) / Cuban Convertible Pesos (CUC) and the decrease in tourist income due to the current health crisis. Therefore, the demand for foreign currency increases due to the need to go to the stores in MLC to access consumer needs as a result of supply shortages. As a result, the price of the Dollar in the IFEM has reached a record high of around 1.50 CUC / USD in the summer of 2020.

Circumstances point to an increase in the prominence of this space in transactions by the population with pernicious effects on the purchasing power of national currencies and the decision-making of agents, given the current high volatility of the informal exchange rate. Pressures on the domestic currency will only increase due to the uncertainty of the monetary outlook.

Therefore, any scenario that contemplates a reduction in the size of the IFEM must include measures with a comprehensive approach, taking into account the shortcomings previously announced, and that go far beyond monetary issues. These should be based on indirect regulation methods, as opposed to administrative controls that would exacerbate the imbalances expressed in the IFEM. For this, the reestablishment of the financial system’s capacity to offer convertibility to national currencies through the official exchange market, to which families and private producers have access, is a necessary condition.

These measures should not be separated from the broader reform of the monetary and foreign exchange environment, and from other structural measures to increase productivity and improve external competitiveness. Keep in mind that the problems of balance of payments will always generate difficulties for the domestic currency. What is clear is that two currencies without convertibility is an absurdity that makes no sense. The criminalization of informal operations does not solve a problem that, again, is economic. The experience of other contexts is overwhelming in this regard. To the extent that the domestic productive fabric is integrated, something that is desirable, makes it necessary to adequately channel the demand for foreign exchange from the private sector.

Ricardo Torres is an economist and professor at the University of Havana. Michel Seguí is studying economics at the University of Havana.