Prepared by Sergio Martin.
In Nicaragua, given the historically high levels of inflation, the exchange rate pass-through has been very large. Choudhri and Hakura (2001) find in a cross-country study that in general, the higher the inflation rate, the larger the exchange rate pass-through. Urcuyo and Rodriguez (2003) in a study of the Nicaraguan economy report a complete pass-through of the exchange rate to prices with a speed of adjustment of 50 percent within two months and the rest within almost a year. As a consequence, the authors conclude that movements in the nominal exchange rate have little impact on the real exchange rate.
Real GDP grew at annual average rate of 2.7 percent during 1960-04—roughly the same as population growth.
A study by Papaioannou (2003) finds that exchange rate regime choices in Central America are related to long-run determinants that are relatively stable over time, such as openness, size of the economy, degree of economic development and geographical concentration of trade. In general, the Central American economies are small, very open, with a low level of economic development, and high concentration of trade with the United States.
The nominal anchor is the exchange rate of the cordoba with respect to the U.S. dollar reflecting in part the role of the U.S. as Nicaragua’s most important trading partner and source of large remittance and other capital inflows. The exchange rate system operates on the announcement of some percentage of nominal depreciation at the beginning of the year, which is applied proportionally on a daily basis. At the given daily exchange rate, the central bank sells or buys any amount of foreign currency with a fee of 1 percent.
Reserve requirements are set at 16.25 percent on both domestic and foreign currency deposits. In recent years, banks have maintained excess reserves at the central bank of about 1-2 percentage points of deposits, despite the fact that reserve requirements are not remunerated. Banks had chosen not to transfer the funds abroad because the fees and commissions involved were higher than the interest rate they could earn abroad. However, this situation could reverse with rising international interest rates.
The banking system is small and highly concentrated with the largest bank accounting for ¼ of system assets.